Wednesday, 1 July 2020

Do Rating Agencies need to be at the Forefront of the Fight Against “Social Washing”?

In an article in The Financial Times yesterday, an issue was raised concerning the potential for the increase in the issuance of ‘social bonds’ to be negatively impacted by a concept known as ‘social washing’. The fear is that instead of utilising the investments that the bonds are intended for, issuing entities will instead use those funds for other purposes, including balancing their books in these economically uncertain times. The article ends with the statement that until standards of disclosure and transparency increase to the level of the green bond marketplace, ‘investors may have to take it on trust that the money will be put to socially useful ends’. However, this is not how the marketplace is supposed to work in the modern environment; credit risk is not supposed to be determined by mere trust, but by the assistance of excruciating levels of data-driven analysis (although, of course, one cannot be 100% certain with regards to the accuracy of risk assessments). With this in mind, there are perhaps two questions to ask: a. what role do the credit rating agencies have in bridging this asymmetric gap, or b. is this just the latest example of credit rating agencies being slaves to the approach taken to disclosure from issuing parties? If so, then what importance should we afford to the connection between the leading agencies and the issuers, via the issuer-pays model, if the agencies are not privy to vital information that actually affects credit risk for investors? To understand more about these issuers, this post will look at the growing issue of ‘social washing’ in this ever-growing social bond marketplace.


So, what are social bonds? Social bonds, like green bonds, are bonds issued by an entity that seeks to garner funds but for a very specific purpose or, sometimes, for a varied set of goals within a larger ideology. That may be to make a company more ‘green’, or for a particular project that will have benefits for the environment, to provide crude examples. Social bonds work in the same manner, but are relatively new compared to their green counterparts. A relevant example of the social bond may be the new ‘coronavirus bonds’ that are being issues by governments, supranational organisations, and companies. It has been reported that the market for these particular bonds is growing massively, with the FT reporting that, as of May, has reached $65 billion and could top $100 billion by the end of the year. Governments have issued such bonds, as well as organisations like the World Bank and the European Investment Bank. Companies have also issued such bonds, with companies like Pfizer and Bank of America being cited, who recently issued a $1 billion coronavirus bond to help fund lending to hospitals, healthcare manufacturers, and other entities in need of funding in the fight against the virus; Bank of America were offering these bonds at the same rate as their normal bonds. If we count coronavirus bonds to be in the same category as social bonds, then in 2020 it was the first time that social bond issuance has outgrown the issuance of green bonds. Analysts have suggested that this growth and outpacing of green bond issuance is purely down to the pandemic and response to it, with green bond issuance having been predicted to have a strong year before the virus took hold. However, as the FT article on the growth of social bonds states, ‘investment banks are now scrambling to understand what use of proceeds from these new classes of coronavirus bonds will be accepted by socially conscious investors’. Since that article was published in May, it seems that there has been little in the way of progress with regards to clarity on the situation.


To assist with this, the International Capital Markets Association (ICMA) has updated its ‘Social Bond Principles’, with S&P suggesting that the update could encourage a greater rate of issuance of social bonds, ‘potentially leading social bonds to emerge as the fastest-growing segment of the sustainable debt market in 2020’. The voluntary principles define a social bond as a bond instrument ‘where the proceeds will be exclusively applied to finance or re-finance in part or in full and/or existing eligible social projects’. Furthermore, the issuer should appropriately describe the project(s) for which the funds will be utilised for, and if the funds are for re-financing then this should be made clear in the documentation. Typical and popular projects may include developing affordable basic infrastructure, essential services, housing, employment generation, food security and sustainable food systems, and socioeconomic advancement. There is no cap or direction on who may benefit from such projects, but suggested ‘target populations’ include those living below the poverty line, excluded/marginalised groups, people living with disabilities, the undereducated, underserved, and unemployed (amongst a longer list of other groups). The bond issuer must communicate with investors the social objectives of the project for which the bond is for, the process by which the issuer has selected the project(s), and any related criteria including any potential excluding criteria. All of this, of course, is particularly relevant. But, for our purposes here, the suggested approach to managing the proceeds is crucial. ICMA suggest that the proceeds of the bond should be separated from other funds and accounts within the issuer, with a clear line of demarcation being visible. Further, any funds that are outstanding, say because a project has come in under-budget, should be tracked and made known to investors. It is stated that ‘the SBP encourage a high level of transparency and recommend that an issuer’s management of proceeds be supplemented by the use of an auditor, or other third party, to verify the internal tracking method and the allocation of funds…’ Such information should be kept and made readily available. The annual report should include a list of all the social projects the issuer is engaging with, as well as the amount allocated to it from the bonds together with their expected impact (where this is not possible, say because of confidentiality agreements, then aggregates should be used). ICMA then go on to encourage all of the above to be verified by external review providers, with transparency being the key according to the set of principles.


