Communication from the Commission on Credit Rating Agencies   (Text with EEA relevance)
Date: 2006-03-11
Institutions: European Commission
Subjects: consultancy, financial institution, financial legislation, financial market

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Communication from the Commission on Credit Rating Agencies

(2006/C 59/02)

(Text with EEA relevance)

1. INTRODUCTION

which form a crucial part of its approach to financial services
policy set out in its recent White Paper (5).

Credit rating agencies play a vital role in global securities and
banking markets. It is essential, therefore, that they consistently
provide ratings which are independent, objective and of the
highest possible quality.

The Commission made a commitment to analyse the issue of
credit rating agencies at the Oviedo Informal ECOFIN Council
(April 2002), in the aftermath of the Enron scandal. The Euro-
pean Parliament then adopted (February 2004) a Resolution on
credit rating agencies (1),
following an own initiative report
from its Committee on Economic and Monetary Affairs (2),
calling on the Commission to produce an assessment of the
need (if any) for legislative intervention in this field. In March
2004, following the Parmalat scandal, the Commission identi-
fied,
in cooperation with the European Parliament and the
Member States, the main regulatory issues of concern with
regard to credit rating agencies. In July 2004, the Commission
asked the Committee of European Securities Regulators (‘CESR’)
to provide the Commission with technical analysis and advice
to assess the need for introducing European legislation or other
solutions. CESR provided its advice to the Commission in
March 2005 (3). Meanwhile, a number of key EU legislative
measures with major implications for credit rating agencies
have been adopted as part of
the Commission's Financial
Services Action Plan (FSAP). Moreover, the International Orga-
nisation of Securities Commissions (‘IOSCO’) published in
December 2004 its Code of Conduct Fundamentals for credit
rating agencies (‘IOSCO Code’) (4).

2. CREDIT RATING AGENCIES

2.1 Functioning of credit rating agencies

Credit rating agencies issue opinions on the creditworthiness of
a particular issuer or financial instrument. In other words, they
assess the likelihood that an issuer will default either on its
financial obligations generally (issuer rating) or on a particular
debt or fixed income security (instrument rating).

These opinions — or ratings — are based on information
relating to revenue stream and balance sheet (with particular
focus on the debt) of the rated entity. Past financial perfor-
mance is also considered. They only give an indication as to
the situation at a given time and must therefore be periodically
confirmed or revised to take account of recent economic or
other developments. The credit ratings effectively categorise
issuers into corresponding grades, depending on whether they
are considered as more or less default-prone. Credit rating
agencies employ comprehensive creditworthiness scales, with
the critical border line running between the so-called invest-
ment grade
(high-risk),
reflecting the risks related to the security (i.e. the likelihood of
default).

and speculative grade

(low-risk)

The purpose of this Communication is to report back to the
Council and European Parliament on the Commission's regula-
tory approach towards credit rating agencies, bearing in mind
these latest developments.
the
Commission has been guided by the advice provided by CESR.
It has also sought to adhere to the principles of ‘Better Regu-
lation’ to which the Commission has committed itself as part of
the drive to boost growth and employment in the Union and

In developing this approach,

(1) European Parliament resolution on Role and methods of rating

agencies (2003/2081(INI)), available at:
http://www.europarl.eu.int/registre/seance_pleniere/textes_adoptes/
definitif/2004/0210/0080/P5_TA(2004)0080_EN.pdf.

(2) Report of the Committee on Economic and Monetary Affairs (A5-

0040/2004); rapporteur Giorgos Katiforis.

(3) CESR's technical advice to the European Commission on possible
measures concerning credit rating agencies, CESR/05/139b, March
2005, available at: http://www.cesr-eu.org.

(4) Code of Conduct Fundamentals for Credit Rating Agencies, The
Technical Committee of the International Organization of Securities
Commissions, December 2004, see Annex on IOSCO Code of
Conduct Fundamentals for Credit Rating Agencies.

Ratings are usually requested — and paid for — by the issuers
themselves. In these cases, they are based on both publicly
available data and information which is not accessible to the
public but which is voluntarily disclosed by the rated entity
(e.g. by means of interviews with senior financial officials of
the rated entity). However, credit rating agencies sometimes
issue unsolicited ratings (i.e. ratings which have not been
requested by an issuer). These are usually prepared without
access to non-public information.

