Study About Legal Supervision On Credit Rating Agencies

Credit Rating Agencies played an ignominious role in the subprime mortgage crisis and was widely blamed. It is usually considered that if there is no credit rating, subprime loan securities can not be successfully released and sold. However, many problems has occurred on Credit Rating Agencies, such as failure in rating model, relaxation on rating criteria, intended neglect of rating problems, opacity of rating adjusting, disturbance on independence, etc. This is not the first time for Credit Rating Agencies to behave so"abnormally". The questions are: why these Credit Rating Agencies make mistakes again and again? Are the Credit Rating Agencies supervised in America or not, and what level of supervision they are got? Do the Credit Rating Agencies who often neglect duties bear the loss of investors, and how to bear the loss? What kind of revolution will happen on the legal supervision system of Credit Rating Agencies in the post-financial-crisis era? The study and answers to these questions can be taken as reference when setting up and perfecting China's legal supervision system of Credit Rating Agencies. Currently, there is little study on the supervision and liabilities of Credit Rating Agencies in China's academic circles. The China's legislation on Credit Rating Agencies is also very simple. Under the background that many international Credit Rating Agencies enter China market, such as Moody's Investor Service Ltd. and Standard & Poor's, while there is not any local agency with international reputation, it is more realistically meaningful to study this subject.It can not leave away the definition of Credit Rating & Credit Rating Agency to study legal supervision on such agencies. Credit Rating is to advise credit risks and to provide risk forecast for the future. The rating results are expressed with signals representing relative gradation of credit risks. The misunderstanding on Credit Rating Agencies will probably impact people's anticipation and comment on them. As a supplier of credit rating product and service, the Credit Rating Agencies are independent, commercial and professional. In America, Nationally Recognized Statistical Ratings Organization (NRSRO) is the most important rating agency, but it's different from the Rating Departments in commercial banks and the Commercial Credit Reporting Company. The Credit Rating Agencies can work with many functions, such as information media, quality recognition, supervision criteria, contract management and control, etc. The value of these agencies can be explained by several economic theories, for example, information asymmetry, transaction cost, principal-agent and so on. All above are introduced in Chapter One.It has been more than 100 years since the emergence of modern rating agencies. Their financial status has been consolidated. The globalization of finance market, financial disintermediation and continuous financial innovation greatly has promoted the importance of Credit Rating Agencies. Correspondingly, Credit Rating Agencies plays a more and more important role in American Law. Since NRSRO concept came out in 1975, NRSRO and its rating results are widely referred to and excerpted in many aspects, no matter Congress legislation, federal regulation or even judicatory trials. NRSRO concept has been deeply embedded into American Law. However, the legal supervision on rating agencies had still not been improved, from loose supervision in earlier time to designated NRSRO, which was not changed until the promulgation of"the Credit Rating Agency Reform Act of 2006,"influence by Enron bankrupt. After that, the supervision system whose hardcore is registration came into being. After the Subprime Mortgage Crisis, America came up with a new round of supervision rules and"Dodd-Frank Wall Street Reform and Consumer Protection Act"represented its latest supervision direction. The evolution process from free competition (self-discipline) to registration (supervision) showed that supervision direction was influence by"credit-derived event, while the theories of Reputational Capitals and Regulatory Licenses took effect on supervision ideology and supervision rules to some extent. The supervision focuses on rating agencies are different in every historic period, but they all point at the problems of competition, independence, transparency and weak liabilities but with strong power. Thus, supervision on market access, interest conflicts, information disclosure and legal liability structures the supervision systems of American credit rating agencies. Compared with America's, China's credit rating agencies drop behind, with smaller scale and less reputation. It's hard for them to resist the entrance of other international credit rating agencies and they depend on government' support. Therefore, we need to foster a favorable environment for local credit rating agencies and let them to generate reputational capitals through free market competition. Additionally, China's"Securities Law"has set principle rules on business of securities credit rating agencies. Meanwhile, only People's Bank of China and China Securities Regulatory Commission have comparatively enacted regulations on credit rating agencies, which have problems of low law status, departmental interests and lack of coordination. This thesis advises to legislate on Credit Rating Agency.Chapter two is followed by another 4 chapters respectively focusing on: market access supervision system of credit rating agencies, interest conflict supervision system, information disclosure supervision system and legal liability system. First of all, market access supervision was discussed in Chapter three, including access of subject and access of business. It's usually considered that American Securities and Exchange Commission (SEC) recognize a little of NRSRO and using NRSRO in regulation is the main reason for market concentration of credit rating industry. In this thesis, it's expressed that besides regulatory barriers, there are also economic barriers to influence rating agencies'access, such as reputational capitals, network effect, scale economy, sunk costs and private contract to use credit rating, etc. After the pass of the Credit Rating Agency Reform Act of 2006, the problem of market access of credit rating agencies has changed into the problem that whether the credit rating agencies are NRSRO or not. Although there are many disputes on whether NRSRO should be kept or discarded, under current supervision system, supervision on market access includes the access procedure and the access criteria of NRSRO. In this aspect, America has gone through long legislation process, from no-action to registration, from