EU

The New Regulation on Rating Agencies is Published in the Official Journal of the

By Nick Shiren and Marco Crosignani (Cadwalader, Wickersham and Taft LLP)

Introduction The Regulation takes a prescriptive, rules-based approach. The wait is over. The EU Regulation1 (the “Regulation”) Its complexity leaves many questions unanswered3. on agencies (“CRAs”) was published in the Offi- cial Journal of the European Union on November 17, 2009 and Entry into Force became effective, subject to certain exceptions, on December The following are the main transitional provisions set 7, 20092. The Regulation represents a fundamental change in out in the Regulation: the regulatory landscape for CRAs, and other market participants investing in rated products in Europe. The main aspects of the Regulation include: The Regulation [on credit rating • registration requirements for CRAs established in Eu- agencies] takes a prescriptive, rules- rope; • an endorsement and certification regime for ratings based approach. Its complexity leaves which are issued by non-EU CRAs and used in Eu- many questions unanswered. rope; • restrictions on the use of ratings by banks and other financial institutions for regulatory capital purposes to • subject as described below, the Regulation entered into ratings issued in compliance with the Regulation; force on December 7, 2009; • strengthened supervision by THE Committee of Euro- • the restriction on the use of ratings for regulatory capital pean Securities Regulators (CESR) and the competent purposes will enter into force on December 7, 2010; authorities of Member States over CRAs and their activi- • CRAs operating in the EU before June 7, 2010 (the “Exist- ties in Europe; ing CRAs”), which intend to apply for registration under • organizational and operational requirements including the Regulation, shall (i) adopt all necessary measures to independence, conflicts of rules, internal quality comply with the Regulation and (ii) submit their applica- control and compliance systems for CRAs; tion for registration, in each case, by September 7, 2010; • detailed disclosure requirements as to rating analysis, and methodologies, due diligence on underlying assets, • Existing CRAs may continue issuing credit ratings which models and key rating assumptions; may be used for regulatory capital purposes unless their • a new rating regime for structured instruments; registration is refused. and • continuing and periodic disclosure and transparency Registration, Endorsement and Equivalence obligations for CRAs. The Regulation applies to credit ratings issued by CRAs registered in the EU and which are disclosed publicly or Nick Shiren is a Partner in Cadwalader’s distributed by subscription. The Regulation does not apply Group. His practice focuses on complex financing transactions to, inter alia, (i) private credit ratings produced pursuant to involving a wide variety of asset classes. In particular, Nick an individual order and which are not intended for public has extensive experience in products (including disclosure, and (ii) certain ratings issued by central banks. credit swaps, credit linked notes, total return swaps, Credit ratings to which the Regulation applies cannot currency and swaps, repos and other complex be used for regulatory capital purposes by banks and other derivative instruments), structured credit transactions (includ- financial institutions in the EU unless: ing collateralized obligations, both and synthetic) • such ratings are issued by a CRA established in the EU and transactions (including of and registered under the Regulation; or residential and commercial mortgages, auto , credit • such ratings are issued by a CRA established outside the cards, aircraft leases and trade receivables). (nick.shiren@ EU if such ratings are “endorsed” by a CRA established cwt-uk.com) Marco Crosignani is an Associate in the Financial in the EU, registered under the Regulation and belonging Services Group of the London office of Cadwalader, Wick- to the same corporate group; or ersham & Taft LLP. His practice is concentrated on capital • in respect of foreign issuers or instruments issued in markets and transactions, including credit and equity derivatives, financial restructuring, collateralized third countries, such ratings are issued by a foreign CRA debt obligations (cash and synthetic) and funds. (marco. where the requirements of the “equivalence” regime are satisfied4. [email protected]) The New Regulation, continued on page 12

11 EuroWatch® January 15, 2010 EU

The New Regulation (from page 11) • disclose the names of their largest clients (i.e. represent- ing more than 5% of their annual revenue); The endorsement regime contains stringent requirements • maintain adequate records of their activities and con- including: flicts; • adequate evidence that equivalent regulation and super- • ensure that rating analysts and related third parties vision are effective in the third country; (including agents) do not invest in financial instruments • the foreign CRA is authorised and registered in such issued by any rated entity within “their area of primary third country; and analytical responsibility”; • cooperation arrangements are in effect between the EU and such third country5. The Regulation does not prescribe The equivalence regime also contains stringent require- ments including: specific penalties for breach. This is • the foreign CRA is authorized or registered in the third country; instead left to be determined by the • the Commission has adopted an “equivalence” decision Member States, raising the potential for recognizing the “legal and regulatory framework of that third country as equivalent to the requirements of [the] disparities between penalties levied by Regulation”; different Member States. • cooperation arrangements are operational between the EU and such third country; • the relevant credit ratings are not of “systemic impor- • operate a gradual rotation mechanism for rating analysts tance to the financial stability or integrity of the financial and persons approving ratings; and markets of one or more Member States”; and • ensure that rating analysts’ compensation is not linked • such CRA is certified according to the Regulation (subject to the revenue generated from the rating activity. to exemptions available in certain circumstances). In addition, CRAs are prohibited from: Strengthened Supervision • rating if such CRA or its analysts, directly or indirectly, CESR and the competent authorities of the Member States own financial instruments of the rated entity or a related where CRAs are established will supervise the rating activi- third party (subject to limited exceptions); ties of CRAs in Europe. Although the EU regulators will not • providing consultancy or advisory services to a rated be involved with the substance of the rating process, extensive entity or a related third party except for ancillary ser- powers relating to registration requirements, withdrawal and vices7; suspension of registration, supervision and enforcement are • making proposals or recommendations, either formally given to CESR6 and the national authorities. or informally, on the design of structured finance instru- ments8 which CRAs are expected to rate. Independence and Avoidance of Conflicts of Interest Transparency and Disclosure Requirements The Regulation imposes on CRAs duties of independence The Regulation introduces a comprehensive transpar- and avoidance of conflicts of interest including detailed or- ency and disclosure regime for CRAs. The relevant require- ganizational and operational requirements. ments include disclosure of: • methodologies, models and key rating assumptions Organizational Requirements (which must be based on historical experience includ- CRAs have to ensure that: ing back-testing) used in credit rating activities and any • credit rating activities are independent, including from material changes to any of these; all political and economic influences or constraints; • the likely scope of credit ratings to be affected by any • at least two independent directors are appointed whose changes to rating methodologies, models or key rating remuneration cannot depend on the business perfor- assumptions; mance of the CRA; and • when departing from a rating previously issued by • adequate on-going compliance policies and internal- another CRA, an explanation of the reasons for their control procedures are established. different assessment; • conflicts of interest and compensation arrangements; Operational Requirements and CRAs are required to: • an annual transparency report setting out, inter alia, the • identify, eliminate or manage and disclose, clearly and relevant CRA’s legal structure and ownership, internal prominently, any actual or potential conflicts of inter- control mechanisms, record-keeping policy and compli- est; ance functions.

