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Journal of Malaysian and Comparative Law |
Since 1990 to date, coporations wich wanted to issue corporate bonds1 were required to obtain a rating from one of the two rating agencies in Malaysia, Rating Agency Malaysia Bhd (RAM) or Malaysian Rating Corporation (MARC).[2]
RAM was established in November 1990 with a paid up capital of RM10 milion. It’s 51 shareholders compries commercial banks, merchant bank, finance companies and two other institutions, the Asian Development Bank and IBCA Ltd, an international credit rating agency based in United Kingdom.[3]
Credit rating services are also provided by Malaysia’s second rating agency, MARC. MARC was incorporated in October 1995 with a paid up capital of RM10 milion and commenced operations in June 1996.
The sharedholders of MARC comprises major life and general insurance companies, stockbrokers and discount houses in Malaysia.[4]
The existence of mandatory credit rating in Malaysia is symptomatic of an emerging debt market where inverstore are less sophisticated and disclosure standarts are low. This is also consistent with the merit-based regime which favours a paternalistic role to market regulation. However, the securities market is moving in stages to a disclosure based sytem. The Capital Market Masterplan[5] has recommended the eventual removal of the mandatory requirement for credit ratings on corporate debt instrument. This would mean that corporate issuers would be free to choose whether or not to submit debt instruments to a rating, which is the situation in U.S.A. The recommended move will certainly impact on the existing as well as future role of credit rating agencies in Malaysia.
When the regional economic turmoil of 1997 resulted in many corporations debt being downgraded, questions were raised as to the competency or limitations of credit rating agencies to predict the competency or limitations of credit rating agencies to predict the economic downturn.
More recently, when Enron and World Com. Inc. collapsed, the American rating agencies, notably Standardt and Fitch’s Ratings were shown to alert the market of a rating downgrade. This has resulted, and raises in a loss of confidence in the credit rating agencies ability to to predict default, and raises questions as to the competencies and role of credit rating agencies.[6]
In the light of the evolving role of credit rating agencies in Malaysia, this article looks at the nature of credit rating and its functions and raisese selected legal issuse, in particualr the liability of credit rating agencies in the event of a negligent assignation of a particular rating. In this respect, comparisons would be drawn to American authorities.
Credit rating is a mechanism whereby an independent third party makes an assessment, based on different sources of information on the likelihood of a default in the debt payment of a corporate issure. A credit
rating focuses on the specific debt instrument and not on the overall credit worthiness or finamcial standing of the corporate issure (although these factors may to a certain extent influence the rating assigned). A rating also takes into consideration various credit enhancement tools like guarantees, sinking fund, letters of credit or any other mechanism devised to reduse the default risk on specific issues. Thus, a corporate issure may have different grades of rating for different debt issues. These ratings are expressed alpha- numeral symbols, indicating the degree of certainty regarding punctual payment of principal and interest on the rated debt instrument.
Once a rating is assigned, the rating agency is obliged to monitor the rating troughout the life of the rated instrument. As part of its surveillance, a rating agency may publish a ‘rating alert’ to inform the market of developments whish may impact on the status of the rated instrument e.g a proposed merger or take over, changes in goverment policies, economic environment and the like . On analysis the rating would either be revised or reaffirmed. The surveillance mechanism is a useful devise to indicate the current quality of a rated debt instrument and allows investors the opportunity, if they so wish, to realign their invesment portfolio.
Credit rating had its origins in USA in the late 1900’s. The dominant issuers of corporate instruments then were the privately owned railroad companies. Inverstors purchased these instruments based on ‘name’ recognition or friendly advise from brokers. Mr John Moody, the founder of Moody’s Inverstor Services, a statistician in a private banking firm, capitalized on the need for a manual which would provide potential inverstor with pertinent information on industrial companies. In 1990 he published ‘Moody’s Manual of Industrial and Miscellaneous Securities’. Its success led him to introduce ‘Moody’s Weekly Review of Financial Conditions in 1909’ where among others, he started rating railroad bonds. His rating were expressed in easy to understand alpha-numeral symbols ranging from ‘Aaa’ (colloquially referred to as ‘Triple A’) through C. These symbols indicated his assessment of the degree of certainlty regarding the punctual payment of principal and interest on the rated bonds. Bonds which were rated ‘Aaa’ implied the highest degree of certainty of timely payment of interest and principal. Those rated C indicated the highest degree of the risk of default in the payment of interest and principal. The in between grades (Aaa, A, Baa, Ba, B) signified relative levels of graduation of risk with regard to the likelihood timely payment of interest and principal. In 1914 John Moody formed ‘Moody’s Inverstor Services’, the world’s first credit rating agency.