the standard of unwritten law during the process of designated NRSRO to the standard of statute law, which shows the guideline of lowering down access threshold of credit rating agencies and strengthening competition among those organizations. China's credit rating agencies shares not only similar but also different characteristics with that of America's. Legislation needs to pay more attention on unifying regulatory departments, establishing market access procedures, promoting access thresholds, supporting national credit rating agencies and restricting entrance of foreign Credit Rating Agencies, etc.Next is the supervision on interest conflicts among credit rating agencies which is divided into two parts: conflicts from companies and conflicts from individuals, conflicts of Issuers-CRA and conflicts of Investors-CRA. The interest conflicts usually include conflicts from issuer-pays model, conflicts between rating service and auxiliary service, conflicts from unsolicited rating, conflicts between credit rating and rating sale, etc. This thesis takes the issuer-pay interest conflict as an example, which is the most serious in the structural finance rating process, to illustrate the dilemma of interest conflict of credit rating agencies, refutes the argument of credit rating agencies with data & facts that they can manage interest conflicts, clarifies the dispute of supervision need. SEC specially established the supervision rules of interest conflicts, modified and supplemented related rules immediately after the subprime mortgage crisis, but theoretical criticism mainly focus on that existing legislation does not solve the problem of issuer-pays interest conflicts. This thesis has also introduced some representative reform suggestions of credit rating agencies'revenue model. China's legislation on credit rating agencies'interest conflict is comparatively rough, and does not involve some possible interest conflict types. Its supervision method is also comparatively simple, and takes no account of the effect that inner control system plays on preventing and managing interest conflicts. For these aspects, we can refer to America's legislation experience.Chapter Five introduces supervision on information disclosure. It is the most important supervision method in America's securities field. However, for the credit rating agencies, America adopted self-disclosure system originally. It gradually developed into compulsory disclosure system which also went through a process from weakness to mightiness. The existing information disclosure rules of credit rating agencies in America include information disclosure content, information disclosure time & way and information disclosure ensuring system. Additionally, the issue related with credit rating agencies'information flow also includes the dispute of Regulation FD application and the prevention of misuse of material information. It is the key supervision point for America to strengthen information disclosure responsibilities of credit rating agencies. The Dodd-Frank Wall Street Reform and Consumer Protection Act supplemented a lot of legal provisions and specially emphasized that transparency of rating methodologies and rating performance is extremely important for investors to judge whether the credit rating is believable or not. In China, credit rating agencies are involved in compulsory information disclosure, but the content, the cycle time and the way are limited. What's worse, the implementation of compulsory information disclosure is quite unsatisfied. In this aspect, we need to take a lesson from the subprime mortgage crisis which reflected opacity of credit rating, to perfect our legislation, to strengthen inspection and to enhance transparency of credit rating.The last Chapter studies legal liabilities of credit rating agencies. Compared with their"brilliant"status and power, legal liabilities of credit rating agencies are quite"low-pitched". There is no provision on credit rating agencies'legal liability in statute law, and credit rating agencies enjoy freedom of press as a news publisher in common law, and are protected by the First Amendment Act traditionally. The subprime mortgage crisis makes it blamed that credit rating agencies are exempt from legal liabilities. The promulgation of Dodd-Frank Wall Street Reform and Consumer Protection Act and some latest cases begin to bring threats to the credit rating agencies that they will probably face lawsuit. With latest legislation and many cases, this thesis points out that there are two possible legal liabilities of credit rating agencies in America. The first is liability of Securities Law, including expert liability and underwriter liability under Section 11 of the Securities Act of 1933 and liability of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 of SEC. The second is liability of Common Law, including not only tort such as fraud and negligent misrepresentation, but also breach of contract such as violate the explicit and implied contractual covenant. Different liabilities have different legal foundations, constitutive requirements, and different application difficulties. From legal practice, more America's courts start from individual cases, and consider credit rating agencies'many aspects, such as business types, status in the rating process, purpose and usage of credit rating results, and credit rating's benchmark of credit risk, to make judgment on whether the credit rating agencies can be protected by the First Amendment Act, and not provide unconditional overall protection to them any more.In China, regarding to the credit rating agencies'liabilities, we highlight administration responsibilities while ignore civil liabilities. The only legislation about the latter is the Securities Law. It prescribes negligent misrepresentation liability when credit rating agencies compile or work out rating reports during business activities. However, no matter"Contract Law"or"Tort Law", there is no clear definition that what kind of civil liability the credit rating agencies should bear. During the subprime mortgage crisis, many investors who had believed the credit rating agencies'rating result and had bought subprime relate securities came across huge economic loss, but there is no department for them to lodge a complaint or the litigation is very hard. Some investors were even forced to become vagrants. The prerogative status of credit rating agencies and serious lack of civil liabilities is disadvantageous to investors'protection, stock market development and social stability. Referring to above, this thesis comes up with a view that we should structure the legal liability frame and system on the basis of our current jurisprudence.