Court of Appeal rules against Moody's in regulatory appeal
Note: This is an update to our October 2016 Regulatory Law Alert. Please see the Alert for more information.
In a recent judgement dated 8 June 2017, the Court of Appeal dismissed an appeal brought by Moody's Investors Service Hong Kong Limited ("Moody's") against a decision by the Securities and Futures Appeals Tribunal ("SFAT"). The judgement upheld the decision of the SFAT and confirmed the underlying decision of the Securities and Futures Commission ("SFC") in fining and reprimanding Moody's.
On 11 July 2011, Moody's published a document entitled "Red Flags for Emerging-Market Companies: A Focus on China" ("Report"), which was distributed to its subscribers and available for sale to the general public. The main part of the Report concerned a system of "Red Flags" ("Red Flags") which rated 49 non-financial Mainland Chinese companies against 20 warning signs, identifying possible corporate governance or accounting risks in the companies.
The Report was published at a time when there were ongoing market concerns about the credit risks of a number of Mainland Chinese companies, arising from rumours about their accounting and corporate governance standards. Shortly after the Report was published, the share price of a number of companies mentioned in the Report dropped significantly, including the share price of four Hong Kong listed companies.
The SFC's investigation into the background of the Report identified a number of problems. The SFC found that the Report failed to provide sufficient explanations for the Red Flags assigned by Moody's, which painted a misleading picture of the companies referred to in the Report. Further, the SFC stated that the Report specifically highlighted six companies as "negative outliers" despite there being no significant correlation between the number of Red Flags and the credit risks of those highlighted companies. As a result, the SFC found Moody's to be in breach of the SFC's Code of Conduct and imposed a fine and a public reprimand.
Moody's Challenge in the SFAT
One of Moody's key arguments was that the publication of the Report did not constitute a regulated activity under the Securities and Futures Ordinance ("SFO"), and that the SFC did not have jurisdiction to regulate the content of the Report. However, the SFAT concluded that the publication of the Report did constitute a regulated activity and that consequently, the SFC has jurisdiction. The SFAT arrived at this conclusion by holding that the Report either:-
• itself constituted a form of credit rating; or
• was intended to be read as amplifying and supplementing Moody's ratings, and thus became part and parcel of Moody's ratings themselves.
On this basis, the SFAT concluded that the preparation and publication of the Report constituted the carrying on of a Type 10 regulated activity, and therefore fell within the SFC's jurisdiction. Moody's subsequently appealed from the SFAT's decision to the Court of Appeal.
Court of Appeal's decision
In the Court of Appeal, Moody's argued that the SFAT was wrong in concluding that the Report constituted a form of credit rating, or that it had the effect of amplifying or supplementing its credit ratings.
First, Moody's argued that the Report was not a form of credit rating, as the Report was not primarily about the creditworthiness of the companies referred to in the Report, and added that the Report only identified two elements of credit risks when a full credit review would involve many different elements. Secondly, Moody's argued that the Report could not have had the effect of amplifying or supplementing its existing ratings, as the Red Flags framework in the Report was not part of Moody's process or methodology in making its usual credit ratings.
The Court of Appeal accepted Moody's first argument that the Report did not by itself constitute credit rating, but disagreed with Moody's second argument. The Court of Appeal held that although the Red Flags framework was not part of Moody's methodology in making its usual credit ratings, this did not preclude the Report from supplementing its credit ratings. The Court of Appeal also confirmed that on a purposive reading of s. 193(1) of the SFO, clarifying or adding to an existing credit rating is a "related" regulated activity. Since the Report by Moody's fell within the definition of a "related" regulated activity, the SFC had jurisdiction, and Moody's appeal was dismissed.
The Court of Appeal in this case partially confirmed the approach taken by both the SFC and the SFAT. It clarified that materials published by credit rating agencies can come under the scrutiny of the SFC, even if the materials are not official credit ratings.
The SFC, by enforcing against Moody's in this case, has demonstrated its concern towards the impact of credit rating reports on the quality of the market. It is also sending a message to those preparing credit rating reports that they should exercise due care when making price-sensitive statements. Credit rating agencies should therefore carefully review materials intending to be distributed to subscribers and to the general public before publication.
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