THE EU CREDIT
RATING AGENCY
LIABILITY REGIME
“Certainty is so essential to a law that a law without it cannot be just. A law ought to give warning before it strikes, and it is a true maxim that the best laws leave least to the breast of the judge” Sir Francis BaconName: T.R. Waterloo Student number: 5811090 Date: 1-2-2016
Master: Privaatrecht, Commerciële rechtspraktijk Supervisor: Prof. Marcel Peeters
Table of Contents
Introduction p. 3
1. Market Rationale for Credit Rating Agencies p. 5
1.1 Bond markets p. 5
1.2 Structured finance markets p. 6
1.3 Conclusion p. 7
2. Regulatory Reliance on Credit Rating Agencies p. 8
2.1 Conclusion p. 9
3. The Global Financial Crisis p. 10
3.1 Conclusion p. 11
4. Difficulties Regarding Credit Rating Agencies p. 12
4.1 Structured finance p. 12
4.2. Conflicts of interest p. 14
4.3 Due diligence p. 15
4.4 Oligopoly p. 15
4.5 Conclusion p. 16
5. The Regulatory Regime in the European Union for Credit Rating Agencies p. 17 6. The EU Civil Liability Regime for Credit Rating Agencies p. 20
6.1 Goals of the new civil liability regime p. 20
6.2 Status of Article 35a CRAR p. 20
6.3 The new civil liability regime p. 21
6.4 Limitations in advance on CRA liability p. 24
6.5 Alternative actions p. 24
6.6 The rationale of the Article 35a CRAR civil liability regime p. 24
6.7 Conclusion p. 25
7.1 Scope of Article 35a CRAR p. 27
7.2 References to national law p. 28
7.3 Burden of proof p. 28
7.4 Qualification and quantification of damages p. 29
7.4.1 Qualification of damages p. 29
7.4.2 Quantification of damages p. 29
7.5 Competent court and applicable law p. 30
7.6 Conclusion p. 33
Overall Conclusion p. 34
Introduction
Credit Rating Agencies (CRAs) are commercially driven private companies that offer opinions about the creditworthiness of issuers or of an issuance, mitigating existing information asymmetries in debt and structured finance markets. They had been left to voluntary codes and self-regulatory regimes for the most part up until the Global Financial Crisis (GFC) while at the same time regulators had awarded them increasingly greater roles in prudential regulations worldwide. Since ratings were considered ‘opinions’ CRAs could not be held liable in the United States. CRAs were protected by the First Amendment. Reputational capital had been viewed as a strong enough incentive for CRAs to provide accuracy in their ratings.
In the years leading up to the GFC in 2007/2008 Structured Finance Products (SFPs) became increasingly complex but also gained in popularity. SFPs were designed to get high ratings that were necessary in order to sell to institutional investors and big profits were made by CRAs. The higher the ratings the more money was made and CRAs seemed less concerned with their reputations. The ratings awarded to structured finance products proved to be too optimistic and when the housing market deteriorated, financial markets collapsed and suffered huge losses.
Regulators and markets did not see this coming. The systemic importance of CRAs had now become painfully clear and they were dealt a big part of the blame for the GFC. In the wake of the GFC regulators have been in a rush to regulate the CRAs, supervise them, and making it possible for investors to actually hold CRAs liable for their actions. EU regulators
introduced a CRA civil liability regime in 2013 when amending the CRA Regulation (CRAR) for the second time in 4 years.
In my thesis I want to investigate whether this newly introduced civil liability regime for CRAs in the EU is compatible with basic legal principle of legal certainty and economic principles since most of the financial regulations after the GFC have been crisis driven and quickly designed. My research question is:
Is the EU CRA civil liability regime compatible with the basic legal principle of legal certainty.
I will start my thesis by setting out the market rationale for CRAs and the role they played in capital markets through prudential regulations. Do we need CRAs?
I will then discuss the GFC and problems regarding CRAs that may have contributed to things spiraling out of control. What kind of factors may contribute to the inaccuracy of CRAs’ ratings?
I will set out the CRA regime that was introduced in the EU after the GFC and zoom in on the new civil liability regime of Article 35a CRAR. Following will be my analysis of whether Article 35a CRAR is compatible with basic legal principle of legal certainty.
This thesis is of a descriptive and analytical nature. Sources used for my thesis contain the EU Regulatory framework for CRAs, other relevant sources from EU Institutions, legal and economic literature and research.
1. Market Rationale for Credit Rating Agencies
In finance the biggest uncertainty is whether a borrower can repay his loan. This is the credit risk of the lender. One aspect of the credit risk of a lender is asymmetric information. The borrower generally has more information about whether he will be able meet his obligations to the lender than the lender himself.
To mitigate the risk of a borrower defaulting on its loan lenders will want to gather information about the borrower before extending a loan. Lenders further want to keep a close eye on the borrower from then on so they can monitor whether a borrowers actions might put them at risk to default.
At its core a bond is a loan. The bond issuer is the borrower and the bond buyer in primary markets is the one extending the loan. The primary bond markets are mostly institutional markets and therefore not easily accessible to retail investors.1 In the primary bond market
decisions are made by bond managers at financial institutions and the risk of not getting repaid plays a central role.2
Credit Rating Agencies (CRAs) play an important role in the debt and structured finance markets. They mitigate the existing information asymmetry when it comes to bonds or Structured Finance Products (SFPs). They collect and analyze information about the issuers (governments, corporations) or underlying assets of SFPs and they offer ‘opinions’ about the creditworthiness of the issuer or more specific to an issuance.
The ‘opinions’ about the likelihood of default further provide a way to put a price on credit risk.3 The higher the risk, the higher the yield. The opinions CRAs give out are in the form of ratings4 which are based on proprietary methodologies analyzing issuers or financial
instruments and categorizing them by giving them grades which represent their risk. This helps market participants to assess risks through standardized risk indicators.5
A strong clue to the market rationale of CRAs is provided when taking a closer look at the bond and structured finance markets.
1.1 Bond markets
The bond market is very large in volume and number of issuers.6 The size of the bond market presents a problem of efficient allocation of research resources. The greater volume and
1 White 2010, p. 4. 2 White 2010, p. 4. 3 Moloney 2014, p. 634.
4 AAA through BBB ratings qualify as ‘ investment grade’. BB or below are of speculative quality (junk bonds). 5 White 2010, p. 7.
6 “As of the second quarter of 2012, the total capitalization of the global capital markets was $225 trillion (Lund
et al., 2013). The following is a breakdown of financial asset classes by dollar volume (in $ trillion) and percentage of the total capitalization. Equities $50 (22%). Government bonds $47 (21%). Financial bonds $42
number of issuers in the bond markets assures that credit analysis would seize a significant portion of the available research resources by investors in the absence of rating agencies. There is a significant amount of information that needs to be processed.7
Without rating agencies investors would have the option to not even consider the bond market at all, to only cover part of the bond market, or cover the entire bond market by researching and processing relevant information themselves or in cooperation with other investors.
