Grounded Ingenuity | Refined Results

March 14, 2011
By Timothy Loh and Guy Connell
The Securities and Futures Commission has created a new regulated activity to bring credit rating agencies under its licensing and registration framework.  Under the revised regulatory regime, credit rating agencies will be subject to capital requirements as well as conduct of business and competency requirements.  In this article, we examine the changes to the law.

On February 18, 2011, the Securities and Futures Commission issued the Securities and Futures Ordinance (Amendment of Schedule 5) Notice 2011 and the Securities and Futures (Financial Resources) Amendment Notice 2011 (together “Notices”).  The Notices will come into effect on June 1, 2011 and will introduce a new regulated activity under the Securities and Futures Ordinance, namely Type 10 (providing credit rating services).

As a result of the financial crisis in 2008, international consensus has emerged that credit rating agencies should be regulated because of the influence ratings produced by such agencies have on public investment sentiment.  The introduction of the new Type 10 regulated activity is intended to ensure that Hong Kong adheres to international standards, to enhance investor protection and to enable credit ratings prepared by Hong Kong based credit rating agencies to be serviceable in other jurisdictions.

Requirement to Obtain SFC License

As a result of the Notices, both credit rating agency firms and their staff may be subject to SFC licensing or registration and compliance requirements for the provision of credit rating services.

Any person who carries on a business (or holds oneself out as carrying on a business) of providing credit rating services should be licensed by or registered with the SFC. For ease of reference, we refer to a firm required to be, or has been, licensed or registered for Type 10 regulated activity as “CRA”.

Further, any individual who performs, or holds himself out as performing, any regulated function in relation to the regulated activity of providing credit rating services carried on as a business should be licensed by the SFC or registered by the Hong Kong Monetary Authority ("HKMA") as a relevant individual engaged by a registered institution in respect of the regulated activity.

Meaning of Providing Credit Rating Services

The regulated activity of  “providing credit rating services” is defined as preparing credit ratings for dissemination to the public, or for distribution by subscription, whether in Hong Kong or elsewhere. 

Credit Ratings

For this purpose, “credit ratings” are opinions, expressed using a defined ranking system, primarily regarding creditworthiness of (a) a person other than an individual, (b) debt securities, (c) preferred securities, or (d) an agreement to provide credit. 

“Debt securities” means debenture stocks, loan stocks, debentures, bonds, notes, indexed bonds, convertible debt securities, bonds with warrants, non-interest bearing debt securities and other securities or instruments acknowledging, evidencing or creating indebtedness. 

“Preferred securities” means preference shares, preferred shares or preferred stock.

Dissemination or Distribution

Actual dissemination or distribution is not required. The preparation of credit ratings is sufficient to trigger licensing or registration requirements if it is reasonably expected that credit ratings so prepared will be disseminated or distributed by subscription.

To the Public

However, any dissemination or distribution (or reasonable expectation of dissemination or distribution) must be to the public, whether in Hong Kong or elsewhere, to constitute Type 10 regulated activity.

Further, it is expressly provided that a person is not required to be licensed or registered for Type 10 regulated activity if, pursuant to a request made by another person, he prepares a credit rating that is exclusively prepared for, and provided to, the requesting person and that is neither intended for dissemination or distribution to the public by subscription, whether in Hong Kong or elsewhere, nor reasonably expected to be so disseminated or distributed.

The preparation of private or internal ratings, for example by banks for internal assessment of counterparty risks, would not constitute the provision of credit rating services.

It should be noted that whilst the preparation of private or internal credit ratings does not necessitate Type 10 license or registration, where a licensed or registered CRA provides private ratings, it is required, by prior written agreement entered into between it and the rated entity, to prohibit the rated entity from disseminating such ratings, or permitting the rated entity’s dissemination, to the public.

Credit Data Collection and Credit Reports 

Persons who gather, collate, disseminate or distribute information concerning the indebtedness or credit history of a person are not within the scope of Type 10 regulated activity.

It is therefore unlikely that consumer credit reference agencies or CRA staff responsible for collecting and preparing credit data for the rating analysts without performing any analysis will be required to be licensed or registered.

Exclusion from Type 4 (Advising on Securities)

The Notices specifically exempt persons who simply provide credit rating services from applying for an SFC license for Type 4 (advising on securities) regulated activity.  

The Notices do not, however, specifically introduce a converse exemption so that persons advising on securities are exempt from the scope of Type 10 regulated activity.  Nevertheless, a person advising on debt securities or preferred securities without a defined ranking system would not fall within the scope of Type 10 regulated activity.

Capital requirements

Under the revised Securities and Futures (Financial Resources) Rules (“FRR”), a CRA is required to at all times maintain a minimum amount of paid-up share capital of HK$5 million as well as minimum liquid capital.

Conduct of Business

Any person licensed or registered for Type 10 regulated activity will be subject to conduct of business standards in the existing SFC Code of Conduct for Persons Licensed by or Registered with the SFC ("SFC Code of Conduct") and the new CRA Code of Conduct for Persons Licensed for Credit Rating Services ("CRA Code of Conduct"). 

The CRA Code of Conduct sets certain requirements in relation to:

  • the quality and integrity of the credit rating process;
  • independence and avoidance of conflicts of interest;
  • responsibilities to the investing public and rated issuers; and
  • disclosure of code of conduct and communication with market participants.

Each CRA must publish its own code of conduct consistent with the CRA Code of Conduct and conduct annual reviews of its methodologies and models for determining credit ratings, and internal control mechanisms and report the findings to the SFC.

Competence Requirements

A CRA, its responsible officers and representatives must satisfy the the requirements of fitness and properness to apply for an SFC license for Type 10 regulated activity. As with other regulated activities, the requirements and exemptions for competence provided in the Fit and Proper Guidelines and Guidelines on Competence are generally applicable. For individuals, relevant industry experiences may include credit risk management of financial institutions, financial analysis, credit analysis and bank’s internal counterparty risk assessment.

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