Moody's, the world-girdling credit rating agency, has taken a decision by Hong Kong's Securities and Futures Commission all the way to the regulatory tribunal and lost, although there are a few crumbs of comfort in the resulting judgment.

Back in 2011, Moody's prepared a report for market consumption which it clearly expected to influence stock prices. The ever-vigilant SFC, probably the most capable financial regulator in the Far East, found that that Moody’s did not have the required procedural safeguards in place to ensure the integrity of the information and also that decided that the report itself was, in a number of material respects, misleading, confusing and inaccurate to the extent that its publication was, or was likely to be, prejudicial to the interests of the investing public, including Moody’s own clients, and prejudicial also to the integrity of the market. The report resulted in panic sell-offs of various stock by private banks, asset managers and others. The regulator gave the ratings agency some time to make representations, and then issued it with a public reprimand and an order to pay a fine of HK$23 million. Moody's took this decision to the Securities and Futures Appeal Tribunal which, although it upheld most of the SFC's reasoning, reduced it to HK$11 million.

How to define credit ratings?

The SFC defines 'credit ratings’ as "opinions about relative credit risk," while describing ‘credit risk’ itself as "the potential for loss due to the failure of a borrower to meet his contractual obligation to repay a debt in accordance with the agreed terms." Moody’s itself describes credit ratings as "probabilistic opinions about future credit-worthiness." The Securities and Futures Ordinance, Cap 571, describes them as “...opinions, expressed using a defined rankings system, primarily regarding the credit worthiness of:
a) a person other than an individual;
b) debt securities;
c) preferred securities; or
d) an agreement to provide credit.”

To regulate or not to regulate

Credit rating agencies, whose pronouncements are of interest to private banks and asset management firms as well as to strict trading firms, have come in for more scrutiny than ever before since the world financial crisis, in which they played a part, erupted in 2008. Jurisdictions all over the world decided to subject them to more official oversight, with Hong Kong introducing its own statutory licensing regime in 2008. There is no regulation for them in the United States, where most of them come from, because the courts would construe this as interference with their rights to free speech under the first amendment to that nation's constitution. Other countries lack these safeguards.

Criticism for the report

The tribunal was satisfied, "on the probabilities," that the collapse in the prices of some equities issued on the Chinese mainland (the focus of the report) was due to the report itself and not to other factors. These shares dropped in some cases by 16% in value just after the report's publication, and did so all together. On top of its normal evaluations, Moody's allocated 'red flags' to various stock issuers and, while averring that these 'red flags' were merely incidental to its evaluations, nevertheless gave off the distinct impression that the company with the most was the worst credit risk and the company with the least was the best. This vagueness drew criticism from many market-watchers. One pointed out (and the SFC concurred) that it "isn’t unheard of for credit-rating firms to affect stock prices by highlighting specific problems at the companies whose debt they assess, but the Moody’s report stood out by touching on broad issues affecting scores of companies, while not offering up any specific rating action.”

The report was not entirely accurate either; one of the companies under consideration, China Glass Holdings Limited, was given a red flag for family ownership of over 30% when this was factually incorrect. The SFC detected 12 errors in the report that dictated the apportionment of red flags. The 'red flags,' incidentally, consisted of such things as a short track record of operations and listing history, murky shareholders’ backgrounds, large and frequent transactions between related parties à la Robert Maxwell, unusually high margins, a concentration of customers, complicated business structures, very rapid expansion, discrepancies between cash flows and accounting profits, disjointed relationships between growth in assets and revenues, large swings in working capital, not enough tax paid in line with reported profits, a switch in auditing firm or the legal jurisdiction of the auditor’s office, delays in the reporting of financial statements, and caustic comments from auditors.

In November 2014, after many representations from Moody's, the FSC decided that it had committed market misconduct which, under s193 of the Ordinance, entails activity that is likely to be prejudicial to the interest of the investing public or to the public interest. The SFC thought that Moody's had, on top of this, broken its code of market conduct, notably principle 1 that calls for honesty and fairness, by doing the following.

• It made misleading statements that created the impression that the red flag system was a part of Moody’s established methodology, having been relied upon in the past.
• It did not explain it or justify it well enough.
• It used 'red flags' to rank companies on a scale despite the fact that, on its own analysis, there was no significant correlation between the number of red flags and credit risk.