Credit rating was institutionalized as a result of a rule enacted in 1933 by the United States Controller of Currency that stipulated banks could purchase only securities rated BBB or Baa or above. This led to banks having to ‘junk’ securities rated in lower grades, thus the etymology for the term ‘junk bonds’. The concept of rating was reinforced in 1970 when Penn Central (then the worlds’ largest transportation company) default on its short term commercial paper amounting to about US$80 million. Until then such instruments by virtue of its issures were considered as safe investment, like US Treasurey bills. The risk of default by Penn Central had been predicted by major rating agencies.When Penn Centrals’ default proved the prediction right it gave amassive boost to the idea that credit risks could be independently assessed.Today in USA virtually 100 per cent of debt issued by corporations carries a credit rating assigned by one or more rating agencies.
The functions performed by credit rating agencies may be summarised thus:
(i) Investor Protection
The independent, objective analysis of the credit quality of debt instruments aids the investor in making informed choices to determine the leve of risk and associated returns they are willing to undertake for theire investment. Beside the predictive value of ratings, the continous surveillance of a rated instrument acts as an early warning system to alert investors to any changes in the quality of the rated debt so that investors may reassess their position and realign their portfolio accordingly. Thus if a particular debt is down graded, investor may decide to sell the investment if they are not prepared to assume the added risk involved.
(ii) Enlarged Investor Pool
The alpa-numerical symbol used to indicated the relative riskiness of a variety of debt instruments are analytical skills or access to assential corporate information wich is necessary to an informed investment decision. Thus this simple yardstick of evaluation widens the pool of investor. This is especially significant as the range and complexity necessary to evalute the credit quality of an instrument.
(iii) Information Disclosure
As the corporate debt market develops and the nature and variety of debt instruments increase, even the experienced investor may find it increasingly difficult to make informed choise because of the lack of accessibility or complexity of information about the corporate issure. The nature and specialization of a credit rating agency puts it in a position where it has access to public as well as private, even confidential, information pertinent to the assessment of credit risk. Such information
is not usually accessible to the individual investor.Futhermore, in an enviroment where public disclosure and accounting standarts are not stringent, a competent rating agency bridges this information gap between the issure of debt and the investor.[8]
(iv) Efficient Capital Market
Rating agencies help create an efficient capital market. In theory an efficient market is one in which all information required to determine the economic value of an asset is available to all market participants and is in turn reflected in the market price of the assets. Conversely, if markets are not efficient, this reflects the limited information content of securities whose prices do not reflect the fundamental value of assets. In providing information on default risk, investors have access to information to anble them to establish benchmarks for comparing the risk and return on their investment.[9]
(v) Lower Cost of Borrowing
A high rating assigned to a corporate borrower translates into a lower cost of borrowing for the issuer as the credit risk premium demanded investors is lower. Thus corporate borrowers are motivated to improve financial structures and operating risk to obtain a high rating for their corporate debt. This in enables such companies to raise more funds to finance expansion and management of its activities, resulting in higher allocative efficiency.
(vi) Aids Issuer in Pricing Decision
The interest payable on corporate debts are linked to the rating assigned. Thus a credible and objective rating is an invalauable aid to investment bankers, underwriters and brokers to determine the prise of the debt. The burden of determining the credit quality of corporate debt is thus shifted to the rating agency.
The assignation of rating to debt instrument by credit rating agencies has been linkened to ‘the world’s shortest editorials’.[10] Given that credit rating agencies play a crucial role in providing information on which investors base their invesment decisions, what standard of care governs rating agencies? Are rating agencies liable for inaccurate, negligent assessment?
At common law, liability for negligent misstatement was established by the case of Hedley Byrne v Heller & Patners Ltd.[11] In this case, the plaintiffs, a firm of advertising agents had asked their bank, the National Provincial Bank Ltd, to make inquiries regarding the financial position of Easipower Ltd., a customer of the defendant-bankers. In reply to enquiries by the National Provincial Bank on the creditworthiness of Easipower, for advertising contracts of specific amounts, the defendent replied in positive term. Their reply contained a disclaimer which read “For your private use and without responsibility on the part of the bank or its officials”.