Yet, there are a number of issues outstanding with regards to this concept of transparency. S&P, in reviewing the data and the development of the field, have highlighted this issue of social washing. In a report recently, they noted that although the market is developing rapidly because of the pandemic – with development banks leading that charge – there are issues in conflating social bonds with coronavirus bonds, which may be developed with more haste and thus may not be aligned to the goals of investors; as one expert noted, ‘COVID-19 is a little bit of a different animal… it’s an emergency and consequently a number of people might do faster financing to make sure they get urgent funding’. Issuers have been advised that whilst investors may welcome issuers who have reacted quickly to the crisis, social bond investors have specific goals and will ‘continue to demand information on the outcomes and the impact’. However, the concern is two-fold; one concern is that issuers may overstate the impact seems as the verification protocols are not yet consistent across the sector, with another concern being that the funds will not be used as they are intended – these two elements are making up the proposed fears for ‘social washing’. As one expert noted, ‘if you think about the heavy emphasis on risk and disclosure around climate, we’re nowhere near that on the social side’. An example has arisen recently with the company Pfizer. In March it issued a $1.25 billion bond, aiming to use the money for ‘eligible projects’, which the company would choose. However, in the prospectus, the company admitted that the fund ‘might temporarily be used for short term investments or to repay other borrowings’. Pfizer have not commented on this issue, but did admit that ‘there can be no assurance that such net proceeds will be totally or partially disbursed for such eligible projects’. The article in the FT cites investment managers who are rejecting a number of bonds in this area because of the vagueness within the information provided: ‘we didn’t feel like there was sufficient information or assurance’. So, how will that asymmetric gap be bridged between the issuer and the investor?


The Principles for Responsible Investment initiative has been putting the pressure on investors to do more to hold issuing companies to account, but how would they do this? One credit fund manager noted that ‘it’s not very easy for our analysts to track the proceeds until a company reports [how they have been spent]’, so is it a question of being held hostage to the disclosure regimes of issuing companies, which as we know are being developed on a voluntary basis? In reviewing S&P’s website for rating methodologies, there does not seem to be anything in particular for these social bonds – please do let me know and correct me if this is not the case. If this is the case, then the rating agencies are not currently contributing to the credit risk assessment with these bonds. We know that the rating agencies are keen to push the narrative that, with regards to rating ESG-related issues, then ‘materiality’ is key. With regards to these social bonds, materiality could be a very broad gambit. For example, would it be material if a company had any sort of record of not utilising the social bond funds for the purpose they were designed for? Would it be material if there issues regarding disclosure within a particular company? The ‘second-party opinion’ verification process is currently being undertaken by the Sustainability Rating Agencies – here is an example from Sustainalytics – but is this enough for an investor base that is, for the most part, seemingly operating in the dark according to their declarations? If leading investment managers are rejecting bonds because of a lack of detail, then surely there is space for more providers to bridge that asymmetric gap.


The question then becomes whether credit rating agencies are well suited to that role. It seems that the biggest issue is that of disclosure, and knowing what happens to the investment once it has been received. Technically speaking, the credit rating agencies should be in a good position to alleviate for this problem, on account of being closer to the issuer because of the issuer-pays model, and their size compared to Sustainable Rating Agencies in terms of operating power. Auditors clearly have a role to play in verifying what has happened to the resources, but this is after the fact and does aid the investor in their decision-making processes, especially in such a nascent environment. There will naturally be a high correlation between those entities that are issuing social bonds and those who have credit ratings attached to them as a corporate entity, but does this help the socially-conscious investor? We have seen only recently how important it is to take into account factors from a wide-range of sources – see the last post on the demise of Wirecard – but there seems to be a massive dearth of credit risk-related information in this growing field, and that is as surprising as it is worrying. Concerns over the efficacy of Sustainable Rating Agencies will not help this issue either. It is therefore arguable that there is a greater role for the rating agencies to play in this growing marketplace. However, the agencies are consistent in their view that they are, essentially, dependent upon the issuers’ approach to disclosure, so if there are clearly disclosure-related issues in this growing field, then rating agencies may just add to the problem and not provide a solution – the entrance of their conflicted business model may cause more harm than good. Therefore, it may be the case that regulators need to intervene and stipulate some rules on disclosure which are enforceable and then enforced, rather than voluntary guidelines set at an international level. It is true that investors can ‘vote with their feet’, but this does not help the investor at the point of entry.


