As the SEC considers the best approach to assuring conflict of interest free credit rating agencies, the Council of the European Union has adopted a Directive and a Regulation mandating the rotation of credit rating agencies for the rating of structured financial products. The adoption of the legislation follows agreement reached with the European Parliament.
The Directive and Regulation amend existing legislation on credit rating agencies in order to reduce investors' over-reliance on external credit ratings, mitigate the risk of conflicts of interest in credit rating activities and increase transparency and competition in the sector. Specifically, the Directive amends current Directives on the activities and supervision of financial institutions for occupational retirement provisions, on undertakings of collective investment in transferable securities (UCITS) and on hedge funds and other alternative investment fund managers (AIFM) in order to reduce the financial institutions' reliance on external credit ratings when assessing the creditworthiness of their assets.
The Regulation introduces a mandatory rotation rule obliging issuers of structured finance products with underlying re-securitized assets who pay credit rating agencies for their ratings (the issuer pays model) to switch to a different agency every four years. An outgoing rating agency will not be allowed to rate re-securitized products of the same issuer for a period equal to the duration of the expired contract, though not exceeding four years.
Mandatory rotation will not apply to small credit rating agencies, or to issuers employing at least four credit rating agencies, each rating more than 10 percent of the total number of outstanding rated structured finance instruments.
A review clause provides the possibility for mandatory rotation to be extended to other instruments in the future. Mandatory rotation is not a requirement for endorsement by the E.U. of U.S. or other third country credit rating agencies. Due to the complexity of structured finance instruments and their role in contributing to the financial crisis, the Regulation also requires issuers to engage at least two different credit rating agencies for the rating of structured finance instruments.
To mitigate the risk of conflicts of interest, the Regulation also requires CRAs to disclose
publicly if a shareholder with 5 percent or more of the capital or voting rights holds 5 percent or more of a rated entity. And to ensure the diversity and independence of credit ratings and opinions, the regulation prohibits ownership of 5 percent or more of the capital or the voting rights in more than one CRA, unless the agencies concerned belong to the same group.