Not considering bond markets at all is an unrealistic option since the biggest part of investments in financial assets are in fixed income instruments.8
If a bond manager would have to do his own research with limited research resources coverage of the entire credit market would be an impossible task. He would then only be able to focus on certain categories of bonds. Considering only part of the bond market would not only limit the investor in being able to select the best investment options for himself but also misallocate resources instead of promoting a broader more liquid credit market which would make this an undesirable option.9
Bond investors cooperating in researching resources is not a realistic option either. A CRA type third party is preferable since there might be problems of coordinating the activities. Problems like how much should each investor contribute to the research activities can arise. Free-riding might become an issue which then in turn would also need to be addressed. Sharing market intelligence amongst parties that compete with each other may further cause problems because information may deliberately be manipulated and no longer be accurate. A dual incentive problem: sharing information means giving away competitive advantages and also exposes the honest investor to manipulation by others for short-term counter-trades.10
1.2 Structured finance markets
Structured finance activities usually consist of the pooling and tranching of (illiquid)
economic assets (e.g. different types of loans, bonds, mortgages, credit card payments etc.) followed by an issuance of securities by a Special Purpose Vehicle (SPV).11 SFPs tend to be
complex and investigating or analyzing risks of these securities requires expertise which may be another reason to outsource this task to CRAs that employ analysts that are equipped to perform this task.
(19%). Corporate bonds $11 (5%). Securitised loans $13 (6%). Non-securitised loans $62 (28%).” See Rhee 2015, p. 165.
7 Rhee 2015, p. 165. 8 Rhee 2015, p. 165. 9 Coffee 2011, p. 275. 10 Rhee 2015, p. 165.
1.3 Conclusion
The scope and scale of research capabilities of CRAs are hard to match by a single investor or group of investors. Even if possible to match this would be undesirable. If every investor would conduct the same research, process and assess the same data, this would be
duplicative, wasteful thus inefficient.12 It would take away the limited research capabilities from investors that could have been better used elsewhere like analyzing equities to invest in or assessing investment options beyond the basic information about creditworthiness. Organizing and assessing all available information on the entire global credit market is an enormous task which is preferably outsourced to an objective third party like a CRA. This allows investment decisions to be conducted in a more efficient manner.13
The three big CRAs (S&P, Moody’s, Fitch) employ over 3500 credit analysts.14 They meet a market need by facilitating market efficiency. As specialized firms with expert analysts CRAs produce credit analysis covering the entire credit market. They promote an efficient use of information by systemizing it through a uniform set of ratings making it easier for market participants to compare issuers and financial products and make informed investment decisions. Ultimately information is key in capital markets to optimally allocate resources and to adequately price credit risk.15
12 Coffee 2011, p. 275. 13 Rhee 2015, p. 165. 14 Rhee 2015, p. 167. 15 Rhee 2015, p. 170.
2. Regulatory Reliance on Credit Rating Agencies
Another factor added to the significance of the role of CRAs in financial markets. As a
reaction to the ‘Panic of 1930’16 in the United States regulators in the United States changed prudential regulations encouraging banks to mainly invest in ‘safe’ bonds. In 1936 banks in the United States were even further restricted by a federal regulatory prohibition to invest in ‘speculative investment securities’ and were only allowed to hold ‘investment grade
securities’ in their portfolios.17
A system of capital requirements was proposed in which assets of banks were weighed to determine the amount of capital banks were required to hold in 1988.18 This system was revised in 2006 (Basel II) which from then on included a choice for banks to choose the ‘Standardised Approach’ when calculating their capital requirements for credit risk by using ‘external credit assessments’19 instead of the ‘Internal Ratings-Based Approach’ in which
banks relied on their internal rating systems for credit risk.20
U.S. state regulators of insurance companies, pension funds, mutual funds, investment banks soon adapted their prudential regulations in a similar manner. Requiring these entities to hold bonds that were considered ´safe´, establishing capital requirements linked to the riskiness of held bonds or applying haircuts to financial investments without such a rating.21 Regulators in the United States had in a way outsourced safety judgements to CRAs because they themselves were unequipped to analyze and define risk. It was found necessary to restrict institutional investors from overinvesting in risky securities and making use of the ratings of CRAs seemed an efficient and safe option. It would take a significant amount of money and time to establish and maintain an institution at government level with the necessary expertise to conduct risk analyses.22
Through all these developments one might say that the ratings of CRAs were given the force of law in the United States.23 This added to the significance of the role CRAs played in financial markets worldwide since financial markets had become increasingly intertwined.24
Some of the major institutional investors in the capital markets were mandated to heed the
16 A financial crisis where U.S. banks in agricultural areas failed which caused panic amongst depositors and
lead to widespread bank runs and thousands of banks failing. See
http://www.federalreservehistory.org/Events/DetailView/20
17 Bonds that were rated BBB or higher on the S&P scale were considered ‘investment grade’. See White 2010,
p. 7.
18 The Basel Basle Capital Accord of 1988.
19 The Accord uses Standard & Poor’s credit ratings as an example, but states that some other external credit
assessment institutions could equally well be used.
20 Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework, p.
19.
21 White 2010, p. 8. 22 Alicanti 2011, p. 8. 23 White 2010, p. 7.
ratings of CRAs for their investment decisions so other investors would also want to know about those ratings and these rating agencies25 causing herding effects.26 Simultaneously
these developments increased the dependence of issuers on CRAs. Issuers needed investment grade ratings for their securities to gain access to a broader market.
In the European Union prudential regulators had made use of CRA ratings but to a lesser extent than the United States had. The most apparent regulatory reliance on credit ratings in the European Union was under the Basel II capital requirements along with the United States in 2004. The adoption of which led to a recast of the Banking Directive27 and the Capital Adequacy Directive28 that were officially adopted and published in June 2006 and entered
into force in July 2006.
2.1 Conclusion
Not only market participants relied on ratings by CRAs out of efficiency reasons mitigating the information asymmetries, governments too chose to rely on CRA ratings in their
prudential regulations trying to restrict institutional investors from taking on excessive risks. Since they were unequipped to (quickly) develop an institution for a similar task it was found to be an efficient and safe alternative.
25 White 2010, p. 7. 26 Moloney 2014, p. 640.
27 Directive 2006/48/EC [2006] OJ L 177. 28 Directive 2006/49/EC [2006] OJ L 177.
3. The Global Financial Crisis
In the years prior to the Global Financial Crisis of 2007-2008 (GFC) it had become fairly easy for U.S. borrowers with poor credit histories to receive a mortgage. Securitization had become very popular over the years as it had proven to be a profitable source of funds and mortgages (for continuously rising house prices) were needed and used for securitization purposes.29 In early 2000 the global excess of capital had led investment managers hungry and searching for investment options which promised decent returns. At that time nobody even considered the possibility of a financial crisis.