It appears that, as it stands, there is a particular need for more information in this marketplace. On top of this, the very nature of the ‘S’ in ESG is more qualitative than quantitative, which further muddies the water for investors. It will be interesting to see if the credit rating agencies step into this apparent void, or whether the height of external review and rating of these products is that which the Sustainable Rating Agencies provide. Either way – and again please do alert me if I have this wrong and it is the case that such bonds are adequately rated – one of the key elements in this dynamic is that of disclosure. It is seemingly the case that only regulators, or even perhaps legislators, can enforce disclosure in this regard so the development of the social bond market may have to continue dealing with a lack of consistent and reliable credit risk data for some time yet.


Keywords – social bonds, investors, business, @finregmatters

Friday, 26 June 2020

Ernst & Young (EY) and Moody’s Under Attack as Gatekeepers’ Failures Continue to be Revealed with Wirecard

The Wirecard scandal has made for an engrossing account of corporate failure since the news emerged that the German financial payments processing company had been inflating its accounts. Now that the company has collapsedthe first time that a member of the German Dax index has failed – the ramifications are starting to be revealed. The EU is now investigating the role played by BaFin, the German regulator tasked with regulating the company, whilst the FCA in the UK has ordered the British arm of the company to freeze all of their customers’ accounts. Now that the aftermath is continuing to fold, the focus is now rightly turning to why the alarm bells were not sounded earlier by those both paid and expected to do so.


Of particular concern has been the auditing conducted by Ernst & Young (EY), and the credit rating conducted by Moody’s. With investors standing to lose out considerably because of this collapse, the performance of these gatekeepers is a massively important issue. Unfortunately, for the two concerned, the information that is slowly-but-surely being revealed does not make for comfortable reading.


Starting with Moody’s, there has been some criticism from industry professionals today regarding their role. During last Friday (19th June) Moody’s had downgraded the company’s rating by six notches, before removing the rating altogether on Monday. This came after EY refused to sign off on the company’s accounts, with Moody’s declaring that it had decided to withdraw ‘because it believes it has insufficient or otherwise inadequate information to support the maintenance of the ratings’. The decision to downgrade prompted Wirecard to seek new financing strategies, although those plans will not be needed now the insolvency process is underway. However, as Gene Phillips of PF2 helpfully pointed out yesterday, the wording attached to Moody’s downgrading of Wirecard reveals a crucial issue for credit rating agencies more generally. It was not until June 2nd that Moody’s downgraded Wirecard, which came less than a year after it had rated the company Baa3 – or, investment grade – citing that despite a number of challenges ranging from competition to its size relative to its US counterparts, the company had a strong market position in Asia and Europe, was diverse, had scalability, and a sound financial profile. Now, less than a year later, the agency stated that it would first place the company on review of a downgrade (on the 2nd June) based on ‘ongoing uncertainties around the allegations regarding fraudulent accounting practices and concentration risks on third party acquirers’. In defence of Moody’s, Wirecard was hovering just above the cut-off for investment-grade, and there were a number of warnings attached to the rating, especially concerning governance. Yet, there is a sentence in the attached dialogue that will prove to damning for the agency: ‘The company’s strong and swift expansion led to some instances in its Asian operations where a lack of corporate control resulted in periodic restatement of booked revenues. Management had immediately taken meaningful measures to avoid such issues in the future. Considering the opinion of external auditors, we assumed that these events have been isolated, regionally concentrated events’. We now know that this ‘assumption’ was a dramatic error, with the sequence of events now being shown to have been quite the opposite from what had been believed by the agency.


