On 11 October 2018, the Court of Final Appeal (CFA) delivered its reasons for judgment (FACV 6/2018;  HKCFA 42) (which judgment had already been handed down at the conclusion of the hearing before the CFA on 3 September 2018) in dismissing the appeal by Moody’s Investors Service Hong Kong Limited (Moody’s) in relation to the Securities and Futures Commission’s (SFC) disciplinary action against Moody’s on its publication of a report entitled “Red Flags for Emerging-Market Companies: A Focus on China” (the Report) in 2011. This decision puts an end to Moody’s challenge to the SFC’s jurisdiction to discipline Moody’s under Part IX of the Securities and Futures Ordinance (Cap. 571) (SFO).
The background of the present case and the decisions by the SFC and the Securities and Futures Appeals Tribunal (SFAT) were discussed in a previous article. The present article focuses on the decisions of the Court of Appeal (CA) ( 3 HKLRD 565) and CFA.
The CA’s decision
“Credit ratings” are in Part 2 of Schedule 5 of the SFO defined as “opinions, expressed using a defined ranking system, primarily regarding the creditworthiness of (a) a person other than an individual; (b) debt securities…”.
The CA disagreed with the SFAT’s finding that the Report itself constituted credit rating. The CA put due emphasis on the word “primarily” in the definition of “credit ratings”, and held that:-
- There is a distinction between an expression of opinions primarily regarding creditworthiness using a defined ranking system (hence caught under the statutory definition of “credit ratings”) and a discussion limited to one or two elements of credit risk without expressing any opinion on the overall assessment of the creditworthiness.
- Moody’s did not represent in the Report that it had adopted an alternative credit risk assessment approach based on corporate governance and accounting risks (which are two of the many elements of credit risk) alone. The focus of the Report was confined to these two types of risks, which are relevant but far from determinative of creditworthiness. The CA held that the SFAT failed to address the requirement of primacy in the statutory definition and the distinction between assessment of some (but not all) elements of credit risk and assessment of creditworthiness, and hence fell into an error of law.
However, the CA upheld the SFAT’s decision on the latter’s alternative reasoning that misconduct could be established on the basis that the preparation and publication of the Report was relating to the carrying on of Moody’s business of credit ratings. The CA concluded that:-
- Even though the red flag framework of the Report was not part of the methodology in arriving at Moody’s credit ratings of a classic kind, the Report itself constituted additions and clarifications which were meant to be read together with such classic ratings and as such, the publication of the Report was an activity “relating to” the ratings within the meaning of section 193(1)(d) of the SFO.
- The business of credit ratings encompasses clarifications or additions to existing ratings on an ongoing basis, and such construction is consistent with the purposive interpretation of the statute and proportionate interference with the freedom of expression.
The Final Battle at the CFA
Moody’s appealed to the CFA to challenge the CA’s finding that the publication of the Report was an activity “relating to” credit ratings within the ambit of section 193 of the SFO. Lord Neuberger of Abbotsbury NPJ gave the only reasoned judgment, with which all the other four members of the Court agreed.
(a) The meaning and effect of “relating to”
Moody’s argued that the preparation and publication of the Report could only be said as “relating to” the provision of credit rating service if it had been (or was understood, or would reasonably have been understood to have been) involved in the preparation of credit ratings. Unless such a clear and limited meaning is given to the phrase, the law would be uncertain, which is particularly inappropriate in the context of Part IX of the SFO, given it creates an offence and involves curtailing freedom of expression.
The CFA observed that “relating to” is a phrase with a naturally wide and broad import. The CFA was of the view that where the legislature has used words which are very general in their natural ambit, it is inappropriate, in the absence of a cogent reason, to attribute a relatively specific meaning to those words.
The CFA opined that section 193(1)(d) of the SFO is contained in a Part of the SFO which is concerned with regulating and sanctioning “regulated activity” in financial markets by licensed persons. One must bear in mind that the provision was enacted as part of a scheme to protect members of the public and financial markets against inappropriate or substandard behaviour by sophisticated people, expert and experienced in financial markets. The CFA therefore rejected such a narrow interpretation of “relating to” put forward by Moody’s.
(b) The proper approach to determine whether the Report was “relating to” the provision of credit rating services
The CFA went on to set out the proper approach to determine whether the Report was “relating to” the provision of credit rating services. According to the CFA, reference should be made as to how the Report would reasonably have been understood by the people to whom it was addressed (i.e. investors and traders for debt and debt-related instruments in the market), and not by reference to the private intentions of Moody’s. A tribunal may also take into account how the market actually reacted when determining what someone with considerable experience of the market should have expected of the market.
The CFA relied on the following factors to conclude that the Report did “relate to” Moody’s credit rating service:-
- All of the Chinese companies covered by the Report were subject to Moody’s existing published credit ratings. Indeed, they were the only Chinese high-yielding non-financial companies for which Moody’s provided credit ratings. This appears to “tie in” the Report with Moody’s previous credit rating reports on those companies, and there was no clear or convincing disclaimer.
- Frequent references were made to the credit ratings of a majority of companies (49 out of 61) covered in the Report. Particularly, Moody’s stated in the “Overview” of the Report that the red flag results are shown “by rating category”. This strongly suggests a connection between the Report and Moody’s credit rating service.
- In all the 8 figures, and in 3 of the 4 appendices of the Report, the “tripped” red flags in relation to companies, or categories of companies, were compared with their respective credit ratings.
- Notwithstanding Moody’s contention that the red flag system did not represent a departure from its previous ratings accorded to any of the companies in its previous credit rating reports, the obvious message to any remotely acute trader or investor was that the red flags attributed to a particular company in the Report should at least be borne in mind when considering that company’s existing credit rating.
- The Report largely concentrated on corporate governance and accounting risks, which are two of the many factors that a credit rating takes into account.
- The announcement accompanying the Report described the Report as being “supplemental to Moody’s methodological approach to rating non-financial corporates in the emerging markets”, which suggests that the Report would also “relate to” Moody’s credit rating service.
- Given the importance accorded by the market to the ratings of companies or to company debt by rating agencies, the only sensible interpretation of the market reaction to the Report is that Moody’s was indeed seen as providing a negative sort of qualification in the Report to the existing ratings.
For the above reasons, the CFA dismissed Moody’s appeal.
It is hardly surprising that the CFA arrived at the conclusion it did. The phrase “relating to” bears the widest possible meaning, so the publication of the Report can be said to be “relating to” the provision of credit rating services which falls within the ambit of the definition of “misconduct” under section 193(1)(d) of the SFO.
The impact of this case is that going forward, credit rating agencies will need to exercise caution when publishing reports to the market. The standards that are expected of them will be high. They will need to ensure that the facts in those reports are verified (at least with reasonable diligence) to be true and accurate and free from material errors; the methodologies and approaches employed in assessing the creditworthiness of companies are logical and consistent; and the opinions expressed therein are fair and reasonable.