A significant amount of money found its way into the U.S. mortgage market through securitization. MBSs were considered to be a great solution for the ever rising demand for assets. Initially (certain tranches of) MBSs were considered more or less safe investment options and investors all over the world had MBSs in their portfolios. But when MBSs became increasingly in demand qualification guidelines for mortgages changed. Borrowers no longer were required to prove their income or creditworthiness when they applied for a mortgage.30 The credit quality of these subprime mortgage products consequently quickly
dropped.31Meanwhile CRAs did not adjust their ratings to reflect this rapid deterioration in subprime mortgage products.32
An investment grade rating awarded to a structured finance product that is backed by risky subprime mortgages does not necessarily constitute an inaccurate or inflated rating because of the process of tranching and subordination. As long as sufficient debt obligations have been subordinated to the senior tranche an investment grade rating can in fact be accurate. Many of the collateralized debt obligations were getting triple-A ratings because CRAs found that sufficient debt obligations had been subordinated. So the real question is whether the ratings at that point accurately reflected the levels of subordination.
Research shows that CRAs did not follow a consistent policy or valuation model to evaluate the levels of subordination.33 CRAs were actually found to regularly disregard outcomes of
their own valuation models by making discretionary adjustments upwards on subjective grounds increasing the sizes of the senior triple-A tranches. Evidence shows that the valuation models used by CRAs were not faulty but the agencies increased the sizes of the triple-A tranches with discretionary adjustments which caused the ratings to become inaccurate.34
29 Hemraj 2015, p. 37. 30 Hemraj 2015, p. 40.
31 ‘Low document loans’ almost doubled in a five year period and became the majority of subprime loans.
‘Adjustable rate mortgages’ rose to over 91% of all the low document loans and ‘interest only loans’ grew with nearly 23% by 2006. See Coffee 2011, p. 236.
32 Coffee 2011, p. 237.
33 Griffin and Tang 2010; Coffee 2011, p. 242. 34 Coffee 2011, p. 242.
The U.S. housing market started to deteriorate and the economy started to slow down in 2006.35 Home owners were starting to have difficulties to keep up with their mortgage
repayments. Lenders then had to write down large amounts on their profits and even suffered losses since they were unable to even recover the principal as the value of
properties were going down when they were trying to sell repossessed homes.36 The rise in
delinquent mortgages and foreclosure rates in 2007 made market participants very anxious. The enormous amounts that had been invested in SFPs that were backed by these
mortgages before the housing bubble popped meant a catastrophe for the entire financial system. Like a domino effect the consequences of the U.S. subprime mortgage crisis spread to other financial sectors and led to a general financial crisis that ultimately affected the real economy. The 2007 financial crisis quickly spread worldwide and ended up affecting the economies of most countries.37
CRAs were blamed for playing a substantial role in the GFC. Underestimating the credit risks concerning SFPs and awarding them ratings that were too optimistic which had impacts worldwide since institutional investors in many countries had stakes in these products.38 Not only had CRAs awarded them overly optimistic ratings they also were slow or even reluctant to downgrade ratings of SFPs when market conditions worsened to reflect changed credit risks.39
3.1 Conclusion
In the years leading up to the GFC CRAs had rated many SFPs as triple-A quality while they were actually based on risky mortgages many of which defaulted and relied on thin levels of subordination. Their ratings were inaccurate, inflated and they were slow to downgrade them to reflect the change in market conditions.
35 Henwood 2006.
36 In Europe mortgage loans secured by personal residences are usually recourse loans. In the United States
however, even though most states permit recourse for residential mortgages, nonrecourse loans are also an option and some states even require nonrecourse mortgages through antideficiency statutes. The essential difference between a recourse and non-recourse loan is which assets a lender can seize if a borrower defaults. If money is still owed after the collateral (the property) is seized and sold, in a recourse mortgage, the lender can go after the borrower's other assets. In a non-recourse mortgage, however, the lender is out of luck. If the asset does not sell for at least what the borrower owes, the lender must absorb the difference himself. See
http://www.investopedia.com/ask/answers/08/nonrecourse-loan-vs-recourse-loan.asp
37 Hemraj 2015, p. 36. 38 Arora 2010, p. 670-669. 39 Lowenstein 2008.
4. Difficulties regarding Credit Rating Agencies
Failures of CRAs have predominantly been in rating SFPs.40 Several factors like the
characteristics of and inexperience with SFPs, conflicts of interest problems, decrease in due diligence activities and little competition among CRAs were thought to have contributed to CRAs being inaccurate, overly optimistic in rating SFPs in the years leading up to the GFC.
4.1 Structured finance
CRAs traditionally assessed the creditworthiness of financial instruments which were clearly ascribed to a single company like corporate bonds or other debt securities whose quality was more or less easy to assess. In this way CRAs provided for a relatively safe means of
increasing liquidity in debt markets. CRAs successfully built trustworthy reputations assessing these debt securities over the years.41
As time progressed more complicated debt instruments emerged. Securitization is a way to transfer risks, increase liquidity by pooling and tranching of illiquid assets through
securitization and the subsequent sale to investors of claims on the cash flows backed by the underlying pool.42 Every tranche represents a different risk profile that is matched by
successively lower ratings. Junior tranches are riskier since they are subordinated to the senior tranche and first in line to absorb losses. The last tranche often does not get a rating and only receives if anything remains. Senior tranches only absorb losses when the junior claims have been exhausted so through tranching many of the securities are actually ‘safer’ than the assets in the underlying pool.43
Some aspects of structured finance proved to be problematic and as the demand for these SFPs grew significantly in the years leading up to the GFC these factors were a recipe for disaster:
When a lender considers extending a loan to a borrower the lender usually wants to know about the creditworthiness of the borrower and will investigate the credit risks thoroughly. When a lender has no intent to hold on to a loan but instead intends to use it for
securitization purposes a lender’s incentive to thoroughly investigate the credit risk may decrease. Not only incentives to investigate and monitor credit risks of the loan decline under these circumstances they may change altogether. Once a lender has intents to use a loan for securitization purposes he might be inclined to not conduct his due diligence as thoroughly in order to avoid finding adverse information. It would make it harder for a lender to sell the loan to potential investors when adverse information is present.44 His
40 Moloney 2014, p. 641. 41 Horner 2014, p. 494. 42 Hemraj 2015, p. 33.
43 Coval, Jurek and Stafford, 2008, p. 2. 44 Horner 2014, p. 490.
incentives ultimately become more aligned with a debtor’s. He might even be inclined to withhold certain adverse information regarding the loan.45
Research shows that loan originators were more prone to sell their ‘bad’ loans to investment banks who were looking to assemble loan portfolios for securitizations. Essentially they were dumping their weaker, riskier loans. Empirical evidence shows that the highest default rates were linked to loans that were sold to unaffiliated financial firms and that a securitized loan portfolio was 20% more likely to default than a non-securitized loan portfolio.46
SFPs can be highly complex, opaque products which are constantly evolving and were relatively new to CRAs. Overly optimistic ratings awarded to these financial products were also likely a result of inexperience and misjudgment.47 CRAs were, along with other market participants, persuaded that risk could be conquered by newly developed high tech products created by ‘rocket scientists’ on Wall Street.48 They were also not able to rely on past
performance data to identify risk accurately since most products did not have any track records yet.49
The market for SFPs has heavily relied on ratings by CRAs as most senior tranches were ultimately designed to get the highest ratings.50 Issuers of SFPs wanted to have tranches assessed and rated on the same scale as bonds in order for them to also be able to sell to institutional investors who were restricted by prudential regulations. By having these complex securities rated issuers created an illusion of comparability with traditional debt securities instead of them being perceived for what they really sometimes are: complex derivative securities.51 This may have attracted certain investors that were looking for safe
investments and did not fully fathom the risks of SFPs.52
Market participants heavily relied on ratings by CRAs when investing in SFPs as these
products became increasingly complex and less transparent. Insufficient transparency levels of the underlying assets and incomprehensible methods used to create these products increased the information asymmetry.53 Then every security had its own levels of risk and consequently value. Because of the increased information asymmetry and the complexity it became harder if not impossible for investors to determine whether a security was a ‘good’ or ‘bad’ investment themselves.54
45 See Horton 2013.
46 Mian and Sufi 2009; Keys, Mukherjee, Seru and Vig 2010. 47 Hill 2010, p. 14.
48 Analysts at Bear Stearns called the CPDO the holy grail of structured finance. See Jones 2008. 49 Andenas and Chiu 2014, p. 195.