The defendant’s replies to National Provincial Bank were communicated to the plaintiff, who in reliance thereon, placed orders for advertising time and space on behalf of Easipower Ltd. Easipower went into liquidation and the plaintiff suffered loss of £17,000 on the advertising contracts.
The plaintiffs brought an action against the defendants replies were negligently made and that the plaintiffs reliance on the negligent misstatement had caused them financial loss.
The case subsequently came for appeal before the House of lords. One of the principal issuer for consideration was whether or not the defendent owed a duty of care to the plaintiff in the circumstances, in the absence of contract or a fiduciary relationship between the parties.
Lord Morris of Borth-y-gest enunciated:
... it should now be regarded as settled that if someone possessed of a special skill undertakes, quite irrespective of contract, to apply that skill for the assistance of another person who relies on such skill, a duty of care will arise... Futhermore, if in a sphere in which a person is so placed that others could reasonably rely on his judgement or his skill or on his ability to make careful inquiry, a allow his information or advice to or allows his information or advice to be passed on to, another person who, as he knows or should know, will place reliance on it, then a duty of care will arise...
However, the defendant bank escaped liability on the basis of the disclaimer which was held to effectively exclude its liability.
Presumably, rating agencies in Malysia would be in an unassailable position as long as an effective disclaimer accompanies their rating. RAM’s publication includes the following clause in bold type set:
A rating is not a recommendation to purchase, sell or hold a security’s market price orits suitability for a particular investor, not does it involve any audit by RAM.
The focus of the above clause appears to reinforce the position that RAM’s opinion is an objective assessment and not intended to be relied on in the investor’s choice of investment.
RAM has been in operation for just over a decade, and MARC was established only in1996. To date there has been no decided cases where an assigned rating has been challenged. Precedents from United States are therefore enlightenin
Presumably, rating agencies in Malaysia would be in an unassailable position as long as an effective disclaimer accompanies their rating. RAM’s publication includes the following clause in bold type set:
A rating is not a recommendation to purchase, sell or hold a security, inasmuch as it does not comment on the security’s market price or its suitability for a particular investor, nor does it involve any audit by RAM
The focus of the above clause appears to reinforce the position that RAM’s opinion is an objective assessment and not intended to be relied on in the investor’s choice of investment.
RAM has been in operation for just over a decade, and MARC was established only in 1996. To date there has been no decided cases where an assigned rating has been challenged. Precedents from the United States are therefore enlightening.
In United States, bond and rating agencies enjoy First Amendment Protection of Commercial Information where by publication of a bond rating agency is treadted as any other publication under the First Amendment. Thus, a bond rating agency is not liable for negligent misrepresentation unless its inaccurate or mistaken advicereaches the levelsof reckless disregard for the truth.13 Thus , it appears that the market plays a crucial role in ‘regulating’ bond rating agencies.
In First Equity Corp of Florida v Standard & Poors Corp,[14]
an investor accused a bond rating agency of negligent misrepresentation. The item of contention in this case was volume 46, no.11 of Standard & Poors Corporation Records (which ‘contains factual descriptions of the principal terms and provisions of bond issued by leading corporation’). In this issue, Standard & Poors provide a rating for convertible secured trust notes issued by Pan American World Airways Inc. The description of the bond was inaccurate. Standard & Poors listed the convertible bonds as including accumulated interest upon conversion. In reality when the notes were converted into common stock in August 1985, only the principal and not the interest was counted in calculating the conversion rate. Two plaintiffs, clients of First Equity, alleged that they had invested in the corporations notes in reliance on the description in Corporation Records.
The District Court rejected the plaintiffs claim for negligent misrepresentation and fraud, and held that the Restatement’s negligent misrepresentation stated did not apply to a newspaper publisher such as Standard and Poors. The court applied the Jaillet rule15 under which a newspaper publisher is not liable to a member of the public for a non-defamatory negligent misstatement of an item of news, ‘unless he willfully...circulates it knowing it to be false, and it is calculated to and does... result in injury to another person’.[16] The rule shields publishers from the spectre of unlimited liability which would have a staggering deterrent effect on publishers.
