Credit Rating Agencies defined

As is the case with hedge funds,²⁵ the answer to what credit ratings actually are, depends on whom one asks. Younglai and da Costa regard the role of CRAs as being “little different from a credit bureau that hands out [credit] scores to individuals and households”.²⁶ In Jefferson County School District v. Moody’s Investor Services, Inc., the court ruled that it was necessary for the plaintiff to identify a “more specific statement [by Moody’s] … to demonstrate that Moody's implied statement about its creditworthiness is provably false”.²⁷ Furthermore, the use of terms like "negative outlook" and "on-going financial pressures" by Moody’s in the rating opinion, for example, were deemed by the court to not be necessarily too indefinite to imply a false statement of fact – as long as they were not used in conjunction with factual assertions. Because the distinction between fact and opinion is oftentimes a faint one requiring qualitative interpretation, its legal implications are significant and hence attaining clarity from the onset on the specific definition of what ratings are is of great importance.

2.1.1. Definition of credit ratings according to the SEC

According to the Securities and Exchange Commission (hereafter, SEC), a credit rating agency is “a firm that provides its opinion on the creditworthiness of an entity and

25 E.g., Russell Mutingwende, Hedge Funds: The Protean Survivalists, 13 (unpublished comment, on file with the Institute for Law and Finance, Goethe University, 2006). See also, Johann A. van Rooyen and Russell Mutingwende, Information Disclosure and Regulatory Issues: A Survey of South African Hedge Funds, 4 J.CORP.OWNERSHIP &CONTROL (4), 74-80 (2007).

26 Rachelle Younglai & Anna da Costa, When Rating Agencies Judge the World – an Analysis, INSURANCE J., Aug. 3, 2011, http://www.insurancejournal.com/news/international/2011/08/03/209191.htm.

27 175 F.3d. 848, 850-51 (10^th Cir. 1999), at 34 n.31.

the financial obligations (such as, bonds, preferred stock, and commercial paper) issued by an entity. Generally, credit ratings distinguish between investment grade and non-investment grade”.²⁸ The greater significance of this definition lies in the SEC’s mission

“to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”.²⁹

The SEC’s mandate to facilitate capital formation has historically at times required its Commissioners to take leaps of faith when permitting new technologies and products, possibly even long before they themselves have gained expert knowledge and understanding about what they were legislating into existence. The Credit Rating of Cashflow Securities Concept Release of September 1994³⁰ highlighted some of the unconventional challenges faced by the SEC in terms of their duty to consider and evaluate new techniques and approaches adopted by market participants. For instance, upon being informed that certain NRSROs had developed techniques to rate the likelihood of a specified dollar payment by the maturity date without regard of whether such payment amount constituted an interest of a principal repayment, and noting that these new instruments constituted both a credit rating and a non-credit rating element, the SEC

28 SEC, ‘NRSROs’, http://www.sec.gov/answers/nrsro.htm (last accessed Sept. 16, 2014); Compare, CESR, IOSCO Code of Conduct’s definition: [A credit rating] “is an opinion regarding the

creditworthiness of an entity, a credit commitment, a debt or debt-like security or an issuer of such obligations, expressed using an established and defined ranking system”,

http://www.esma.europa.eu/system/files/CESR_08_277.pdf (last accessed May 23, 2016).

29 SEC, ‘The Investor's Advocate’, at http://www.sec.gov/about/whatwedo.shtml (last accessed May 23, 2016). Similarly, the ESMA’s mission is to ensure “[i]ntegrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection”,

http://www.esma.europa.eu/page/esma-short (last accessed March 15, 2015).

30 E.g., of mortgaged backed securities

acknowledged that despite representing “a departure from traditional rating techniques”, it was one which the Commissioners were required to evaluate.³¹

The SEC has until recently appeared to regard CRAs as a semi-autonomous extension of its own regulatory infra-structure³² in that it has accepted the predominant role and function of CRAs as being that of providing “credit ratings [that] distinguish between investment grade and non-investment grade”.³³ For their part, CRAs only proclaim their ratings to be just one of several tools that investors should use when making their investment decisions, and in particular emphasize that the ratings are only opinions on the relative credit quality of a security.³⁴ In addition, CRAs also concede that their ratings generally ignore other relevant information necessary for diligent investment decision-making such as “changes in money rates and general economic trends, as well as by the length of maturity …[]”.³⁵

31 SEC Release No. 33-7085; 34-34616; IC-2050, 3 (International Series Release No. 706. File No. S7-23-94, Aug. 31, 1994).