Therefore, the question to ask is likely a simple one: what purpose do the rating agencies actually serve if they are assuming critical issues such as those highlighted above? A number of societally important investors are bound to invest only in instruments which agencies deem to be of investment-grade, but we now have the admittance that one of the major agencies was assuming key information to be case, when in fact deeper investigation would, or at least should have revealed greater issues and affected the creditworthiness of the firm in question. One might well argue that this is an issue of disclosure, and that the rating agencies are not either a. set up or b. supposed to uncover fraudulent activities – the argument being that this is the role of the auditor. Perhaps that is the case, and it is why we shall turn our attention to EY next. However, the continued usage of the rating agencies’ products must continue to critically analysed because it is clear that there are important issues that need to be considered when understanding the usefulness of a rating, like how much of it can be relied upon to be objectively true? How much is assumed? Why and when would an agency make critical assumptions, and when would it not? It is questions like these that lead prominent critics to suggest ratings have very little to no value. I argue that they do, but not in the traditional sense, in that they serve more of a signalling purpose required for the functioning of the financial system, and not much else. But, to admit to assuming key material information, irrespective of whether it came from an auditor or not, is telling. Important journalistic investigations conducted by the FT had demonstrated, at least enough to inject doubt into the picture being painted, that more caution should have been afforded to the allocation of an investment-grade rating, with all that entails. Other examinations, like that conducted by Sigma Ratings, demonstrated quite clearly that much greater caution should have been afforded when assigning this particular rating. Why that caution was not afforded is solely for Moody’s to answer; saying ‘we assumed’ is not enough.


Yet, Moody’s will receive some criticism for the Wirecard scandal but, for the gatekeepers, the majority of the criticism will rightly be reserved for EY. The audit firm had provided clean audits for Wirecard for a number of years. However, despite journalistic investigations and whistleblowers raising the alarms, together with internal investigations (which were ultimately mothballed), the auditor continued to give clean audits. It was revealed today that they actually went further, and not only turned a blind eye but actively did not perform as they were supposed to. Billions of Euros were said to be housed in Wirecard’s Asian arms, but rather than investigate this and perform the due diligence that is expected of a Big Four auditor, the FT revealed that EY failed to even request the bank statements from a bank in Singapore where Wirecard had claimed it had more than €1 billion. EY has not commented on these allegations yet, but other auditors and expert onlookers have. One auditor said ‘the big question for me is what on earth did EY do when they signed off the accounts?’, whilst another said that obtaining independent financial information is akin to one of the fundamentals of auditing. A Professor of Accounting declared, quite rightly, that is was ‘not sufficient’ for an auditor to accept account confirmations from third parties, but a head of a rival auditor went even further when they suggested that ‘it is beyond the realms of reality that EY wouldn’t have had [the bank balance confirmations] unless they did a very poor audit’. If it is the case that this is just extremely poor auditing, EY will be in trouble. However, if it is the case that EY had the information it needed to know that Wirecard did not have the money it said it had, and still signed off on key audits, then EY will be in serious trouble. It is elements such as these which are causing people to liken this collapse to the collapse of Enron, at least in terms of the damage it will do for the auditing sector.


As investors, regulators, and politicians line up to blame and punish, the gatekeepers stand in a particularly vulnerable position. This will be added to Moody’s’ long list of instances where they have fallen short, but for EY it could be extremely problematic. Akshay Naheta, a SoftBank executive who was involved with SoftBank’s investment into Wirecard last year, neatly summed up why this is potentially such an impending issue for EY; ‘I’m totally baffled by the lack of competence and responsibility displayed by E&Y… as an organisation that is meant to protect all stakeholders – creditors and shareholders – in companies, both public and private, they have materially failed in their fiduciary duties’. Auditors have a massively important role in the efficient running of the economic system, and their unique position between the company and the outside world is one which will, inevitably, lead to some failures which are usually massive in scale. According to Moody’s account, their whole system relies upon the auditor-company relationship too, which only adds weight to the philosophical importance of that relationship. However, is it too much for just a few auditors to bear? Are there too many engrained conflicts of interest within that relationship? The dynamics of that relationship were considered at length after the Enron/WorldCom scandals but, like most instances of reform-laden eras with regards to gatekeepers, the economic cycles brought around other issues which caused audit-related concerns to become of less importance. The rules implemented after those scandals, most notably concerning the enforced division of the major auditors away from their commercial consulting arms, were overridden by the industry not long after. The cyclical nature of reform and regulation must be brought to an end, with rules designed to increase the effectiveness of the said gatekeeper within the financial system needing to be consistently applied, not just for the economic cycle (mostly because we do not seem to have so-called ‘Quiet Periods’ any more!).


Keywords – Wirecard, Moody’s, EY, Audit, @finregmatters

Monday, 8 June 2020

The SEC Receives Renewed Calls for Credit Rating Industry Reform, but Will it Act?

