Credit rating agencies (‘CRAs’) play a crucial role in global securities and banking markets, as their credit ratings are used by market participants to make investment and financing decisions.
Prior to the global financial crisis CRAs were not formally regulated in the European Union. Following the financial crisis, however, CRAs became subject to significant regulatory scrutiny.
In 2009 the EU introduced a formal regulatory regime for CRAs. The regime was contained in Regulation (EC) No 1060/2009 (the ‘CRA Regulation’).
In 2013 a number of reforms to the CRA regulatory regime were introduced by Regulation (EC) No 462/2013. Among other things, Regulation (EC) No 462/2013 established a new civil liability regime for CRAs. The regime, which is contained in a new Article 35a of the CRA Regulation, allows civil claims to be made against CRAs in certain defined scenarios. Article 35a has been implemented in the United Kingdom by the Credit Rating Agencies (Civil Liability) Regulations 2013 (the ‘Regulations’).
Set out below is a summary of the main elements of the new liability regime. Other aspects of the reforms introduced by Regulation (EC) No 462/2013, such as the rotation of rating agencies for resecuritisations, are outside the scope of this article.
Civil liability regime
The new cause of action
Article 35a(1) of the CRA Regulation provides for civil liability of CRAs in the following terms:
‘Where a credit rating agency has committed, intentionally or with gross negligence, any of the infringements listed in Annex III [of the CRA Regulation] having an impact on a credit rating, an investor or issuer may claim damages from that credit rating agency for damage caused to it due to that infringement.
An investor may claim damages under this Article where it establishes that it has reasonably relied … on a credit rating for a decision to invest into, hold onto or divest from a financial instrument covered by that credit rating.
An issuer may claim damages under this Article where it establishes that it or its financial instruments are covered by that credit rating and the infringement was not caused by misleading and inaccurate information provided by the issuer to the credit rating agency, directly or through information publicly available.’
The most important feature of Article 35a is that it allows relevant market participants to claim compensation from CRAs where there is no contractual relationship or other relationship giving rise to a duty of care between them. In other words, an investor or issuer who suffers loss as a result of a flawed credit rating may claim compensation from the relevant CRA even though there is no proximate relationship between them.
The imposition of liability in the absence of a proximate relationship represents a significant departure from the traditional approach in England and Wales, which has been cautious about permitting claims for economic loss flowing from negligent statements. That caution has been driven by a desire to avoid a flood of claims and to ensure that those who publish information do not face liability which is out of proportion to their culpability, the fee earned or their ability to insure against the consequence of negligence (see for instance Caparo v Dickman  2 A.C. 605). Indeed, expansive liability to market participants has traditionally been resisted on the basis that it would expose defendants to ‘liability in an indeterminate amount, for an indeterminate time, to an indeterminate class’ (Ultramares Corporation v. Touche (1931) 174 N.E. 441, 444, per Cardozo C.J). Although, in the recent Australian case of Bathurst Regional Council v Local Government Financial Service Pty Ltd (No 5)  FCA 1200, it was held that a CRA, in assigning a rating to a debt instrument, owed a duty of care to potential investors.
It was in recognition of the difficulties associated with establishing civil liability against CRAs that Article 35a was introduced.
Elements of the new cause of action
In order to make out a successful claim under the new civil liability regime, investors who do not have a contractual relationship with the defendant CRA will have to prove that:
- The CRA has committed an infringement of the type listed in Annex III of Regulation (EC) No 1060/2009.
- The infringement was committed intentionally or with gross negligence.
- The infringement had an impact on a credit rating and caused the investor to suffer loss.
- They (the investor) reasonably relied on the relevant credit rating when deciding whether to invest into, hold onto or divest from a financial instrument covered by that credit rating.
These matters are considered briefly below.
The types of infringements under Annex III that potentially give rise to civil liability are mainly procedural in nature. There are, however, a range of substantive infringements upon which claimants may rely. For example, the following infringements by CRAs can form the basis of a claim under the new regime:
- Not ensuring rating analysts have appropriate knowledge and experience for the duties assigned (paragraph 1(27) of Annex III).
- not adopting adequate measures to ensure that credit ratings are based on a thorough analysis of all the information that is available (paragraph 1(42) of Annex III).
These substantive breaches are similar in nature to errors that one would expect to find in an ordinary claim for negligence.
In addition to proving that a CRA has committed a relevant infringement, claimant investors must prove that the infringement was committed by the CRA intentionally or with ‘gross negligence’. This is a relatively high threshold.
It is entirely possible that claimants will have difficulty in establishing that relevant infringements took place intentionally or with gross negligence. This is particularly so given the restrictive way in which ‘intention’ and ‘gross negligence’ have been defined by the Regulations.
Under the Regulations, an infringement shall be considered to have taken place intentionally or with gross negligence in the following respective circumstances:
‘if the senior management of the credit rating agency acted deliberately to commit the infringement’; or
‘if the senior management of the credit rating agency were reckless as to whether the infringement occurred’.
The definition of ‘gross negligence’ is further restricted by paragraph 4(2) of the Regulations, which states that for the purposes of the Regulations, the senior management of a credit rating agency are reckless ‘if they act without caring whether an infringement occurs’. This definition is similar to the test for subjective recklessness.