50 Hill 2010, p. 5.
51 Coval, Jurek and Stafford, 2008, p. 3. 52 Coval, Jurek and Stafford, 2008, p. 18. 53 European Commission 2014, p. 99. 54 Alicanti 2011, p. 13.
4.2 Conflicts of interest
In 1909 John Moody had established a business model where investors would pay the rating agency to provide for an assessment of creditworthiness of bond issuers. Securities research consisted of an analyst report and the investor would pay a subscription fee for access.55 Free riding however became a problem with this business model.56 Once paying investors received the information about the securities from the analysts they could share this with other (non-paying) investors and encourage them to trade too as investors tend to have incentives to make the analyst’s report a self-fulfilling prophecy. Another factor that
contributed to the free-riding problem was the development of new technology such as the high-speed photocopy machine in the early 1970s.57 Assessing securities also became more
costly for CRAs, due to increased complexity requiring the agencies to hire more
sophisticated personnel. CRAs switched from the original ‘subscriber pays’ model in which investors paid subscription fees to an ‘issuer pays’ model to overcome the free riding problems and generate sufficient revenue.58
It is argued that the ‘issuer pays’ model may have led to some conflicts of interest problems especially in rating of SFPs.59 As issuers need high ratings for their products CRAs might get
the incentive to inflate the ratings out of fear of losing market share. In the case of structured finance losing a dissatisfied customer meant losing a substantial volume of
business. There were only a limited number of major underwriters who each accounted for a great deal of revenue for CRAs.60 The ‘issuer pays’ model was thought to have also provided
for a disincentive to continue monitoring rated securities to avoid coming across adverse information requiring an undesired downgrade.61
Another conflicts of interest problem was the fact that prior to the GFC CRAs would typically offer consulting services and advice to structured finance issuers in order for them to get the much desired ratings. When CRAs would eventually rate the products they previously
assisted on they were more or less rating their own work.62
Then on a more individual level conflicts of interest could have affected rating accuracy as well. When analysts have personal or business relationships with the issuers they rate, they for instance own stocks, are former employees, or receive gifts from issuers this may cause conflicts of interest situations. When remuneration is tied to analysts nurturing business
55 Horner 2014, p. 489. 56 White 2010, p. 10. 57 White 2010, p. 10. 58 White 2010, p. 10.
59 As the switch to the ‘issuer pays’ model did not seem to have led to inaccurate, inflated ratings in the
corporate bond markets. In fact hardly any received a triple-A rating. See Sommer 2001.
60 Coffee 2011, p. 237-239. 61 Horner 2014, p. 499.
relationships or increasing market share rather than providing accurate ratings this may also give rise to conflicts of interest problems.63
Prior to the GFC it was assumed that the fear of losing reputational capital would provide enough incentive to provide high quality, accurate ratings. CRAs put their reputation on the line to generate investors’ confidence in their ratings. Losing reputational capital by giving out inaccurate or even false ratings would lead to the CRAs demise because they would no longer serve a purpose as their ratings are no longer credible. It is of the utter most
importance that their independence and competence does not get questioned by financial markets participants.64 But since CRAs were so off rating SFPs in the years leading up to the
GFC it is argued that CRAs were found willing to sacrifice a little of their reputational capital for enhanced revenues at that time.65 The reputational capital did not provide for a be strong enough incentive to withstand these new circumstances.66
4.3 Due diligence
CRAs do not verify the information they receive and on which their models rely. Instead CRAs usually disclose that they rely on information provided by others. This can be problematic as the models are not designed to filter out false, inaccurate information or substitute important undisclosed information.67
Prior to 2000 third parties would undertake due diligence activities during the rating process to provide for some factual verification. These third parties were usually hired by the
investment banks to review the quality of loans that were collected in a portfolio by
sampling and checking some of them. After 2000 these activities decreased and CRAs did not insist in the continuation of the due diligence activities. Reasons behind the decrease in due diligence activities in the structured finance field were thought to be the suppressing of ‘red flags’ rather than economizing on costs.68
4.4 Oligopoly
Globally ‘The Big Three’ (Moody’s, S&P, Fitch) dominate the field as CRAs. One factor that has contributed to this is that SEC never recognized more than 5 companies as NRSROs at the same time since the 1920s and not even allowed a single company in enter into the NRSRO category between 1991 and 2003 for reasons that are not quite clear.69 Another reason for the oligopoly is that it is nearly impossible to obtain clients when a company does not have a track record for reliable ratings. A good and established reputation is essential.
63 Andenas and Chiu 2014, p. 195. 64 Moloney 2014, p. 635.
65 Coffee 2011, p. 232.
66 Others disagree. See Hill 2010. 67 Coffee 2011, p. 244.
68 Coffee 2011, p. 245. 69 See White 2005.
But without clients, for lack of a track record, it is impossible to build one which is a Catch-22 situation for new CRAs.70
When an industry is an oligopoly there is no optimal level of competition. When companies have a significant market share it is assumed they have market power and are likely to take advantage of their position. Since generally two ratings are required to issue debt
instruments the absence of real competition and the risk of abusing market power is even further increased.71
Lack of competition is generally viewed as undesirable. The question however is if lack of competition is undesirable when it comes to CRAs. Increased competition may actually have some undesired effects as CRAs are likely to start competing for the market rather than in the market.72 It can create a situation where issuers are able to pressure CRAs to relax their standards and issue the ratings they desire because they otherwise will take their business elsewhere.73 This can cause a ‘race to the bottom’ and lead to inflated, inaccurate ratings.
When Fitch for instance entered the markets shortly after 2000 and grew into a real third alternative in the structured finance markets after a series of acquisitions, the major issuers were able to exert pressures on Moody’s and S&P for desired ratings. Empirical evidence shows that the percentage of investment grade ratings rose with the rise of Fitch and the percentage of non-investment grade ratings went down.74
4.5 Conclusion
Several factors may have contributed to CRAs inaccurately rating SFPs in the years leading up to the GFC in 2007-2008. It could have been intentional because of conflicts of interest problems or unintentional because CRAs were inexperienced, products did not have any track records yet and they (like other market participants) believed in the hype of the possibilities to fully eliminate risk through high tech financial products designed by ‘quants’ or maybe even a combination of the two.