There have been a number of developments recently with regards to the Securities and Exchange Commission receiving advice on how best to regulate the credit rating industry. Last month, a panel was convened so that the Investor Advisory Committee could hear from a number of experts on some of the issues facing the industry, and some potential solutions. Then, at the beginning of this month, the Credit Ratings Subcommittee of the Fixed Income Market Structure Advisory Committee (FIMSAC) produced a recommendation outlining three key areas for regulatory development. In light of this, this post will review the developments, and also examine whether the calls are realistic, or whether they may spurn the SEC into more action in this area.


The meeting of the SEC’s Investor Advisory Committee took place on the 21st May, virtually – recording available here. In the afternoon, a panel was convened that was made up of: Professor Frank Partnoy of the University of California, Berkeley; Marc Joffe of the Reason Foundation, Yann Le Pallec who is the Head of Global Rating Services at S&P; Van Hesser who is the Chief Strategist for Kroll Bond Rating Agency; and Professor Joe Grundfest of Stanford University. Van Hesser addressed the Committee first, noting that increased business in the past few years indicates that KBRA is progressing in the market. The point was made that KBRA aimed to offer a differentiated experience for the industry in the wake of the Crisis, and that this recent and consistent upturn in their fortunes was an indication of that model being accepted by the marketplace. In discussing the pandemic, Van Hesser mentioned how there are a wide range of factors that affect credit ratings, and that the current situation is very fluid and, in many ways, unprecedented.


Professor Frank Partnoy then followed with a succinct overview of the industry’s regulation and some of the issues that have emerged since the Crisis. One of which was the fact that, despite some successes, a number of regulatory initiatives have failed. One such failure is with regards to the attempted to reduce ‘regulatory reliance’, which is based on a concept Partnoy developed known as the ‘regulatory licence’. Partnoy noted how a number of pieces of legislation, and ensuing regulation that dictated that references to ratings should be entirely removed, simply have not been implemented. This is on top of the behavioural difficulties in removing reliance on the ratings. As potential solutions to such issues, Partnoy suggests a number of approaches. First, he suggests that financial entities, such as banks, should have to disclose what they are holding if they are using rated investments, and preferably on a granular level. Also, as he has long since championed, a number of other more market-based approaches to understanding creditworthiness should be utilised by the market. He then turned his attention to the way in which the SEC actually provides details of its investigations and examinations. A point of issue has been that the SEC will not ‘name names’ when it comes to providing information on who it has found to be transgressing – it will often say things like ‘we found that a mid-sized agency did not…’, which Partnoy suggests affects the regulatory capital in this area; he argues that there is a benefit in the market knowing who has been found to be falling below the standards set. Finally, he discusses the issues with regards to aspects such as the protection being afforded to the agencies via the exemption of the application of Section 11, which was repealed in the wake of the Crisis to expose the agencies to liability, something which has never taken hold.


Marc Joffe then followed, and addressed issues regarding the negative effects of increased competition i.e. increased rates of ‘ratings shopping’. He followed this with a discussion around higher CMBS ratings, which appear to be inconsistent with the push by the Dodd-Frank Act to implement ‘universal ratings’ which would increase transparency and clarity in the area. Joffe then produced a number of interesting proposals, including insightful declarations of the alternatives to credit ratings that exist within the marketplace (he cited analytics firms/ regulator-developed methodologies/ the incorporation of Universities [he cited the work at the NUS in Singapore] and non-profits/ and open-sourced methodologies) as well as a number of distinct policy recommendations. Those included avoiding the use of NRSROs in standards, eliminating the concept of NRSROs altogether, enforcing the 17g-5 program better, and potentially incorporating machine-readable financial disclosures into the financial system more.


Following on from Joffe, S&P’s Yann Le Pallec introduced the viewpoint of one of the ‘Big Two’, and discussed a number of elements and initiatives that S&P have undertook. He mentioned how S&P have invested heavily in a number of safeguards to prevent, or at least reduce the impact of a number of recognised conflicts of interest. This was adjoined to the interesting point that the company deals with more than 20 regulators worldwide, perhaps hinting at the need for more joined-up regulatory thinking. He then detailed how S&P has invested heavily in its compliance functions, although this has been noted in the literature (not just related to S&P) as being a negative outcome of the regulatory era i.e. simply moving to a tick-box culture as opposed to focusing on the underlying causes of such failures. In addition to this, Le Pallec discussed how new training initiatives and standards have been developed. To address some of the more obvious criticisms of the rating industry, he concluded by discussing how both S&P has long since supported the reduction of regulatory reliance, and that every remuneration model in the rating industry comes with conflicts and that, ultimately, the responsibility lies with the investor to utilise the information they have available to them responsibly.


