EU Council and Parliament Reach Agreement on Legislation to Enhance Regulation of Credit Rating Agencies, Including Mandatory Rotation

The Council of EU Member States and the European Parliament have reached an agreement on legislation to broadly overhaul the regulation of credit rating agencies. The draft Directive and draft Regulation are aimed at reducing investors' over-reliance on credit rating agencies, mitigating conflicts of interest and increasing transparency and competition. The texts will be submitted to the Parliament and the Council for approval and adoption.

Specifically, the draft Directive amends current Directives on undertakings of collective investment in transferable securities (UCITS) Directive 2009/65/EC and on alternative investment funds managers (AIFM) Directive 2011/61/EU in order to reduce these funds' reliance on external credit ratings when assessing the creditworthiness of their assets. The draft regulation introduces a mandatory rotation rule forcing issuers of structured finance products with underlying re-securitized assets who pay credit rating agencies for their ratings under the issuer pays model to switch to a different agency every four years. An outgoing rating agency would 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.

But the legislation would not impose mandatory rotation on small credit rating agencies , or on issuers employing at least four rating agencies each rating more than 10 percent of the total number of outstanding rated structured finance instruments.

A review clause in the legislation provides the possibility for mandatory rotation to be extended to other instruments in the future. Mandatory rotation would not be a requirement for the endorsement and equivalence assessment of third country rating agencies. Due to the complexity of structured finance instruments and their role in contributing to the financial crisis, the draft Regulation also requires issuers to engage at least two different credit rating agencies for the rating of structured finance instruments.

In an effort to mitigate the risk of conflicts of interest, the legislation would require rating agencies to disclose if a shareholder with 5 percent or more of the capital or voting rights holds 5 percent or more of a rated entity, and would prohibit a shareholder of a rating agency with 10 percent or more of the capital or voting rights from holding 10 percent or more of a rated entity.

And to ensure the diversity and independence of credit ratings and opinions, the proposal would prohibit ownership of 5 percent  or more of the capital or the voting rights in more than one rating agency, unless the agencies concerned belong to the same group.

Investors or issuers would be able to claim damages from a rating agency if they suffered a loss due to an infringement committed by the agency intentionally or with gross negligence.

Moreover, sovereign debt ratings would have to be reviewed at least every six months rather than the 12 months that is currently required and investors and Member States would be informed of the underlying facts and assumptions on each rating. Rating agencies would also have to provide more information on the reasons behind sovereign ratings, explaining why it took a specific rating action.