70 Coffee 2010, p. 234. 71 Ryan 2012, p. 8.
72 The effect of CRAs competing for market share rather than them competing on having the most accurate,
quality ratings. See Langohr and Langohr 2009.
73 Coffee 2011, p. 234. 74 Becker and Milbourn 2001.
5. The Regulatory Regime in the European Union for Credit Rating
Agencies
CRAs had been left unregulated in the European Union prior to the GFC.75 The reliance on
their reputational capital was thought to be a sufficient disciplining mechanism.76 After the Enron, WorldCom and other scandals in the 2001-2002 period the Committee of European Securities Regulators (CESR)77 conducted a study78 and concluded that regulatory
intervention was not necessary. Instead the Commission chose to rely on a Code of Conduct from the International Organization of Securities Commissions (IOSCO Code).79 The IOSCO Code was based on a self-regulatory ‘comply or explain’ model.80 The IOSCO Code addressed the quality and the integrity of the process of rating, avoiding conflicts of interest, the
independence of CRAs and the responsibilities of CRAs towards investors and issuers through a set of detailed recommendations. There was a high level of compliance with the IOSCO Code up until the GFC in the industry but compliance was only subject to a non-binding agreement between CESR and the CRAs. Annually each CRA had to make public a letter disclosing to what extent it complied with the IOSCO Code and disclose where it deviated from the IOSCO Code along with reasons therefor.81
After the GFC opinions about regulating CRAs changed.82 The systemic impact of credit
ratings was now recognized and consensus existed that action needed to be taken to prevent another GFC which was reflected in the statements made by the G20 in November 2008 in Washington83, in April 2009 in London84 and in September 2009 in Pittsburgh85.
75 Recital 2 of Regulation (EC) No 1060/2009 [2009] OJ L302/1. 76 Moloney 2014, p. 642.
77 Committee of European Securities Regulators. This was an independent committee of European securities
regulators established by the European Commission on June 6, 2001 (Decision 2001/527/EC). CESR was replaced on 1 January 2011 by the European Securities and Markets Authority (ESMA).
78 “On 30 March 2005, at the request of the European Commission, CESR delivered its advice (CESR/05-139b)
regarding the potential options to regulate Credit Rating Agencies (CRAs). In its advice, CESR proposed not to regulate the Credit Rating Agencies industry at an EU level for the time being, and instead proposed that a pragmatic approach should be adopted to keep under review how CRAs would implement the standards set out in the IOSCO Code of Conduct.” See CESR’s Report to the European Commission on the compliance of credit rating agencies with the IOSCO Code, 2006.
79 International Organization of Securities Commissions, Code of Conduct for Fundamentals for Credit Rating
Agencies, 2004.
80 Provision 4.1 of the IOSCO CRA Code states that a CRA “should disclose to the public its code of conduct and
describe how the provisions of its code of conduct fully implement the provisions of the IOSCO Principles Regarding the Activities of Credit Rating Agencies and the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies. If a CRAs code of conduct deviates from the IOSCO provisions, the CRA should explain where and why these variations exist, and how any variations nonetheless achieve the objectives contained in the IOSCO provisions. The CRA should also describe generally how it intends to enforce its code of conduct and should disclose on a timely basis any changes to its code of conduct or how it is implemented and enforced.”
See IOSCO, Code of Conduct for Fundamentals for Credit Rating Agencies, 2004.
81 CESR 2005, Dialogue with rating agencies to review how the IOSCO Code is being implemented, December
13, Reference 05-751, 1-7.
82 See G-20 Statements November 2008, April 2009 and September 2009. 83 G20 2008.
An agreeance emerged that the IOSCO Code should be supplemented with regulation of CRAs by national competent authorities and that that “all CRAs whose ratings are used for regulatory purposes should be subject to a regulatory oversight regime that includes registration and is consistent with the IOSCO CRA Code.”86 The ‘comply or explain’ model was abandoned and a mandatory system of registration and administrative supervision was set up.87
The main EU objective of regulating CRAs was to introduce a:
“common regulatory approach in order to enhance the integrity, transparency, responsibility, good governance and reliability of credit rating activities, contributing to the quality of credit ratings issued in the Community, thereby contributing to the smooth functioning of the internal market while achieving a high level of consumer and investor protection.”88
The EU CRA regime mainly consists of three CRA regulations: CRA I adopted in 200989,
amended by CRA II in 201190 and by CRA III in 201391. The regime further consists of the
2013 CRA Directive92, corresponding administrative rules93 and ESMA supervisory convergence measures94. The regulations impose rules which have a legally binding character and reflect to a large extent the standards set in the IOSCO Code.
The first CRA Regulation (CRA I) imposes registration requirements on EU CRAs.95 It further mandates detailed operational and organizational rules. The second CRA Regulation (CRA II) adds reforms to CRA I. it delegates all supervisory and enforcement powers on to the European Securities and Markets Authority (ESMA). In 2013 the third CRA Regulation along with the CRA Directive reforms the previous two and its main focus is to mitigate systemic risks CRAs pose.96 CRA III focuses on the structure of the market and reducing the reliance on CRAs by market participants.97
84 G20 2009. 85 G20 2009. 86 IOSCO 2011, p. 8. 87 Coffee 2011, p. 249. 88 Art. 1 CRAR. 89 Regulation (EC) No 1060/2009 [2009] OJ L302/1. 90 Regulation (EU) No 513/2011 [2011] OJ L145/30. 91 Regulation (EU) No 462/2013 [2013] OJ L146/1. 92 Directive 2013/14/EU [2013] OJ L145/1.
93 Commission Delegated Regulations: (EU) No 946/2012 [2012] OJ L282/23; (EU) No 272/2012 [2012] OJ L90/6;
Four Regulatory Technical Standards (RTSs): Commission Delegated Regulations: (EU) No 446/2012 [2012] OJ L140/2; (EU) No 447/2012 [2012] OJ L140/14; (EU) No 448/2012 [2012] OJ L140/17 and (EU) No
449/2012[2012] OJ L140/32.
94 ESMA/2013/720 (2012 ESMA Guidelines on the scope of the CRA Regime) and ESMA/2011/139 (2011 ESMA
Guidelines on the CRA Endorsement Regime). And ESMA Q&A on the CRA regime(ESMA/2013/1935).
95 Art. 14-20 CRAR. 96 Moloney 2014, p. 650. 97 Recital 5 CRA III.
CRA I and II are a reflection of some of the G20 commitments to register CRAs and subject them to oversight. CRA III reforms reflect the Financial Stability Board (FSB) principles of reducing regulatory reliance on ratings.98
The EU CRA regime applies to credit ratings issued by CRAs registered in the EU which are disclosed publicly or distributed by subscription.99 A CRA that is established in the EU is required to register in order to conduct credit rating activities independent of whether they are used for regulatory purposes.100 The regime requires CRAs’ physical presence within the EU if their ratings are to be used for regulatory purposes101 to support ESMA’s supervisory activities.