Professor Grundfest then followed, with the initial part of his segment addressing the view that the stable duopoly in the sector produces very little innovation. He then clarified that, in his view, the issuer-pays remuneration model is the only realistic model for agencies who are the largest in the industry. He then discussed an idea that he has championed. This is the ‘Buyer-owned and Controlled Rating Agency’, or BOCRA. Essentially, the idea is that these entities would be owned and operated by some of the larger investors, with the concept being that the entity would have ‘strong incentives to promote an investor’s point of view in the rating process’. The financial support for such entities would be gained from a partnering arrangement whereby every time an issuer pays for an NRSRO’s rating, they would have to pay for a rating from a BOCRA. Grundfest suggests that there would be no limit on the amount of BOCRAs, but that in reality only two would likely emerge and that the market would dictate its prices. This approach contains many more details - available in the link above – but Grundfest did begin with acknowledging that it is slightly ‘controversial’.


The section concluded with some interesting Q&As, with one in particular (from JW Verret of George Mason University) raising the issue of the Office of Credit Ratings being particularly underfunded in relation to other bodies in other industries that have similar mandates (like PCAOB).


Then, on June 1st, the Credit Ratings Subcommittee of FIMSAC announced that it was recommending a number of proposals with regards to the regulatory needs within the rating sphere. In its recommendations, that were based on a number of months of research and testimony, the subcommittee focused on three elements in particular: the need for increased NRSRO disclosure; the need for enhanced levels of issuer disclosure; and a mechanism for bondholders to vote on the issuer-selected NRSROs.


On the first point, the recommendation is that NRSROs should provide more in-depth information about their models and how the models differ by industry. Furthermore, if there are any inputs that effect a model, for example any qualitative inputs, then these should also be declared publicly. With regards to deviations from stated methodologies – which is not allowed unless expressly declared and with good reason – the subcommittee suggests that additional summary statistics on how often, and to what extent NRSROs have deviated would be useful for further research.


With regards to increased disclosure from issuers, the subcommittee first finds that for corporate issuers, the process of how NRSROs are selected should be more transparent, and to this end they suggest that the SEC should work alongside trade groups so that ‘best practice’ in this area can be identified and replicated. For securitised issuers, the same selection process is of interest to the committee, with it suggesting that more transparency is needed. In addition to a similar establishment of ‘best practices’ in this area, the subcommittee also suggests that any time a rating agency is selected but the rating not subsequently published, then this should be made public so that investors can be aware of any potential instances of ‘rating shopping’.


Finally, in relation to the bondholders voting on the selection of NRSROs, the subcommittee suggests that, like public auditors, the bondholders should be able to vote on whether to ratify, or simply to confirm confidence in the NRSRO selected to develop the rating for the bond. The subcommittee argues that this may provide for additional discipline on the rating agencies. The report concludes with a number of acknowledgements regarding the issues with such policy recommendations, with the most prominent being that the current regulatory framework may prevent some or all of the policies being implemented.


The thing to note is that there is certainly no shortage of proposals with regards to what may be done to ‘fix’ the rating arena. If we proceed on the basis that this ‘fix’ is desired, which in certain points I suggest is not actually the case – my forthcoming research on ‘rating addiction’ argues that the system is addicted to ratings quite simply because they fulfil a number of purposes – then the issue is whether such policies are reasonable. A number of the above are reasonable, but some of the above may need a lot of regulatory capital, or better still ‘regulatory will’ to eventually succeed. Whether this ‘will’ exists is, perhaps, truly the question. I have argued in the past, and will no doubt argue in the future, that the real question is ‘who does the current system serve?’ I believe that the answer to this question dictates how much regulation, and by that I mean truly impactful/altering regulation, will be implemented. Partnoy noted in his section that a number of elements of Dodd-Frank have not been adopted – the question then becomes ‘why not?’ If it is because the proposed regulations were not workable within the current regulatory framework, then the issue is that either the legislators are out of touch, or that the framework is not fit for purpose and needs to be changed. Perhaps on the back of these currently proposed policies, the actions of the SEC will be telling.


