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IOSCO Consults the buy-side on the over reliance of external credit rating agencies

The International Organization of Securities Commissions (IOSCO) has published a consultation paper on Good Practices on Reducing Reliance on CRAs in asset management (CR04/14). The consultation is aimed at gathering the opinions and practices of investment managers and institutional investors, with a view to developing a set of best practices reducing their over reliance on external credit rating agencies (CRA). The report stresses the importance for the buy-side to have the appropriate expertise and governance processes in place to assess and manage the credit risk associated with their investment decisions. It lists some examples of good practices which include:

  • Where external credit ratings are used, investment managers understand the methodologies, parameters and the basis on which an opinion of a CRA was produced, and have adequate means and expertise to identify the limitations of the methodology and assumptions used to form that opinion.
  • Regulators might engage with investment managers to review their disclosures describing alternative sources of credit information in addition to external credit ratings.
  • Regulators could encourage investment managers to disclose the use of external credit ratings and describe, in a plausible way, how these complement or are used with the manager’s own internal credit assessment methods.
  • Investment managers make their own qualified opinions as to the credit quality of a financial instrument before investing and ongoing throughout the holding period.

The consultation arrives the same week that a major credit rating agency and Dutch Bank were found liable in Australia for investment losses on securities bought by twelve local government councils, upholding a 2012 verdict that they had misled investors.

The firms who had appealed the 2012 verdict were found guilty by the Federal Court, for giving triple-A ratings to tens of millions of dollars’ worth of toxic financial products. Investors had successfully sued the ratings company and the bank over credit derivatives that lost almost all their value in the run-up to the global financial crisis. The court also ordered the firms to completely compensate the investors for their losses.

The ruling paves the way for comparable legal claims elsewhere from investors who lost billions of dollars during the global financial crisis in part due to an overreliance on credit ratings. During the appeal, the ratings agency argued the councils had contributed to their own losses by not properly investigating the triple-A rated securities they purchased.

“This is a landmark decision that changes the legal landscape,” Amanda Banton, a partner with Piper Alderman Lawyers who represented the councils, said in a statement. “The implications for other claims currently in the court are enormous.”

The bank had paid the ratings agency for the credit ratings and then sold on the constant proportion debt obligation notes, also known as “Rembrandt” notes, in the market in late 2006. The ratings agency gave the notes its highest possible rating before they were sold to the councils by the Australian Local Government Financial Services who assured the councils that they had a less than 1 percent chance of defaulting. Within six months, they failed to pay and the councils lost A$16 million ($14.89 million USD), or 90 percent of the funds they had invested.

The court found that the securities were sold on the basis that the triple-A rating was established on “reasonable grounds”, and as the result of an exercise in “reasonable care and skill”, while neither was true. The judgment added that the agency was “misleading” and “deceptive” when it awarded its highest credit rating to the debt instruments.

The ratings agency did not comment on whether the company was considering an appeal to the High Court. “We are disappointed with this ruling,” they said in a statement. “We continue to believe that it is bad policy, and inconsistent with well-established laws outside Australia, to enforce a legal duty against a party which has no relationship with investors who use rating opinions, yet impose no responsibility on those investors to conduct their own due diligence.”

The RIMES Reference Data Service (RDS) offers a bespoke gateway to a better data service, including credit ratings from numerous agencies. RIMES RDS is an integral part of our managed data services and offers a superior, cost-effective alternative to an in-house operation. It offers a single solution to the multiple challenges of building and managing a global repository of dynamic reference data.

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