The court noted that the First Amendment requires a showing of falsity or at least recklessness disregard: ‘There must be sufficient evidence to permit the conclusion that the defendent in fact entertained serious doubts as to the truth of his publication’.[17]
The court was mindful of the fact that the readership of a publication such as Corporation Records is very large, and that this implicates many possible plaintiffs. Futher, the court stated that: ‘The potential for meritless or even fraudulent claims was high and the cost of even successful defenses potentially prohibitive’.[18]
Finally, the court observed that the contents of Corporation Records were not a viable substitute for the actual prospectus issued by a company. The court concluded thus:
In such circumstances we believe that a user is in the best position to weigh the danger of inaccuracy and potentialy loss arising from a particular use of a summary against the cost of verifying the summary by examination of the original documents or prospectus. That being the case, the user should bear the risk ... of proof of a knowing misstatement.[19]
In a more recent decision, County Orange v McGraw-Hill Companies Inc,[20] one of the arguments put before the court was that in misrepresenting the plaintiffs financial ability to pay its debt, the rating agency, rather than on professional negligence.
Standard & Poors and Moodys do not undertake investigative work of their own. Rather they rely on public information provide to them by the rated compony itself. While they do analyse data, they do not independently seek to verify the information received. In short, the rating methodologies utilised falls short of an audit. Standard & Poors Debt Rating Criteria has the note : ‘The rating do not... attest to the authenticity of the information provided by the issuer and upon which the rating may be based’. Futher, Standard & Poors cautions in every issue of Creditweek that:
Because of the possibility oo human or mechanical error by our sources, Creditweek or others, Creditweek does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors or omissions or for the result obtained from use of such information.[21]
Moody’s publication similarly notes that the information herein has been obtained from sources believed to be accurate and reliable, but because of the possibility of human and mechanical errow its accuracy or completeness is not guaranteed.[22]
One of the questions that has been raised is whether the ‘recklessness standard’ that governs liability should be maintained. It has been argued[23] that to impose a higher standard of negligence on rating agencies would only drive up rating costs while yielding little increase in rating accuracy. In addition, it is contended that even absent any legal intervention whatsoever, market forces are sufficient to regulate rating agencies. Bond rating agencies in U.S face significant economic pressures which force them to take the proper degree of care.
The position in U.S. is that bond-rating agencies collect revenue by charging bond issuers feesthat very according to the size of the offering and by charging subscribers fees for the information service. Thus the argument goes, if tort liability is imposed on the bond rating agency, higher rates would be passed to the subscriber. Imposing a higher standard of care is only proper if the judicial system can pinpoint most instances of negligent behaviour without falsely implicating non-negligent behaviour. However, bond rating agency negligence is difficult to determine. Securities rating is so specialized that it is difficult to identify negligent behaviour in all but the most obvious cases.
Thus imposing a higher standard of care may force rating agencies to insure themselves against liability for negligence suits and this cost will be passed on to the consumer. It has been argued that such additional cost is worthwhile only if the deterrent effect is so great. Since market forces work to exert pressuer on rating agencies to maintain a higher degree of accuracy, imposing negligence liability provides only minimal deterrent effect.
Rating agencies, it is claimed maintain a high level of accuracy because of existing market forces. In U.S. rating agencies operate in a very competitive environment as there are a number of rating agencies. There is therefore competitive pressure to provide subscribers with accurate information. Thus rating agencies provide checks on each other. Also in-house technical analysts whose services many securities firms offer to both their clients and investors are close substitutes to rating agencies. The performance of rating agencies can be monitored by the simple method of correlating past rating with actual defaults. It is common in U.S for several ratings agencies to rate the same debt. Split ratings in which two major rating agencies give different ratings to the same issue are potential evidence of mistaken ratings. Thus a rating agency may lose its credibility in the market if its rating are found to be inaccurate or mistaken.
The Malaysian position differs substantially from the U.S. position. Currently, rating are assigned to companies on specific request. there are no possibility of split rating.
Credit rating originated from the idea that an independent assessment of adebt instrument with regard to timeliness of payment of principal and interest would aid investors to make informed decisions. However, the rating are only ‘calculated predictions’ and has inherent limitations. All ratings are, in essence ‘forward looking’ in the sense that the fokus is on pridicting the future ability of the corporate issuer to make timely payment of fincial obligations on the rated instrument. Thus, the ultimate accuracy of rating is difficult to evaluate as it is only tested on maturity. The fast changing economic environment lends a certain measuer of unpredictability to any assessment however well researched. It has been said[24] that some professionals view ratings of agencies as ‘rear view mirrow analysis’ i.e. lagging indicators of credit quality. Like in the equity market, there is no guarantee against default in debt intruments.