Keywords – CRAs, regulation, @finregmatters

Thursday, 4 June 2020

Scope Ratings Fined by ESMA

We have covered the European-based Scope Ratings a number of times in Financial Regulation Matters, here, here, and here. Also, recently the agency has received positive reviews in the financial press, with one outlet prescribing Scope Ratings as ‘the new challenger’ to the credit rating space, complete with a new approach. However, it was announced today that Scope Ratings had been fined by ESMA for a practice which is particularly familiar in the ratings arena – saying one thing and doing another.


The news broke this morning that ESMA had fined Scope for breaches of the Credit Rating Agencies Regulations (CRAR), to the tune of €640,000. ESMA also published a ‘public notice’ explaining the reason for the regulatory action. The regulator found that there were a number of breaches, with the fine being divided between: a failure to apply a methodology systematically (€550,000); and a failure to revise methodologies (€90,000). The action revolves around the time of 2015, a point in time which the regulator has since discovered that Scope adopted a particular ‘covered bonds methodology’ (CBM) and then never actually applied it. The methodology consisted of an analysis of an issuer’s strength, but also supposedly an analysis of the legal framework and also an analysis of the cover pool. Yet, when the ratings were issues Scope never actually applied this methodology properly even though it had declared it had, with the result being that ‘559 ratings [had been] issued without analysis being conducted according to the publicly disclosed CBM, our of a total of 622 ratings issued under the 2015 CBM’. Furthermore, ESMA also found that when changing to the 2016 version of the methodology, Scope did so without consulting the regulator nor, publicly at least, any stakeholders (in breach of CRAR).


Scope has the right to appeal against the decision, and it remains to be seen whether it will do so. Scope, for its part, has said that ‘at the time, Scope had inadvertently taken a different interpretation of relevant parts of EU legislation on credit rating agencies which turned out to be different from ESMA’s… since 2016, Scope has entirely remedied the issues identified by ESMA and reinforced its internal controls regarding he application of the relevant regulations’. The report from Nasdaq suggests that Scope have already made provisions for the fine, which suggests that it will not appeal.


Keywords – Scope Ratings, Scope, ESMA, regulation, business, @finregmatters

Monday, 1 June 2020

Start-up Profile – CRED iQ

Last year we reviewed a new entrant into the financial information landscape, with the start-up Sigma Ratings which exists to provide focused and specialised information regarding anti-money laundering and its effects on creditworthiness (amongst a number of other aims). In today’s short post we will be introduced to another start-up aiming to impact the marketplace, this time in the field of information relating to commercial real estate intelligence, which is particularly apt given the market shift in focus to commercial mortgage-backed securities over the past few years – that company is CRED iQ.


CRED iQ, founded by Bill Petersen and Michael Haas, has the expressed aim of providing the marketplace with a flagship platform which provides for interactive commercial real estate valuation, CMBS monitoring, and also involves a ‘lead generation platform delivering objective risk assessments to CRE (Commercial Real Estate) and capital market investors’. The innovative platform provides users with commercial real estate valuations that is based on in-depth and relevant market data, trend analysis, and more than 20 years of valuation experience, whilst the interactive valuation scenarios (MyQ) enables users to navigate user-friendly software that can adjust CRED iQ valuations and observe the adjustments across loans, deals, and portfolios. There are also elements of the platform that provides information on loss projections, portfolio analytics, and there is also the opportunity to set real-time alerts so that changes in the marketplace that may be relevant to a portfolio can be incorporated instantly into the decision-making process. Additionally, the company is launching what it calls Investment Quality Scores (iQ), which it says are ‘numerical tranche and deal level objective risk assessments free from market perceived conflicts of interest’.


The company states that it serves a number of industries, including mortgage brokers, leasing agents, investment sales, and capital markets amongst a large list of others. The independence that the company is seeking to display should be of real benefit to those potential industries that may use the new company’s platform and services. To subscribe to the platform, the rates are $149 per month per user for the Standard package, and $249 per month per user for the Ultra package. The new company is growing well, as evidenced by a current recruitment drive for software engineers and their recent contribution to a Wall Street Journal article which saw their valuation of the Fontainebleau Hotel in Miami incorporated into the analysis being developed by the WSJ. For those readers who may be interested in learning more about the company and the platform it offers, there is a free trial available. If more information is required, then the company can be contacted here.


The aim to inject impartial and considered information into the CRE landscape is a welcome one, particularly as the company aims to develop useful information that is free from the conflicts of interest that can cause so much damage in a field such as this one. Hopefully the company will continue to grow and we shall monitor its progress here in Financial Regulation Matters. You can follow the company on LinkedIn here.