Although the provision of ratings is obviously their core
activity, many credit rating agencies make use of their expertise
in risk assessment
to provide other financial services (e.g.
investment advice) to issuers (either directly or through related
entities).

(5) White Paper on Financial Services Policy (2005-2010), COM(2005)

629 final.

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2.2 Impact on the financial markets

Credit ratings carry considerable weight in financial markets.
There are two basic reasons for this. First, although they are
based on complex assessments they can be easily and instantly
assimilated by investors regardless of their expertise and profile.
Secondly, credit rating agencies enjoy a good reputation and
are seen by market participants to be providing unbiased data
analysis.

The importance of credit rating agencies in recent years can be
observed in both business practice and regulatory requirements.
On the one hand, the commercial success of most debt instru-
ment issues largely depends on the rating granted. A rating has
become a pre-requisite for seeking external financing in the
securities markets (especially when issuers do not have an
established presence on the debt markets).The credit rating of
an issuer determines the interest rates that they will have to
offer in order to obtain external financing. Moreover, credit
ratings are increasingly used in contractual provisions regarding
the termination of credit availability, acceleration of debt repay-
ment or modification of other crediting conditions.

On the other hand, several jurisdictions now insist that certain
types of investment products can only be sold if the issuer can
demonstrate a certain grade of creditworthiness reflected in a
rating issued by a recognised credit rating agency. Credit rating
agencies are also increasingly involved in the assessment of the
risks associated with assets held by financial institutions which
are subject to capital adequacy requirements.

The role which credit rating agencies play in the markets is
generally very positive for both investors and issuers. They
provide investors with information which helps them to assess
the risks related to a security. And they help to lower the costs
of raising capital for issuers (or at least for those issuers who
receive a favourable rating).

2.3 Issues of concern

The Resolution of the European Parliament does not call into
question the positive role that credit rating agencies can and
generally do play. However, it identifies a number of issues of
concern which require serious attention in order to ensure that
all credit rating agencies exercise their functions responsibly at
all times (6).

Concern centres on the quality of credit ratings provided by
credit rating agencies. Credit rating agencies must base their
ratings on a diligent analysis of the available information and
control continuously the integrity of their information sources.
if
This means that credit ratings must be regularly updated,

(6) See footnote 1.

necessary. Credit rating agencies must also be more open about
the way in which their ratings are arrived at. In addition, it is
important
that credit rating agencies are independent and
entirely objective in their approach. The position of credit
rating agencies must not be compromised by the relationships
which they have with issuers. There are also concerns relating
to the access which credit rating agencies have to inside infor-
mation of issuers. It is important that credit rating agencies are
prevented from using this information for other activities.
Finally, the European Parliament expressed concern about the
degree of concentration in the ratings industry and its possible
anti-competitive effects.

3. RELEVANT REGULATION

The issues relating to credit rating agencies are serious and
must be tackled. Both the new EU-level legislative framework
and the IOSCO Code seek to do this. The EU legislation applies
only to credit rating agencies operating in the EU. The Code,
on the other hand, is expected to be applied by credit rating
agencies in all
jurisdictions where they operate. In terms of
content, the Code complements the EU legislation. While the
Directives are legally binding, the Code works on a ‘comply or
explain’ basis — i.e. credit rating agencies are expected to
incorporate all the provisions of the IOSCO Code into their
own internal Codes of Conduct. Where they choose not to do
this, they must explain how their Code nevertheless gives effect
to the provisions of the IOSCO Code.

3.1 EU legislation

The aim of the FSAP was to create open, integrated and effi-
cient financial markets in the EU — where competitive forces
maximise investors' returns — but where investors are not
subject to excessive risk. It therefore sought to minimise the
regulatory burden on firms while at the same time maintaining
an effective level of regulatory control and a high level of
investor protection.

There are three FSAP Directives which are relevant to credit
rating agencies. The most important is the Market Abuse
Directive (‘MAD’) which — together with its implementing
Regulation and Directives (7) — tackles the issue of
insider
dealing and market manipulation (market abuse) in order to
ensure the integrity of Community financial markets and to
enhance investor confidence in those markets. Insider dealing
and market manipulation prevent
transparency,
which is important for trading for all economic actors in inte-
grated financial markets. In the field of conflicts of interest, fair
presentation of investment recommendations and the access

full market

(7) Directive 2003/6/EC of 28/01/03 (OJ 2003 L 96/16); Commission
Directive 2003/124/EC of 22/12/03 (OJ 2003 L 339/70); Commis-
sion Directive 2003/125/EC of 22/12/03 (OJ 2003 L 339/73);
Commission Directive 2004/72/EC of 29/04/04 (OJ 2003 L
162/70) and Commission Regulation (EC) No 2273/2003 of
22/12/03 (OJ 2003 L 336/33).

