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.