32 David Segal, Debt Raters Avoid Overhaul After Crisis, N.Y.TIMES, Dec. 8, 2009 “[B]ut we don’t want to kill the institutions (i.e. CRAs) because we have nothing to replace them with”, [Representative Paul E.

Kanjorski, Democrat of Pennsylvania, the Chairman of the Financial Services Sub-Comm]”., available at http://dealbook.nytimes.com/2009/12/08/debt-raters-avoid-overhaul-after-crisis/ (last accessed May 23, 2016)

33 SEC, ‘NRSROs’, http://www.sec.gov/answers/nrsro.htm

34 See e.g., Daniel Indiviglio, Rating Agency Liability Wouldn't Have Prevented the Crisis, THE ATLANTIC, Dec. 9, 2010 (CRA ratings are “…not infallible gospel.”)

http://www.theatlantic.com/business/archive/2010/12/rating-agency-liability-wouldnt-have-prevented-the-crisis/67810/ (last accessed May 23, 2016).

35 Moody’s, Limitations to Uses of Ratings, http://www.moodys.com/ratings-process/Ratings-Definitions/002002 (last accessed May 23, 2016).

2.1.2. Definition of credit ratings by the Big Three Credit Rating Agencies Moody’s, S&P and Fitch have each developed ‘boilerplate’ definitions of the role and function of credit ratings which go a long way towards highlighting the gap³⁶ in their interpretation compared to that adopted by the SEC. Although uniquely customized, the three firms’ definitions still follow very similar themes. These themes are summarized in general below:

They state that credit ratings do/are:

▪ Opinions on the relative ability of an entity to meet its financial commitments, such as interest, preferred dividends, and repayment of principal.

▪ Relied upon as indicators of the likelihood of receiving the money back in accordance with the terms under which it is invested.

▪ Express risk in relative rank order, they are ordinal measures of credit risk³⁷ and are not predictive of a specific frequency of default or loss.

▪ Diligent efforts at looking at the "worst" possibilities in the "visible" future, rather than solely at the past record and the status of the present.

They state that credit ratings do/are not:

▪ Address any risk other than credit risk.

36 Stephane Rousseau, Enhancing the Accountability of Credit Rating Agencies: The Case for a Disclosure-Based Approach, 51MCGILL L.J., 620, passim (2006).

37 Standard and Poor’s, The Fundamentals of Structured Finance Rating, at 10 (“Ratings are ordinal, not cardinal, in that they rank issues in order of relative credit risk, but do not specify any particular expected default”) (2007), www2.standardandpoors.com/spf/pdf/fixedincome/Fundamentals_SF_Ratings.pdf (last accessed, Sept. 16, 2015)

▪ Forecast absolute probabilities of default and therefore are not guarantees of credit quality or of future credit risk.³⁸

▪ Deal with the risk of a market value loss on a rated security due to changes in interest rates, liquidity and other considerations.

▪ Have any value in forecasting the direction of future trends of market price.

▪ Investment advice, neither are they "buy, hold, or sell" recommendations.

They are just one factor investors may consider when making their investment decisions. For example, on its “Limitations to Uses of Ratings” section, Moody’s website cautions that: “During its life even the highest rated bond may have wide price movements, while its high rating status remains unchanged”. ³⁹

As was shown above, in terms of wording, there is apparently little difference in terms of the SEC’s definition when compared to those of the Big Three. While all four definitions reiterate that the role of credit ratings is to provide an opinion on the creditworthiness of debt securities, it is the SEC’s definition and interpretation of (i) what credit ratings are, and (ii) how they are used, that is preeminent and thereby supersedes those held by CRAs. Accepting the SEC’s definition of a credit rating agency as provided above, it then follows that a closer review of the creation of the NRSRO status as well as the role that the selective awarding of the designation played in both establishing and maintaining the existing market structure from which current the contentions regarding NRSROs’ exemption from liability emanate, is necessary. In particular, an understanding of the NRSRO designation and its impact on the development of the CRA industry, sheds

38 Visitors to the S&P homepage requiring more information about Credit Ratings are directed in S&P’s handbook -- Guide to Credit Rating Essentials – What Are Credit Ratings and How do They Work? -- to visit two further websites: www.AboutCreditRatings.com, and www.UnderstandingRatings.com (last accessed May 23, 2016).

39 Moody's, About Moody's Ratings: Ratings Definitions,

https://www.moodys.com/Pages/amr002002.aspx (last accessed May 23, 2016

light on why investors and other market participants (elect to) rely on credit ratings in the first place as well as the basis upon which NRSRO-designated CRAs were exempted from liability.