Background

Although credit rating organizations (CROs) are not currently subject to formal securities regulatory oversight in Canada, they nonetheless play an important role in Canadian securities legislation. If appropriately rated by an "approved credit rating organization," short-term debt securities may be distributed to the retail market under an exemption from the prospectus requirement, and are eligible investments for money-market funds, while debt securities of all maturities can be distributed by short-form prospectuses (including shelf prospectuses). Under Canadian prospectus rules, a credit rating (and certain related information) must be disclosed in the prospectus if the securities being offered have received a rating from an approved rating organization (and it is the general practice to obtain such a rating for an offering of debt securities and preferred shares).

The credibility of the CROs (Fitch, Moody’s, S&P and, in Canada, DBRS) was significantly eroded by the recent credit crisis, as so many of the "toxic assets" (synthetic collateral debt obligations referenced to underlying sub-prime mortgages and other delightful concoctions) that turned up on the balance sheets of financial institutions worldwide had been highly rated by the CROs. Not to mention the securities that made up Canada’s own non-bank-sponsored, asset-backed commercial paper market, which froze up in 2007. No surprise, then, that Canadian securities regulators, as well as their counterparts in the US and Europe, have been rethinking the role CROs play in the capital markets and how they should be regulated.

In October of 2008, the Canadian Securities Administrators (CSA) published for comment a consultation paper that proposed establishing a regulatory framework for CROs. The CSA has now published for comment proposed National Instrument 25-101 Designated Rating Organizations (the Proposed Instrument), which aims to introduce securities regulatory oversight of CROs. The comment period is open until October 25, 2010.

The Proposed Instrument

Under the Proposed Instrument, CROs will have to apply to be "designated rating organizations" (DROs), which would ultimately replace the concept of "approved rating organization" currently found in Canadian securities legislation. The application would be made by filing a completed Form 25-101F1, which would also have to be filed on an annual basis within 90 days of the DRO’s financial year-end.

Each DRO would be required to establish, maintain and ensure compliance with a "code of conduct" on terms substantially the same as the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies of the International Organization of Securities Commissions. On a "comply or explain" basis, the code of conduct could deviate from IOSCO Code provisions, but only if it indicates how it deviates and how it nonetheless achieves the objective of the IOSCO Code provisions.

A DRO’s code of conduct would have to be filed "prominently" on its website, and no waiver of any provision of the IOSCO Code would be permitted.

The Proposed Instrument imposes additional specific requirements on DROs, including a requirement that the DRO have policies and procedures in place to identify and manage conflicts of interest and to prevent inappropriate use or dissemination of certain material non-public information, not issue or maintain a credit rating in the face of any specified conflict of interest, and appoint a compliance officer to be responsible for monitoring and assessing the DRO’s compliance with its code of conduct.

The Proposed Instrument makes consequential amendments to the prospectus form, requiring enhanced disclosure when issuers have received a credit rating from a CRO for any of its securities (and not just for the securities being offered under the prospectus), including disclosure of the amount of any payments the issuer has made to the CRO with respect to the rating or for any other services provided by the CRO to the issuer during the previous two years.

CROs as "experts" for purposes of civil liability

As mentioned above, issuers must disclose credit ratings they have received from a CRO when offering securities to the public by way of prospectus. Concurrently with the filing of the final prospectus, issuers must file the consent of any "expert" named in the prospectus as having prepared or certified a report, valuation, statement or opinion referred to in the prospectus, any such expert assuming statutory liability for the opinion in question.

The CSA does not currently consider CROs to be "experts" for such purposes, but in its request for comment on the Proposed Instrument it has specifically asked for comment as to whether this remains appropriate. In the light of the recent rescission in the United States — under the Dodd-Frank Wall Street Reform and Consumer Protection Act — of the rule1 providing that rating agencies would not be considered "experts" for registration statement purposes, it will be interesting to see where the CSA ends up on this issue2.