The law and Regulation of Credit Rating Agencies in the US and EU

Abstract

The need for regulation of the credit rating agencies (CRAs) arose due to their role in the subprime mortgage crisis. The CRAs awarded risky securities ‘3-A’ investment grade status and then failed to downgrade them quickly enough when circumstances changed which led to investors suffering substantial losses. The causes identified by the regulators for the gatekeeper failure were conflicts of interest (as the issuers of these securities pay for the ratings); lack of competition (as the Big Three CRAs have dominated the market share); and lack of CRA regulation. The regulators, both in the US and EU, have tried to address these problems by introducing soft law self-regulation in accordance with the International Organisation of Securities Commissions Code and hard law statutory regulation such as that found in the “Reform Act” and “Dodd-Frank Act” in the US and similar provisions in the EU. This thesis examines these provisions in detail by using a doctrinal black-letter law method to assess the success of the regulators in redressing the problems identified. It also examines the US case law regulation relating to the legal liability of CRAs. The findings are that the US First Amendment protection, exclusion clauses and case law, all lack a deterrent effect on the actions of CRAs. As CRAs have escaped substantial damages, investors are left uncompensated for their losses. The thesis concludes that the issues of conflicts of interest and an anti-competitive environment persist. This thesis recommends the introduction of liability for the CRAs based on the Australian Bathurst case and which should be put in a statutory footing, including the requirements that are needed for making exclusion clauses effective. Rotation of CRAs for every three years would minimise the conflicts of interest. Regulators should require CRAs to purchase professional indemnity insurance, if available, to compensate investors.