The Big Three have their headquarters outside of the EU but they do have subsidiary companies102 established throughout the EU as part of their group.103 Ratings originating from third country CRAs who are within a group with a registered EU CRA can be used through an endorsement process.104 Once their rating has been endorsed it is considered to
be a rating issued by a EU-established and registered CRA.105
Credit ratings issued by third country CRAs in relation to financial instruments issued in third countries may be disseminated in the EU if the third country is certified by ESMA.106 ESMA will take enforcement actions against any CRA that issues, endorses or distributes credit ratings without being registered first.107
98 Recital 3 CRA III. 99 Art 2(1) CRAR. 100 Art 2(3) CRAR. 101 Art 4(1) CRAR.
102 EU CRAs are not allowed to rely heavily on non-EU branches for significant operational functions. ESMA sees
this as a potential threat to its supervisory duties and could potentially trigger enforcement action. See ESMA 2013 n 15, 15-16.
103 Moody’s 2014, p. 5.
104 It is not likely that a CRA that largely operates outside of the EU would be able to obtain an EU registration
based on a minimal or shell registered office. See Andenas and Chiu 2014, p. 202. The Art. 4 CRAR endorsement process is due to the heavy reliance across the EU on the big three. There is a potential for significant market disturbance if institutional investors were prohibited to apply the use of their ratings in the EU for regulatory purposes. Particular concerns rose with respect to the banks’ capital requirements relating to rated
securitization exposures originating in the US and rated in the US. See Moloney 2014, p. 678. A registered CRA may endorse ratings of a third country CRA if the requirements set out in Art. 4 CRAR are met.
105 Art 4(4) CRAR.
106 Art. 5(2) CRAR. The third country CRA must apply for certification, and has to fulfil the conditions in Art. 5
CRAR to get the certification. ESMA has proven to be tolerant of the US jurisdiction. S&P and Moody’s are authorized by ESMA. Fitch has been registered. See Andenas and Chiu 2014, p. 203.
6. The EU Civil Liability Regime for Credit rating Agencies
CRA III introduced a EU civil liability regime for CRAs in 2013 since “credit rating agencies have an important responsibility towards investors and issuers in ensuring that they comply with Regulation […] so that their credit ratings are independent, objective and of adequate quality.’’108
The Article 35a CRAR civil liability regime caters to both issuers and investors as claimants but I will restrict my analysis to CRAs’ civil liability towards investors who do not have a contractual relationship with the CRA.109
6.1 Goals of the new civil liability regime
The new CRA Regime provides that investors can hold CRAs liable, even when they do not have contracts with any CRAs, for damages that were caused by an incorrect rating. This may seem odd since investors in the EU do not have an obligation to rely on a rating. In the absence of a contract investors do not even pay for a rating. The justification lies in the goals of the civil liability regime.
The Commission found a civil liability regime on EU level was needed not only to guarantee an adequate right of redress and prevent forum shopping but also to ensure compliance with the Regulation.110 An important goal of introducing a civil liability regime in the CRA regulation is therefore not to repair damages but rather to deter CRAs from infringing on regulatory rules. This should lead to more compliance with the Regulation by CRAs which then ultimately should lead to more accurate ratings. Because CRAs fulfil such a significant role in financial markets it is found necessary to sanction them when they violate regulatory rules.111
6.2 Status of Article 35a CRAR
A regulation has general application within EU Member States. It is binding in its entirety and directly applicable in all Member States.112 In EU Member States a regulation consequently has the status similar to their own national laws. The goal, when using a regulation as a tool on EU level, is to unify and harmonize applicable law in EU Member States. The EU has generally refrained from interfering in private law relationships through regulations. The introduction of a civil liability regime for non-contractual relationships in a regulation,
108 Recital 32 CRA III.
109 As contractual relationships between CRAs and investors are uncommon after the switch to the ‘issuer pays’
model.
110 European Commission 2010, p 24/32 111 Lehman 2014, p. 4.
creating rights and obligations for private parties on EU level which they can evoke and rely on in horizontal cases, is therefore quite novel.113
6.3 The new civil liability regime
CRA III adds Article 35a to the CRA Regulation. Article 35a(1) CRAR reads:
“Where a credit rating agency has committed, intentionally or with gross negligence, any of the infringements listed in Annex III having an impact on a credit rating, an investor […] may claim damages from that credit rating agency for damage caused to it due to that infringement.”
“committed […] any of the infringements listed in Annex III”
The cause of action can only be based on an infringement listed in Annex III and not on a ‘incorrect’ rating. As Recital 33 of CRA III explains that “[…] the activity of credit rating involves a certain degree of assessment of complex economic factors and the application of different methodologies may lead to different rating results, none of which can be
considered as incorrect.” The infringements listed in Annex III of the CRA Regulation consequently function as a conditio sine qua non.
Annex III was added to the CRA Regulation by CRA II and CRA III added to the total of currently 99 listed infringements.114 The infringements are divided into infringements
related to conflicts of interest, organisational or operational requirements115, infringements related to obstacles to the supervisory activities of ESMA116 and infringements related to disclosure provisions117.
“having an impact on a credit rating”
The infringement must have had an actual impact on a credit rating, so claims where the rating would not have been affected by the infringement are excluded. This eliminates several infringements listed since it would be hard or impossible to prove that certain types of infringements have actually had an impact on a rating.
The infringements that are most likely to have an impact on a rating and therefore most likely to be used as a base for a liability claim are number 42 and 43 in part I of Annex III;118
Infringement 42: The agency does not adopt, implement or enforce adequate measures to ensure that the ratings are based on a thorough analysis of all the information that is available and relevant.119
113 Hartkamp 2015, p. 177; Haentjens and den Hollander 2013. 114 Annex III CRAR.
115 Annex III part I CRAR. 116 Annex III part II CRAR. 117 Annex III part III CRAR. 118 Lehman 2014, p. 16.
Infringement 43: the agency does not use rating methodologies that are rigorous, systematic, continuous and subject to validation based on historical experience, including back-testing.120
“[h]as committed, intentionally or with gross negligence, any of the infringements listed in Annex III […]”
A CRA is liable when it committed the infringement intentionally or with gross negligence. This limits CRA liability under Article 35a CRAR. Recital 33 of the CRA III explains this limitation to be appropriate since the activity of credit ratings involve a certain degree of assessing complex economic factors and use of different methodologies which can lead to different results none of which can be said to be incorrect. It further adds that unlimited liability can only be appropriate when the Regulation is breached intentionally or with gross negligence. Another reason for limiting civil liability to intentional or grossly negligent infringements is that investors are to an extent responsible themselves when using ratings by CRAs for investment decisions.121
“It shall be the responsibility of the investor […] to present accurate and detailed information indicating that the credit rating agency has committed an infringement […] and that that infringement had an impact on the credit rating issued.”
The burden of proof has been placed on the claimant, the investor. The investor needs to state accurate and detailed information about the infringement, the intent or gross negligence of the CRA and the impact of the infringement on the rating.
Subparagraph 2 of Article 35a(2) CRAR provides that it is up to the national courts to assess what constitutes accurate and detailed information. National courts have to take into account that an investor may not have access to all information.