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the provisions of

the Market Abuse
to inside information,
Directives constitute a comprehensive legal
framework for
credit rating agencies while, at the same time, acknowledging
their specific role and the differences between credit ratings
and investment recommendations.

In order to prevent insider dealing and market manipulation,
the Directive 2003/125/EC addresses the fair presentation of
investment recommendations and the disclosure of conflicts of
interest. For the purposes of the said Directive, credit ratings do
not constitute a recommendation but they are regarded as
opinions on the creditworthiness of a particular issuer or finan-
cial instrument. Nevertheless, it is stipulated that credit rating
agencies should consider adopting internal policies and proce-
dures designed to ensure that credit ratings published by them
are fairly presented. Moreover, it is stated that a credit rating
agency discloses any significant interests or conflicts of interest
concerning the financial instruments or the issuers to which
their credit ratings relate (8). Additionally, it follows from the
Directive 2003/6/EC that, in case a credit rating agency knew,
or ought to have known, that the credit rating was false or
misleading, the prohibition to disseminate false or misleading
information, constituting market manipulation, may apply to
credit ratings (9). Considering these provisions, it is clear that
credit rating agencies need to implement internal procedures
and policies to ensure objective,
independent and accurate
credit ratings which will benefit investor confidence. It is of
major importance for the Commission that credit rating agen-
cies will effectively enforce their procedures to ensure high
quality of credit ratings.

With respect to the legal treatment of credit rating agencies'
access to inside information, the Directive 2003/6/EC prohibits
any person possessing inside information from using that infor-
mation by acquiring or disposing of financial instruments to
which that information relates. Inside information is defined as
information of a precise nature which has not been made
public, relating, directly or indirectly, to one or more issuers of
financial instruments and which, if it were made public, would
be likely to have a significant effect on the price of those finan-
cial instruments or on the price of related derivative financial
instruments (10). As a rule, an issuer must disclose inside infor-
mation as soon as possible. Consequently, there will be few
circumstances in which an issuer can legitimately be in posses-
sion of inside information that has not already been disclosed
to the market. If an issuer decides to allow a credit rating
agency access to inside information, the credit rating agency
would owe a duty of confidentiality as required by Article 6(3)
of Directive 2003/6/EC.

(8) See Article 1(8) and recital 10 of Directive 2003/125/EC.
(9) Article 1(2) under c stipulates that ‘market manipulation shall mean:
dissemination of information through the media, including the Internet, or
by any other means, which gives, or is likely to give, false or misleading
signals as to financial instruments, including the dissemination of rumours
and false or misleading news, where the person knew, or ought to have
known, that the information was false or misleading.(…)’

(10) Article 1(1) and 2(1) of Directive 2003/6/EC.

As a result, a credit rating agency or an employee who has
access to inside information of any sort is prohibited from any
trading using inside information. Moreover, it is not allowed to
disclose this inside information to anyone else except in the
normal course of employment, profession or duties. In this
respect, Article
of Directive
2003/6/EC states that issuers, or persons acting on their behalf
or for their account, draw up list of persons working for them
who have access to inside information. This provision allows
Member States to require credit rating agencies to draw up lists
of insiders. These lists must regularly be updated and trans-
mitted to the competent authority whenever the latter requests
it.

subparagraph

third

6(3),

In addition to having access to inside information of the issuer,
it is possible that a credit rating itself constitutes inside infor-
mation, in particular when the credit rating agency has access
to non-public information of the issuer. This implies that using
the unpublished rating for trading or disclosing this informa-
tion to anyone else, except in the normal course of employ-
ment, profession or duties,
is prohibited. However, a credit
rating agency communicating an imminent rating publication
to the issuer on a confidential basis for the purpose of checking
is based on would be
the accuracy of
allowed.

the information it

The Commission believes that the provisions of the Market
Abuse Directives provide a comprehensive set of rules for the
activities of credit rating agencies in the area of market abuse
concerns. The specific role of credit rating agencies in the
financial markets requires diligent application of these provi-
sions. Consequently, the Commission will monitor actively the
implementation and enforcement of these provisions in the
Market Abuse Directives in relation to credit rating agencies.