12 EuroWatch® January 15, 2010 EU

Structured Finance Investments the Member State’s regulator for breach of the Regulation. More stringent (and controversial9) obligations are im- posed on CRAs in respect of the rating of structured finance Regulatory Powers and Due Process instruments, such as: The Regulation gives Member States and CESR far- • the use of rating categories that are “clearly differenti- reaching powers over CRAs and their activities in Europe. ated using an additional symbol which distinguishes In particular, the authorities of the relevant home Member them from rating categories used for any other entities, State and, in certain circumstances, the authorities of the financial instruments or financial obligations”; other Member States where a rating is used, may, if it has • the disclosure of all information relating to the CRA’s been established that a breach of the Regulation by a CRA loss and cash-flow analysis; has occurred: • the disclosure of the extent of due diligence carried out • withdraw such CRA’s registration; by the CRA on the underlying assets and the extent of • impose a temporary prohibition on such CRA issuing their reliance (if any) on a third party assessment; ratings; and • the provision of guidance that explains assumptions, • impose a suspension on the use of its credit ratings for parameters, limits, and uncertainties surrounding the regulatory purposes throughout the EU or in the relevant models and rating methodologies including simulations Member State. of stress scenarios, in a clear and comprehensible way; and • the disclosure, on an ongoing basis, of information about The authorities of the Member States all structured finance instruments submitted to CRAs for their initial review or for a preliminary rating, irrespec- will have extensive powers to access tive of the final rating. documents from CRAs, demand

A statutory duty “not to rate” or to withdraw an existing information and carry out on-site rating has been expressly provided by the Regulation where inspections without announcement. “the lack of reliable data or the complexity of the structure of a new type of or the quality of informa- tion available is not satisfactory or raises serious questions The authorities of the Member States will also have as to whether a credit rating agency can provide a credible extensive powers to access documents from CRAs, demand credit rating”. The effect and enforceability of such a duty is information and carry out on-site inspections without an- questionable. nouncement. Many of these powers conferred on the authorities of the Regulatory Inefficiencies Member States and CESR may be exercised where the rel- The registration process and supervision procedures are evant Member State has “established that a registered credit complicated, involving all Member States where a particular rating agency is in breach of the obligations arising from this rating is used (deliberating through a college chaired by a Regulation”10 following notification to the facilitator and facilitator) and, at a higher level, CESR. These requirements consultation with the members of the college but without, have been criticized as being likely to create unnecessary at present, a right of CRAs to object or be heard. regulatory costs and inefficiencies, including: • overly registration or withdrawal discussions be- Impact tween the college and CESR; The impact that the Regulation will have on the credit • large numbers of Member States becoming members of rating business in Europe is potentially significant. Many the college, potentially affecting its smooth operations; aspects of the Regulation such as the rules on disclosure of and rating information and the conflicts of interest rules may • the potential interference between the regulators of dif- help to increase market efficiency and restore investor con- ferent Member States if they take conflicting decisions fidence. Other aspects of the Regulation such as the lack of or measures. due process, the procedural complexities and the perceived lack of global approach may increase regulatory inefficiencies The Regulation does not prescribe specific penalties for and costs. It is the explicit intention of the Regulation not to breach. This is instead left to be determined by the Member interfere with the substance of credit ratings. This raises the States, raising the potential for disparities between penalties question whether regulating the conduct of the credit rating levied by different Member States. These issues raise the risk business without supervising the merits and contents of the of regulatory . In determining their jurisdiction of rating activity itself, will prove to be adequate. o operations, CRAs are likely to take into account criteria in- cluding the sophistication and responsiveness of the Member 1. See Regulation (EC) No 1060/2009 of the European Parliament State’s regulator, their ability to cooperate with other regula- and of the Council of 16 September 2009 on credit rating agencies tors within the EU and overseas and the penalties imposed by The New Regulation, continued on page 14

13 EuroWatch® January 15, 2010