Paragraph 4 of Article 35a CRAR further sets out that national courts also have to interpret terms as “damage”, “intention”, “gross negligence”, “reasonably relied”, “due care”, “impact”, “reasonable”, and “proportionate” and apply them in accordance with the applicable national law.
Matters concerning civil liability of a CRA which are not covered by the Regulation shall be governed by the applicable national law.
This means the majority of key elements in the EU civil liability regime for CRAs has been left to EU Member States to interpret and work out through their national laws which seems
119 Art. 8(2) CRAR. 120 Art. 8(3) CRAR. 121 Van der Weide 2014.
contrary to the goals of regulations on EU level that ultimately aim to provide unity and harmonization throughout EU Member States.
The applicable national law has to be determined by the relevant rules of private
international law. The competent court shall also be determined by the relevant rules of private international law.
“[A]n investor […] may claim damages from that credit rating agency for damage caused to it due to that infringement […] where it establishes that it has reasonably relied, in
accordance with Article 5a(1) or otherwise with due care […]”
An investor not only has to establish that a CRA has committed, intentionally or with gross negligence, an infringement on the Regulation and that the infringement has had an impact on the rating, he has to also establish that his damages are due to that infringement.
Causation between the infringement and the impact, and between the impact and the damages of the investor are to be decided by applicable national laws as recital 35 of CRA III sets out:
“matters concerning the civil liability of a credit rating agency which are not covered by or defined in this Regulation, including causation and the concept of gross
negligence, such matters should be governed by the applicable national law.”
Investors then have to establish that they reasonably relied on the rating in accordance with Article 5a(1) CRAR or otherwise with due care when they do not fall within the scope of Article 5a(1) CRAR. This paragraph aims to deter overreliance on credit ratings. Reasonable reliance also needs to be interpreted and applied in accordance with the applicable national law.122
Article 5a(1) CRAR mandates that entities referred to in the first subparagraph of Article 4(1) CRAR123, shall make their own credit risk assessment and not solely rely on CRA ratings.
Nonetheless Recital 36 of CRA III states that even though these entities are obliged to carry out their own credit risk assessments they can still hold CRAs liable for damages caused by an infringement of the Regulation. Courts will have to take into consideration to what extent an investor is responsible for occurred damages himself124 and to what extent a CRA is
responsible.
122 Art. 35a(4) CRAR.
123 Credit institutions, investment firms, insurance undertakings, reinsurance undertakings, institutions for
occupational retirement provision, management companies, investment companies, alternative investment fund managers and central counterparties.
124 Contributory negligence by not performing his duty to assess his own credit risk assessment optimally. Or
6.4 Limitations in advance on CRA liability
Paragraph 3 of Article 35a CRAR provides that it is possible to limit CRA civil liability in advance but only when it is proportionate, reasonable and allowed by the applicable national law otherwise it is without legal effect. A total exclusion of civil liability is without legal effect.
In the majority of Member States parties to a contract are allowed to limit or exclude civil liability in tort by using disclaimers.125 The Commission initially proposed that the civil liability of CRAs could not be excluded or limited in advance by an agreement126 but after receiving opposition127, the final version of Article 35a(3) CRAR allows for limiting civil
liability in advance if the limitation is ‘reasonable and proportionate’. Whether the limitation is reasonable and proportionate shall be interpreted by the applicable national law.128 In this way the general use of disclaimers has been recognized while the right of redress for
claimants is ensured since parties cannot exclude civil liability in advance.129 6.5 Alternative actions
Paragraph 5 of Article 35a CRAR provides it does not exclude further civil liability claims by investors in accordance with national law. Recital 35 of CRA III provides that “Member States should be able to maintain national civil liability regimes which are more favourable to investors or issuers or which are not based on an infringement of Regulation (EC) No 1060/2009 […]”
ESMA can also still sanction CRAs for infringements130 when investors claim damages under
Article 35a CRAR.131
6.6 The rationale of the Article 35a CRAR civil liability regime
Recital 32 of CRA III sets out that it is important that it is possible for investors, that do not have a contractual relationship with a CRA, to hold CRAs liable for damages they suffered after a breach of the Regulation.132 Recital 49 of CRA III further provides that the objectives
125 De Pascalis 2015, p. 18.
126 European Commission 2011, p. 33.
127 The Bank of England for instance found that by taking away the option for parties to limit or exclude civil
liability in advance this would reduce legal certainty as this is common practice between commercial parties. Article 35a CRAR would ‘run contrary to the general tenor and thrust of Member States’ existing legal regimes.’
See Bank of England Financial Markets Law Committee 2012; De Pascalis 2015, p. 19.
128 Art 35a(4) CRAR. 129 De Pascalis 2015, p. 19. 130 Art. 36a CRAR.
131 Art. 35a(6) CRAR.
132 The scope of Article 35a is broader. Issuers and investors can base a claim on Article 35a CRAR indifferent of
whether they have a contract with a CRA or not. See recital 32 CRA III. My analysis is limited to investors without a contractual relationship with a CRA.
of the Regulation cannot be sufficiently achieved by the Member States themselves and can therefore be better achieved at the EU level.133
With the introduction of a civil liability regime in a regulation, investors can now base their claims directly on Article 35a CRAR and do not have to rely on national laws which do not always provide for an adequate right of redress for non-subscribing investors.134 Member States’ national tort laws for instance often require that the law that has been invoked by a party aims to protect that party and the type of damages claimed.135 Lack of relativity can limit the possibility of actions by investors on a national level and Article 35a CRAR clearly provides it is meant to provide an action for investors, in the absence of a contract, that suffered losses due to an infringement on the Regulation by a CRA.136
6.7 Conclusion
The Commission and ESMA found that differences between Member States' civil liabilities regimes applicable to CRAs led to different levels of protection for investors and could even incentivize forum shopping. The Commission consequently found that a civil liability regime on EU level was needed in addition to Member States’ national civil liability regimes, not only to guarantee an adequate right of redress and prevent forum shopping but also to ensure CRAs’ compliance with the regulation.
133 Haentjens and den Hollander 2013.
134 The Commission found that Differences between Member States' civil liabilities regimes applicable to CRAs
led to different levels of protection for investors and could even incentivize forum shopping. ESMA conducted a survey on Member States' civil legal orders in respect of provisions on which investors could base claims against CRAs having infringed the CRA Regulation and found that in some Member States including Poland and Sweden civil claims would not even be possible. See European Commission 2011, p. 19/193.
135 In the Netherlands for instance a relativity requirement (Schutznorm) can be found in Art. 163 of Book 6
Dutch Civil Code.