The second item of EU legislation which is relevant to credit
rating agencies is the Capital Requirements Directive (‘CRD’)
which introduces a new capital requirements framework for
banks and investment firms (11). The CRD is based on the new
international capital requirements framework agreed by the
Basel Committee on Banking Supervision (‘Basel II’) in 2004.

The CRD provides for the use of external credit assessments in
the determination of risk weights (and consequential capital
requirements) applied to a bank or investment firm's exposures.
Only the use of assessments provided by recognised External
Credit Assessment Institutions (‘ECAIs’), mainly credit rating
agencies, will be acceptable to the competent authorities. A
recognition mechanism is also outlined in the Directive.

(11) Re-casting Directive 2000/12/EC of the European Parliament and
of the Council of 20 March 2000 relating to the taking up and
pursuit of the business of credit institutions and Council Directive
93/6/EEC of 15 March 1993 on the capital adequacy of investment
firms and credit institutions.

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The CRD sets out a number of requirements which ECAIs
should meet before the competent authority grant them recog-
nition. For example, their ratings must be objectively and inde-
pendently assigned and reviewed on an ongoing basis. In addi-
tion, their rating procedures should be sufficiently transparent.
In addition, the competent authorities should assess whether
individual credit assessments are recognised in the market as
credible and reliable by the users of such credit assessments
and accessible at equivalent terms to all interested parties.

cases, the MiFID provisions regarding conduct of business and
organisational requirements will apply to the firm and its
undertaking of investment services and activities. Where, for
example, a credit rating agency provides investment services
(such as investment advice) to clients that fall under the MiFID,
the provisions on conflicts of interest will apply to protect the
interest of those who receive these services. The provisions on
conflicts of
interest may require an appropriate degree of
separation of investment services from the credit rating process
so that ancillary services may not interfere with the quality and
objectivity of credit ratings (14).

Building on the CRD, the Committee of European Banking
Supervisors (‘CEBS’) is working to promote convergence of the
recognition processes of ECAIs across the EU by defining a
common understanding on the criteria necessary to implement
the recognition requirements laid down in the CRD (12).

This comprehensive legal framework is now being put in place
by the Member States. All Directives must be correctly imple-
mented. Consequently, the transposition of the Directives is
actively monitored by the Commission. It may initiate infringe-
ment procedures on the grounds of incorrect or non-transposi-
tion of the Directives, where necessary.

Clearly, the CRD does not constitute a form of regulation of
credit rating agencies on how to do business but focuses predo-
minantly on the weighting of capital requirements. Conse-
quently, the recognition process of ECAIs does not address the
broader conduct of business issues concerning credit rating
agencies in general. Moreover, credit
rating agencies may
choose not to become ECAIs under the CRD and therefore the
CRD may not cover the entire population of credit rating agen-
cies. However, the objectives and effects of the ECAI recogni-
tion system cannot be seen separately from the aims of other
legislation and supervisory standards applicable to credit rating
agencies since the CRD affirms the meaningful function of
credit rating agencies. To this end, the Commission will closely
monitor developments with regard to the recognition of ECAIs
and assess whether credit rating agencies perform their impor-
tant role adequately under the CRD. Hence, competent authori-
ties should ensure that the effects of recognition are shared
with all stakeholders in order to assess whether the ECAI recog-
nition criteria could be used in the future for conduct of busi-
ness regulation of credit rating agencies, if this appears to be
necessary.

The final piece of relevant legislation is the Markets in Finan-
cial Instruments Directive (‘MiFID’) (13). MiFID and its future
implementing measures are not applicable to the rating process
of credit rating agencies in the case where the rating process
itself does not involve the firm undertaking investment services
and activities as defined in the MiFID. In other words, the
issuing of a credit rating will normally not result in the credit
rating agency also providing 'investment advice' within the
meaning of Annex I to the MiFID. But credit rating agencies
should be aware of the precise limits of this activity in order to
continue to operate outside MiFID regulation. However, credit
rating agencies that also provide investment services and activ-
ities on a professional basis may require authorisation. In such

Another area of Community law which is potentially important
for credit rating agencies is competition law. The Commission
does not share the European Parliament's concerns about the
degree of concentration in the ratings industry. There is no
indication of any anti-competitive practices in this industry but
any evidence to the contrary will be examined thoroughly. The
Commission does not therefore see the need for action in this
area at the moment. Moreover, one could conceive that in this
particular industry, excessive market fragmentation could have
adverse consequences (i.e. credit
rating agencies may face
undue pressure to issue favourable ratings in order to attract
clients).