Keywords – CRED iQ, Analytics, CMBS, Commercial Real Estate, @finregmatters.

Wednesday, 20 May 2020

Dingemans Quits the Financial Reporting Council (FRC)

Simon Dingemans, the former finance chief for GlaxoSmithKline and long-term employee of Goldman Sachs, has surprisingly and abruptly quit his role as the Chairman of the Financial Reporting Council, less than a year after taking the helm. In this post we will look back at his tenure and find out why he has decided to move back into the private sector.

We analysed Dingemans’ appointment late last year here in Financial Regulation Matters, where we discussed his taking aim at the auditing oligopoly that the FRC has responsibility for regulating. At the time, Dingemans stated that ‘this is a rare opportunity to reform something so wholeheartedly’, and he made the break-up of the ‘Big Four’ and their oligopolistic hold on the auditing marketplace a priority. However, since his appointment it has been business as usual. The regulator has continued investigating members of the oligopoly, whilst also calling on members to upgrade their auditing tools. This is nothing out of the ordinary for the regulator. Yet, today’s announcement has come as a surprise for the regulator, and the market.

Dingemans, who came under pressure regarding the late filing of accounts he was a director of, had an arrangement with the FRC that he would be paid £150,000 to work a three-day part-time week, with Dingemans allowed to take on other roles as long as they did not conflict with his Chairmanship. It was announced by the FRC that the reason for his departure was because of him ‘being prevented from taking additional roles that may have conflicted with his duties at the FRC’. There has been no announcement as to what these roles may be, or where Dingemans will be going next. The FRC declared that the regulatory reform agenda is still on track – one that includes the breaking up of the Big Four – but time will tell. One element that will be of interest will be to see where Dingemans goes next, because there is an increased potential that this chain of events will be a fantastic example of the ‘revolving door’ that describes the consistent transition of regulators into industry, and vice-versa. The breaking up of the Big Four has been suspended because of the pandemic, and now it will be on the top of the agenda for the new Chair, if the FRC is true to its word. How the Big Four respond to this development will be of interest too, as they are already making moves to ‘break-up’ in principle, although this is questionable as the leading auditors have form in this area; in the aftermath of the Enron scandal a number of auditors split their auditing and consultancy services, only to restart a few years later once the media cycles had moved on to other areas of the financial system. What is for sure is that this development comes as a massive blow for the FRC, which at the same time fundamentally increases the pressure on the regulator as it seeks to protect its future as a regulatory entity.

Keywords – audit, FRC, regulation, @finregmatters

Tuesday, 19 May 2020

Johnson & Johnson Ceases Selling Talcum Powder in the US and Canada – Update

Late last year we discussed here in Financial Regulation Matters the news that Johnson & Johnson had been ordered to pay billions of dollars in damages for the side effects that talcum powder was causing. It had been suggested at the time that the spate of litigation could end up costing the giant conglomerate more than $20 billion and, just today, the news broke that the company would cease selling the product in the US and Canada.

The talc-related saga for J&J is a long one. There has been a vast number of legal actions taken against the company, with a number of claimants being awarded large amounts, with one claim leading to $417 million in damages being awarded, and in another $4.7 billion to 22 women in the US. Interestingly Forbes said recently that J&J stock may be undervalued, but that may be about to change. The Financial Times is leading the way with the reporting that the company has dropped the sale of the product in the North American market, although they have responded as expected. Firstly, the have claimed that the cessation will not be too damaging, as the market only makes up 20% of the global market and the product will remain on sale across the rest of the world. The head of the Consumer Health division, Kathleen Widmer, was quoted in the article as blaming ‘misleading litigation advertising’ as the cause for the drop in demand of the product. The company points towards a mini-legal industry that has emerged looking for claimants, with just under 20,000 lawsuits pending against the company. The company has maintained that its product is safe, although it will now be switching to its cornstarch-based baby powder instead of the talc-based product; also, its claims that the product is widely regarded as being safe is not universally accepted.

The decision will fall into the company’s decision to ‘streamline’ its product offering in light of the COVID-19 pandemic, but in reality it will not stop the avalanche of legal action that is continuously heading its way. However, there may be an opportunity to finally switch to a non-talc based product irreversibly. Yet, the continued demand for the product around the world means that this may be some way off, unless similar legal actions are repeated in other markets.

Keywords – Talc, Johnson & Johnson, retail, business, law, @finregmatters