7. Compatibility of Article 35a CRAR with legal certainty
“The rule of law is a legally binding constitutional principle, unanimously recognized as one of the founding principles inherent in all the constitutional systems of the Member states of the EU and the Council of Europe.”137
The Court of Justice of the European Union (CoJ) provides in its case law that the rule of law is the source of general legal principles applicable within the European Union. One of the most noteworthy principles are:
1. The principle of legality138; 2. Legal certainty139;
3. Prohibition of arbitrariness of the executive powers140;
4. Independent and effective judicial review including respect for fundamental rights141; 5. Fair trial by an independent court142;
6. Equality before the law143.
The CoJ (as well as the European Court of Human Rights) confirmed that these principles stemming from the rule of law are not purely formal and procedural requirements but a “vehicle for ensuring compliance with and respect for democracy and human rights.” The CoJ emphasizes that these principles have substantive value by specifying that a “Union based rule of law” means that the EU institutions are subject to judicial review of the compatibility of their acts not only with the Treaty but also with these general principles.144
Legal certainty means that a law must be clear, precise and its legal implications should be foreseeable as “legal rules guide people’s actions and judges’ decisions.”145 Legal certainty further serves to protect individuals “against arbitrary government action by controlling the use of power to make and apply law.”146
137 European Commission 2014, p. 1.
138 Case C-496/99 P, Commission v CAS Succhi di Frutta [2004] ECR I-03801, para 63.
139 Joined cases 212 to 217/80 Amministrazione delle finanze dello Stato v Salumi [1981] ECR 2735, para
10.
140 Joined cases 46/87 and 227/88 Hoechst v Commission [1989] ECR 02859, para 19.
141 Case C-583/11 P Inuit Tapiriit Kanatami and Others v Parliament and Council, not yet published, para
91; Case C-550/09 E and F, [2010] ECR I-06213, para 44; Case C-50/00 P Unión de Pequeños Agricultores [2002] ECR I-06677, para 38 and 39.
142 Joined cases C-174/98 P and C-189/98 P Netherlands and Van der Wal v Commission, [2000] ECR I-
00001, para 17; Case C-279/09 DEB, [2010] ECR I-13849, para 58.
143 Case C-550/07 P Akzo Nobel Chemicals and Akcros Chemicals v Commission [2010] ECR I-08301,
para 54.
144 Case C- 50/00 P, Unión de Pequeños Agricultores [2002] ECR I-06677, para 38 and 39; Joined Cases C-402/05
P and C-415/05 P, Kadi, [2008], ECR I-06351, para 316; See European Commission 19.3.2014, p. 4.
145 Maxeiner 2008, p. 36. 146 Maxeiner 2008, p. 36.
Legal rules cannot always be as precise and definite since there is always a certain degree of discretion in their application and enforcement, depending on circumstances in each case but they always should be clear about: “1. Who may invoke them, 2. Who may apply them and 3. What the consequences of application may be.”147
There has been some debate about the Article 35a CRAR civil liability regime.148 It is argued that the amount of references and core elements of the regime left to national laws to interpret and decide on may lead to unforeseeable outcomes for parties involved. The Article 35a CRAR civil liability regime is clear about who may invoke the rule but the clarity of who may apply it and what the consequences of application may be remains questionable for all parties involved. I will therefore analyze whether the Article 35a CRAR civil liability regime is compatible with the principle of legal certainty.
7.1 Scope of Article 35a CRAR
Article 2(1) CRAR provides that the CRAR is only applicable to credit ratings issued by CRAs that are registered in the EU, the scope of the CRAR is therefore limited. Consequently the civil liability regime of article 35a CRAR, as part of the CRAR, is only applicable to CRAs that are registered within the EU.
The Big Three149 are headquartered outside of the EU, their subsidiaries are registered in the
EU and endorse their ratings.150 This means that The Big Three cannot be touched by the civil liability regime of article 35a CRAR. Their EU subsidiaries of The Big Three could be held liable151 but since the CRAR does not require them to hold a certain amount of capital or a
guarantee by their parent company their financial resources will most likely be limited and the costs of suing them will in that case outweigh the benefits for investors.152
This seems to conflict with the goal of the civil liability regime of article 35a CRAR, providing an adequate right of redress, considering a substantive amount of ratings within the EU are endorsed ratings. It remains to be seen whether the parent companies of The Big Three EU-subsidiaries will contribute when one of their EU-subsidiaries is found liable under the Article 35a CRAR regime. Will they allow one of their EU subsidiaries to become insolvent when it finds it does not hold adequate financial resources? Will they risk their reputational capital in capital markets?
147 Maxeiner 2008, p. 39.
148 Lehman 2008; De Pascalis 2015; Nästegård 2015; Deipenbrock 2015; Haar 2014; Horsch 2015; Den
Hollander 2013; Kleinow 2015; Wanambwa 2014; Hilgard and Gharibian 2013; Van der Weide 2013; Haentjens and den Hollander 2013.
149 S&P and Moody’s provide ratings for at least 70 per cent of the corporate debt market. See Andenas, Chiu
2014, p. 203.
150 Art. 4(3) CRAR.
151 Article 4(5) CRAR provides that the CRA that endorsed a credit rating issued in a third country will remain
fully responsible for such a credit rating.
7.2 References to national law
The number of references in the regime to national law systems is peculiar and provides for uncertainties since the outcomes of a procedure may vary considerably depending on what Member State court is found competent and what law is found to be applicable.
The number of references is quite peculiar because of the legal nature of a regulation and its relationship to the national laws of Member States. A regulation has general application, is binding in its entirety and is directly applicable153 in Member States without any
transformation or adoption by national legal provisions with the principle of supremacy of Union Law154 to ensure uniformity amongst Member States.
Even though it is not uncommon for a Regulation to refer to national law, and the CoJ has accepted that the principle that Union law should be interpreted and applied autonomously without such references has its limits,155 the extent to which this regime refers to national law is unusual. The amount of terms that Member States need to interpret is not only extensive156 they also constitute the core terms of the liability provision.157
7.3 Burden of proof
The regime places the burden of proof on the investor. The investor has to present accurate and detailed information about the CRA infringing the Regulation, that the infringement had an impact on the rating and that his damages are caused by these events. What constitutes accurate and detailed information remains unclear since the Regulation leaves that to the national courts to determine. The extent of the obligations for the investor to sufficiently establish the CRA’s liability under the EU civil liability regime is uncertain.
An investor also needs to establish that he “reasonably relied” on the rating. The objective of this provision is to decrease investor reliance on credit ratings. What constitutes reasonable reliance is also not specified under the regime. Instead of defining the important elements of the CRA civil liability regime it provides that they all are to be interpreted and applied in accordance with the applicable national law158. The same goes for limiting liability in advance159 and matters concerning the civil liability of a CRA that are not covered by the Regulation.160
153 The direct effect principle ensures the application and effectiveness of European law in EU Member States.
Art. 288 TFEU specifies that regulations are directly applicable in EU Member States. Case 26/62, van Gend en
Loos [1963] ECLI:EU:C:1963:1.
154 Case 6/64, Flaminio Costa v ENEL [1964] ECR 585.
155 Case C-403/98 Azienda Agricola Monte Arcosu Srl v. Regione Autonoma della Sardegna [2001] E.C.R. I-103,
para 26.
156 And not exhaustive. The use of the term “such” indicates this. See Lehman 2014, p. 19. 157 Lehman 2014, p. 19.
158 Art 35a(4) CRAR. 159 Art 35a(3) CRAR. 160 Art 35a(4) CRAR.