The upshot of the above tests for ‘intention’ and ‘gross negligence’ is that claimant investors will not be able to establish liability under the new regime simply by showing that an infringement occurred by mistake or by reason of a failure to take reasonable care. It will be necessary to persuade a court that relevant infringements were committed deliberately by senior management or, alternatively, that senior management were subjectively reckless regarding whether the relevant infringement occurred.
In order to make out a claim, investors will also have to show that the relevant infringement had an impact on the CRA’s credit rating (i.e. that the infringement resulted in a different rating category being assigned to the issuer or the financial instrument of the issuer to which the credit rating relates) and that the infringement caused them to suffer damage.
The test for causation under the new liability regime will be the same as the test used in negligence claims. In other words, causation will be established by applying the ‘but for’ test. Claimants will need to show that but for the CRA’s relevant infringement they would have been better off.
The defendant CRA will have a good defence if it can establish that the infringement did not cause the investor to suffer loss. In other words, CRAs will be able to escape liability if they can persuade the court that:
- Even if a proper rating had been given, the claimant would have been no better off.
- The way in which the claimant says he would have acted in an infringement-free context would not have conferred on him the benefits for which he seeks compensation.
Questions of causation are often fact sensitive and the success of CRAs in deploying causation defences will very much depend on the evidence presented to the court.
The final hurdle that claimant investors must overcome relates to ‘reasonable reliance’. It must be shown that the claimant investor ‘reasonably relied’ upon the CRA’s credit rating when making its investment decision.
Whether an investor’s reliance on a credit rating was reasonable will depend upon the facts of each case. However, a clue as to the circumstances in which reliance on a rating will not be reasonable is given by Article 5a(1) of the CRA Regulation. Article 5a(1), which is applicable to commercial market participants such as credit institutions, investment firms and insurance/reinsurance undertakings, requires such entities to make their own credit risk assessment and prohibits them from solely or mechanistically relying on credit ratings for assessing the creditworthiness of an entity or financial instrument. It is therefore likely that commercial entities which fail to assess their investments independently, and instead rely mechanically on CRA ratings, may well have difficulty in making out a claim under Article 35a.
In order to make out a successful claim private investors must also take due care with their investment decisions, i.e. take the care a reasonably prudent investor would have exercised in the circumstances. The extent to which the ‘due care’ test requires private investors to conduct their own credit risk assessment, and the nature of those risk assessments, is currently unclear and is likely to be a key area of debate in future claims made under the new regime.
Sales J found that even if there had been a breach of duty, the omission to inform Torre did not cause Torre’s loss. The purpose of the information duty was to enable Torre to exercise its rights under the loans effectively, not to help it decide whether or not to continue its investment. So losses in relation to investment decisions fell outside the scope of foreseeable losses flowing from breach of the duty and were not caused by it.
Where the claim is for an omission to pass on information, proving causation may be particularly problematical. A claimant has to show not only that on the counterfactual assumption that the information had been passed on that it would have acted differently and so avoided a loss, but also that the loss suffered fell within the scope of the duty to act. This latter point has not been sufficiently highlighted previously and is a substantial burden for a claimant to overcome.
Sales J also dealt in passing with a factual causation argument that would have defeated the claim. If it had come to light that an event of default had occurred, this would have reduced the price of the loans, thereby removing the incentive for Torre to sell them. In other words, telling Torre the event of default had occurred would not have caused them to sell the loans because the sale price would be reduced due to the event of default and they would accordingly obtain no advantage from a sale. Although it was only a brief discussion, this argument could be used in a wide variety of claims to negate causation.
Article 35a was implemented because of concerns that investors did not have an effective right of redress against CRAs if they suffered loss as a consequence of a flawed rating.
The new liability regime provides such a system of redress and thereby creates significant additional litigation risks for CRAs. The precise extent of those litigation risks, however, is not yet entirely clear. For example, section 14 of the Regulations provides that where there is no contract between the CRA and claimant investor, the damages recoverable by the investor are to be calculated on the same basis as if the claimant had succeeded against the CRA in a claim for negligence. While section 14 makes it clear that principles such as mitigation and remoteness may serve to reduce the damages payable by CRAs, it is not entirely clear whether (and to what extent) other common law principles may serve to limit the damages payable by CRAs. The extent to which CRAs may limit their liability using the principle that recovery is limited to the difference between the value the CRA attributed to the investment and the true value of that investment (known as the ‘SAAMCO cap’ after Banque Bruxelles Lambert v Eagle Star (SAAMCo)  UKHL 10), for example, may well have to be determined by a court.
Also, the Regulations permit CRAs expressly to limit their liability, provided that such limitation is ‘reasonable and proportionate’. Sections 10-12 of the Regulations set out specific factors that are relevant to determining whether a limitation is reasonable and proportionate. However, the application of this test is likely to be highly fact dependant and it is another area where the courts may be asked to give clarification.
Given the entirely new risks presented by Article 35a, and the inevitable uncertainties associated with new claims based on that Article, CRAs will have to give careful consideration to their current risk management procedures and the potential liabilities they may incur under the new civil liability regime.