3.2 The IOSCO Code

In September 2003, IOSCO published its Principles Regarding
the Activities of Credit Rating Agencies (‘IOSCO Principles’) (15),
setting high-level objectives for credit rating agencies, securities
regulators,
issuers and other market participants to improve
investor protection and market fairness, efficiency and transpar-
ency and to reduce systemic risk. In response to comments on
these principles, IOSCO developed the IOSCO Code of Conduct
Fundamentals for credit rating agencies (see Annex).

Reflecting the global nature of the market for credit rating
agencies, the IOSCO Code is meant to be applied by rating
agencies of all sizes and business models and in every jurisdic-
tion. The Commission notes that the IOSCO Code has not been
implemented into the national law of Member Sates. However,
credit rating agencies are expected to give full effect to the
provisions of the IOSCO Code — as long as these provisions
are consistent with the EU Directives. This requires that credit

(12) CEBS Consultation paper on the recognition of External Credit
Assessment Institutions, 29 June 2005, available at http://www.c-
ebs.org/pdfs/CP07.pdf

(13) Directive 2004/39/EC of 21/04/04 (OJ 2004 L 145/1).

(14) See Articles 13(3), 13(10) and 18 of the MiFID.
(15) IOSCO's Principles Regarding the Activities of Credit Rating Agen-

cies, available at www.iosco.org/IOSCOPD151.

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rating agencies incorporate the IOSCO Standards in their
procedures. Recent market developments show that several
credit rating agencies have set up their own Codes of Conduct
along the lines of the IOSCO Code which proves that the latter
provides a useful set of standards for self-regulation of the
credit rating industry.

It is very important that credit rating agencies not only incor-
porate the IOSCO Code in their own Code of Conduct but fully
comply with the IOSCO Code by enforcing their Code of
Conduct in daily practice. Credit rating agencies need to inform
regularly in the coming years all stakeholders about
their
compliance with their Codes of Conduct. To this end, the
Commission recommends to analyse the effects of the IOSCO
Code on a regular basis.

4. CONCLUSION

request by the European Parliament,

the
Following the
Commission has considered very carefully whether or not fresh
legislative proposals are required to regulate the activities of
credit rating agencies.

Its conclusion is that at present no new legislative initiatives are
needed. One of the central principles of ‘Better Regulation’ is
that legislative solutions should be applied only where they are
strictly necessary for the achievement of public policy objec-
tives. The Commission believes that the case for new legislation
in this area remains unproven.

There are already three new financial services Directives which
cover credit rating agencies. The Commission is confident that
these Directives — when combined with self regulation by the
credit rating agencies themselves on the basis of the newly
adopted IOSCO Code — will provide an answer to all the
major issues of concern raised by the European Parliament.

In its advice to the Commission, CESR also indicated that the
right balance between legislation and self-regulation had been
struck and that no further regulatory initiatives were needed
for the time being.

However, the Commission is continuing to monitor develop-
ments in this area very carefully.
the new
arrangements will only produce the desired results if credit
rating agencies take the task of regulating themselves suffi-
ciently seriously. They must be scrupulous in implementing the
provisions of the IOSCO Code. And they must be open and
transparent about the way in which they are doing it.

is clear that

It

It is encouraging that many credit rating agencies have estab-
lished their own Codes of Conduct based on the IOSCO Code.
But establishing these Codes in itself is not enough; they must
also be implemented in practice on a day to day basis. The
Commission intends to ask CESR to monitor compliance with
the IOSCO Code and to report back to it on an annual basis. It
will also consider how best to gauge the opinions of market
participants, especially those purchasing complex financial
instruments. This might include the setting up of an informal
expert group. The ratings industry should be aware that the
Commission may have to take legislative action if it becomes
clear that compliance with EU rules or the Code is unsatisfac-
tory and damaging EU capital markets.

The Commission will also consider
introducing legislative
proposals if new circumstances arise — including serious
problems of market failure.

Finally, the Commission intends to monitor the global develop-
ment of the rating business. If there are significant changes in
the way credit rating agencies are regulated in other parts of
the world, it may be necessary for the Commission to re-eval-
uate its approach.