In the first case of its kind in Hong Kong, the SFAT has confirmed that Moody’s Investors Service Hong Kong Ltd’s (Moody’s) publication in June 2011 of a Report, entitled “Red Flags for Emerging-Market Companies: A Focus on China”, fell within the “Type 10” regulated activity of providing credit rating services. The SFAT upheld the SFC’s decision to publicly reprimand and fine Moody’s for breaches of the SFC’s Code of Conduct.17
The Report shone a spotlight on certain Mainland Chinese issuers of fixed-income securities, adopting a system of allocating “red flags” to identify potential areas of concern with those companies. Those red flags covered matters such as weaknesses in corporate governance, fast growth, risky business models and concerns over the quality of financial reporting.
The Report focused in particular on six companies with the highest number of red flags – so-called “negative outliers”.
Following publication of the Report, the share prices of more than half of the Hong Kong-listed companies red-flagged in the Report suffered substantial falls.
In the aftermath, concerns were raised about the validity of the red flag framework adopted in the Report. In addition, the accuracy of the Report was called into question. This led to an SFC investigation. In its Decision Notice dated 3 November 2014, the SFC determined that Moody’s had breached the Code of Conduct. Specifically:
- General Principle 1: the SFC found that the red flag framework gave an unfair and misleading impression of the companies concerned. For example, no commentary was provided on the red flags, and there was no significant correlation between the number of red flags and credit risk. Moody’s was stated to have failed to act fairly, in the best interests of its clients and the integrity of the market
- General Principle 2: the SFC found that the Report contained numerous errors, which had created a wrong and potentially harmful impression in the eyes of the market. Moody’s was stated to have failed to act with due skill, care and diligence, in the best interests of its clients and the integrity of the market
- Paragraph 4.3: the SFC found that Moody’s did not have in place sufficient internal control procedures.
The SFC imposed a public reprimand and a fine of HK$23m.
Moody’s appealed to the SFAT on jurisdictional grounds. They argued that preparation and publication of the Report did not fall within the “Type 10” regulated activity of providing credit rating services, and that the SFC’s Code of Conduct, therefore, did not apply.
The SFAT rejected this argument, finding that “even if unintended, in its preparation and publication of the Report, Moody’s was carrying on its regulated activities”.18 The SFAT found that the red flag system adopted by Moody’s was a form of credit rating, or at least a method by which the market could assess risk and act on that risk.
The SFAT, therefore, upheld the SFC’s decision to fine and publicly reprimand Moody’s, although it reduced the original HK$23m fine imposed by the SFC to HK$11m. The SFAT also overturned the SFC’s finding that Moody’s did not have in place sufficient internal control procedures in breach of paragraph 4.3 of the Code of Conduct (albeit on technical grounds).19
The case marks the first disciplinary action against a credit rating agency since the activities of such firms became regulated by the SFC in June 2011. The SFAT’s confirmation that the SFC’s jurisdiction encompasses more than just rating services of the “classic kind” is likely to encourage rating agencies to consider more carefully the potential impact of their publications on the market.
At the time of writing, press reports stated that Moody’s intends to appeal the SFAT’s decision. Any such appeal will be to the Court of Appeal and is likely to focus on the application of the law (for example, the scope of the SFC’s jurisdiction). Few SFAT decisions have been appealed to the courts. If an appeal does proceed, market watchers will wish to review what the Court of Appeal’s judgment may mean for (among other things) the scope of public research reports in Hong Kong.