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Hong Kong's Court of Final Appeal says Moody's must accept SFC action

BIScom Subsection: 
Peter Lee

In 2011, Moody’s Investors Service Hong Kong Limited which along with many associated companies is generally known only as "Moody's," and which has forgone the sobriquet "ratings agency" in favour of the much more honest "ratings organisation", issued a document entitled "Red Flags for Emerging-Market Companies: A Focus on China." Ignoring, for the sake of simplicity, that the document referred to warning signs and not red flags in the true sense, it contained material that the Hong Kong Securities and Futures Commission (SFC) decided was not apt. That started a battle which continues.

The headline is this: Hong Kong's Court of Final Appeal (The Hon Ribeiro PJ, The Hon Tang PJ, The Hon Fok PJ, The Hon Bokhary NPJ and Lord Neuberger of Abbotsbury NPJ) has dismissed Moody's application for an order that the SFC has no jurisdiction. The reasons have not yet been published (we've been waiting). What it means is that the SFC can now enforce the order that it made in 2011, shortly after the report was published. That's where we are. This is how we got where we are.

On 11th July, 2011 Moody's issued a "report" that, the SFC found after investigation, contained "various failures relating to its preparation and publication of the special comment report."

The report, said the SFC,

"- failed to provide sufficient explanations for the red flags assigned by it to the rated companies and to set out relevant justifications to the red flags in the Report, and had, as a result, painted an unfair, unclear and misleading picture of the companies;
- chose to list the red flags assigned to each company and to highlight six companies with the largest number of flags in the Report as “negative outliers” to make the Report “actionable” despite the assessment performed by its analysts showed that there was no significant correlation between the number of red flags and the companies’ credit risk; and
- failed to ensure the accuracy of the red flags assigned to the companies."

Having made the findings, the SFC ordered Moody's to pay a penalty of HKD23 million and issued a public reprimand. Moody's appealed to the Securities and Futures Appeals Tribunal, SFAT. Moody's argued that the SFC had no jurisdiction over Moody's in relation to this case. The SFAT found in favour of the SFC. According to a statement by the SFC in April 2016, "The SFAT found that in the preparation and publication of the Report, Moody’s was carrying on its regulated activity of providing credit rating services. The SFAT also found that there were substantive breaches of General Principles 1 and 2 of the Code of Conduct (Notes 5 & 6). The SFAT has determined that Moody’s should be subject to a public reprimand and a pecuniary penalty of HKD11 million."

In the Report, Moody’s assessed 49 non-financial Chinese entities against 20 warning signs it called “red flags” to identify possible corporate governance and accounting risks. The Report highlighted and discussed six companies which received the highest number of red flags among the other rated peers, and they were identified as “negative outliers”. The Report also displayed the number and type of red flags assigned to each of the 49 companies in various tables.

The share prices of more than half of the Hong Kong-listed companies covered in the Report dropped substantially on the following day, ranging from 5% to as much as 16.8%, compared to their previous closing prices on 8 July 2011. In particular, four of the six companies singled out as “negative outliers” in the Report suffered the biggest drop in their share prices.

-- SFC statement 5th April 2016.

The SFC's case is based on General Principle 1 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct) which requires that a licensed or registered person should act honestly, fairly, and in the best interest of its clients and the integrity of the market in conducting its business activities.

The SFC’s findings under General Principle 1 were, it said, limited to Moody’s failure to act fairly, in the best interests of its clients, and the integrity of the market. In its Reasons for Determination, the SFAT also made it clear that there are no findings of dishonest conduct or intention to mislead by Moody’s.

General Principle 2 of the Code of Conduct requires that a licensed or registered person should act with due skill, care and diligence, in the best interests of its clients and the integrity of the market in conducting its business activities.

However, the SFAT did not go all the way in support of the SFC. The SFC, in a footnote to its statement about the positive news added the following:

The SFAT reduced the penalty imposed by the SFC from HKD23 million to HKD11 million after rejecting the SFC’s findings that:

(a) the Report and its accompanying press release created a misleading impression that the red flag methodology had been in use over time and had been relied upon by Moody’s in rating Chinese companies and would continuously be applied in the future; and

(b) Moody’s did not have in place sufficient internal control procedures to ensure that its business activities which were related to and part and parcel of its regulated activities complied with paragraph 4.3 of the Code of Conduct.

With respect to the findings set out at (b) above, the SFAT commented that it is not that Moody’s had no internal control procedures in place but that it failed to recognise that the Report should have been subject to the existing internal controls covering the regulated activity of providing credit rating services.

-- SFC statement 5 April 2016

This, then, is consistent with Moody's continued appeal in which it argued that the SFC did not have jurisdiction. If the SFC had no jurisdiction, then the various checks and balances which the SFAT says Moody's had in place but did not apply in the case of this report, would not apply and, if they did not apply, the penalty and reprimand could not be imposed.

What is perhaps most interesting about the FSAT's Determination (the equivalent of judgment) is that it consistently raises questions about the use of buzzwords instead of terms of substance. In particular, there is repeated implied criticism of the term "red flag" for which there is no clearly defined or consistent meaning. The Determination is a wake-up call for those in compliance and related functions to distance themselves from the superficial and vague or, even, inaccurate and to adopt terms which have import, are properly defined and used consistently. It goes further than application in compliance, etc. and goes to marketing, research and production. In short, it proves that a whole business is regulated, top to bottom, side to side, front to back. The Determination quotes other examples with extracts where there are lots of words but little clear meaning.

None of these criticisms refer to quality of research or analysis. Those are separate matters. The Determination is clear: content and style are both matters that come within the regulatory umbrella.

Moody's carried on with its appeals.