EU The New Regulation on Credit Rating Agencies is Published in the Official Journal of the European Union 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 credit rating agencies (“CRAs”) was published in the Offi- cial Journal of the European Union on November 17, 009 and Entry into Force became effective, subject to certain exceptions, on December The following are the main transitional provisions set 7, 009. The Regulation represents a fundamental change in out in the Regulation: the regulatory landscape for CRAs, banks 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, 009; • 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, 010; authorities of Member States over CRAs and their activi- • CRAs operating in the EU before June 7, 010 (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 interest 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, 010; • 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 finance 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 Financial Services 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 derivative products (including disclosure, and (ii) certain ratings issued by central banks. credit default swaps, credit linked notes, total return swaps, Credit ratings to which the Regulation applies cannot currency and interest rate 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 debt obligations, both cash and synthetic) • such ratings are issued by a CRA established in the EU and securitization transactions (including securitizations of and registered under the Regulation; or residential and commercial mortgages, auto loans, 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 structured finance 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 1 11 EUROWATCH® January 15, 010 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. 1 EUROWATCH® January 15, 010 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