Broken rules

It also broke principle 2, which relates to having to act with due skill, care and diligence, by filling the report with errors. Moody's tried to argue that these errors were trifling; the SFC disagreed profoundly. Meanwhile, paragraph 4.3 of the code of conduct, which enjoins firms to set up control procedures to protect all concerned from fraud, was another stumbling block, with the regulator finding that Moody's had practically no controls in place to ensure that the report was presented in a fair, accurate and 'non-misleading' manner. Moody's tried to argue that its contraventions of general principles 1 and 2 and paragraph 4.3 were one and the same thing; the regulator thought that it had committed, and therefore should be fined for, each one separately. Its therefore levied three separate fines of $9 million, $6 million and $8 million. It never made any allegation of dishonest conduct, however.

A matter of jurisdiction

Paragraph 63 of the determination notice states that Moody’s principal complaint was one of jurisdiction. It thought that in preparing and publishing the report it was not a carrying out a regulated activity for which it was licensed and that the report was not part of its credit rating services. In other words, it portrayed it as a commentary on market-related issues, saying that it may have borne some relationship to the provision of credit rating services but that its preparation and publication nevertheless constituted a "distinct activity."

The Securities and Futures Appeal Tribunal decided that this was a matter of statutory interpretation. Hong Kong's judiciary, like the UK's, no longer interprets every statute by looking at what the words mean with reference to a dictionary if needs be, but is instead on a mission to "pull the Government's chestnuts out of the fire" as often as possible, interpreting statutes 'purposively.' Lord Hoffman was the apostle of this approach in the UK before his retirement and his influence has evidently spread elsewhere. This carries the obvious risk that Lord Millett pointed out in China Field Ltd v Appeal Tribunal (Buildings) (No.2): "There has been a distressing development by the courts which allows them to distort or even ignore the plain meaning of the text and construe the statute in whatever manner achieves a result which they consider desirable." Moody's relied on the argument that the SFC had misused 'purposive interpretation' to implying additional words in its decision notice that suggested that activities that are merely ‘proximate to’ or ‘connected with’ regulated activities should somehow fall into the interpretative net.  

The tribunal, in paragraph 93 of its determination document, upheld the 'purposive' way of interpreting the Ordinance and went on to judge that, Moody’s use of red flags, whether intended or not, constituted a well-defined system or mechanism for judging levels of credit risk and, as such, constituted a credit rating.

A public reprimand, but a reduction in the fine

The tribunal added: "it appears that the basic concern of the SFC was that readers of the report would have been left in a state of confusion – and thereby misled - as to the true nature and purpose of the red flag framework." It concluded, however, that the report (read with its press release) did not give the misleading impression that the use of red flags was an established methodology that had been used before. It determined that Moody's presented each red flag to investors as thought it carried the same weight as the next one, when actually "on the information available to the analysts at Moody’s, it was evident that certain red flags should be given less weight than others." Therefore, in its failure to provide commentary on all of the red flags, Moody’s not only made it impossible for readers to assess the significance of the flags in context but, by that fact, created an unfair, unclear and misleading picture of companies' creditworthiness. In paragraph 186 it alludes to Moody's habit of referring to firms with large numbers of red flags as 'negative outliers' - a term that in the eyes of the tribunal was bound to hold those firms up as 'lepers' and damage them in the market. This, it thought, was therefore a breach of the SFC's code of conduct. It added that "in the circumstances, as there was no significant correlation between the number of red flags and the level of credit risk, retaining the description was misleading and unfair."

In paragraph 241 the tribunal pointed to a fundamental botch-up on Moody's part: "The Moody’s team working on the preparation of the report came to understand that the red flag framework was not as accurate as originally had been anticipated. It appears that by the time the misgivings were being recognised the forward momentum to have the report published was determinative. Qualifications were therefore inserted but, on any ordinary reading of the publication as a whole, those qualifications acted more to compound the confusion rather than to set it aside."

Moody's did score a victory, however: the tribunal struck down the SFC’s findings of culpability under paragraph 4.3. The tribunal was nonetheless satisfied that a public reprimand was justified. It therefore settled on a $5 million penalty for the breach of principle 1 and a $6 million penalty for the breach of principle 2, plus the public reprimand. The tribunal also promised to issue an order nisi to dictate that Moody’s should pay 60% of the SFC’s costs. Such costs are also to include provision for two counsel because the tribunal was satisfied that the complexity of the matter justified the briefing of such a number. One presumes that Moody's would have had to pay 100% of costs if the tribunal had agreed with the SFC in every particular.