The role of credit rating agencies in Malaysia has been significant in contributing to the development of the corporate bond market. It is a role that changes as the corporate bond market evolves. In broad term, rating agencies evolve through three (though not necessarily distinct) stages: the formative or emerging stage, the growth stage and the mature stage.[25] In the formative stage, credit rating may be (as is the case in Malaysia) made compulsory to establish the ‘culture’ of credit rating and to aid in the development of the corporate bond market. In the growth stage, the debt market becomes established with a variety of instruments and a wendening investor base. The expension of investor to include international investors may lead rating agencies to take on a cross-border or regional role. In the mature stage, credit rating becomes institutionalised: credit rating becomes market driven, rather than regulatory driven. This stage also sees sophisticated accounting systems and disclosure standards. Rating agencies alsoperform an international role.
Malaysia’s rating agencies are at the formative stage where credit rating is still largely regulatory driven rather than market driven. The Capital Market Masterplan envisages that in time credit rating will be market driven, consistent with the move from a merit-based to a disclosure-based system. Market acceptance of credit rating is crucial to the maturing of the bond market. the ability of rating agencies to make reliable, accurate and timely assessment is critical to their credibility and continued existence.[26]
“Even more than accountants and lawyers, [rating agencies] must trade in their reputations. If bond investors lose faith in the integrity of rating agencies’ judgements, they will no longer pay attention to their rating; if agencies opinions cease to effect the price that borrowers pay for capital, companies and governments will not pay their fees. So market forces should make rating agencies careful of their good names”.
[1]Also referred to interchangeably as ‘corporate debt’, ‘private debt securities’, ‘corporate securities’, or ‘ringgit bonds’, or ‘bonds’.
[2]Rating of bonds is made compulsory under para. 20 of the Guidelines an the Offering of Private Debt Securities and para. 21.05 of the Policies and Guidelines of the Securities Commission.
[3]To ensure a measure objectivity and a balanced assessment, one of the subscribers hold more than a 4.9% equity stake. The trigger point for a ‘substaintial share holding is 5% voting right under section 69D of the Companies Act, 1965.
[4]Like RAM, each shareholder owns no more than 4.9% equity in MARC.
[5]Recommendation 35 at p. 151.
[6] “A year after Enron, rating agencies slow to change”, repoted in NST 30 November 2002.
[7]Yeah Kim Leng, Role of Rating Agency of Malaysia, August 2, 1994.
[8]Dato C Rajandram, CEO RAM, ‘Use of Rating as an Investor Tool’.
[9]Masara Kakutani, Managing Director, Moodys, Japan, ‘Role of Rating Agencies in the Development of Efficient Capital Markets’.
[10]See Husisian, Gregory, “What Standard of Care Should Govern the World’s Shortest Editorials?: An analysis of Bond Rating Agency Liability” [1990] Cornell Law Review 411- 461.
[11][1964] AC 465.
[12]Refer to supra, n 10.
[13]Cases applying First Amendment Protection to Financial Data: First Equity Corp. Of Fla. v Standard & Poor’s Corp., 869 F 2d 175 (2nd Cir. 1989); First Equity Corp. Of Fla. v Standard & Poor’s Corp. 690 F. Supp. 256 (S.D.N.Y. 1899) aff.
[14]First Equity III, 869 F. 2d 175.
[15]Jaillet v Cashman, 115 MISC 383, 384, 189 N.Y.S. 743, 744 Supreme Court 1921.
[16]First Equity I 670 FSupp at 117.
[17]First Equity 11, 690 F Supp at 289 (quoting St Amant v Thompson, 390 US 727, m 731 (1968).
[18] Ibid., at 180.
[19]Ibid., at 180.
[20]No. SA CV 96-0765-GLT, 1997 U.S. Dist. LEXIS 22459(C.D. Cal. June 2, 1997).
[21]Standard & Poor’s Creditweek.
[22]Moody’s Bond Record.
[23]Husisian G at n 4.
[24]Refer to Husisian, G. n. 10 at p. 411.
[25]Refer to C. Rajandram, ‘Use of Ratings as an Investor’s Tool and in-House Development of Credit Analytical Capabilities’, October 1996.