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  • Dec 18, 2014
  • Updated: 6:56am

Scrutiny of rating agency may raise its own red flags

PUBLISHED : Saturday, 16 July, 2011, 12:00am
UPDATED : Saturday, 16 July, 2011, 12:00am

The word most uttered over business lunches in Central this week must have been 'Moody's'. The rating agency's 'red flag' report on mainland companies stirred up as much controversy about its own reputation as that of the corporations it rated.

All eyes are now on the Securities and Futures Commission, which managed to put credit rating agencies (CRA) operating in Hong Kong under its regulation last month, after their controversial role in the global financial crisis.

But does the SFC, which licenses credit rating agencies, have any teeth? Despite public outcry over their questionable independence and poor ratings performance, none of the rating agencies has been sanctioned so far.

Nevertheless, our regulator has been vocal. Just hours after Moody's red-flag report knocked down share of dozens of mainland companies, the commission said it was looking into the case. This test case, however, may be more difficult than most people think.

Angry companies that lost value because of the red flags and equity analysts who have been busy defending their recommendations, have plenty of questions for - and criticism of - Moody's.

The first question is motive. Why did Moody's use a red-flag approach when it has not done so elsewhere? Why focus only on China and not other emerging markets? Why issue the report now when the credibility of mainland financial reports has been in the news for months? What new ammunition have short-sellers gained from this report?

The question of Moody's motive is attention-grabbing but won't prompt regulatory action unless evidence of a short-selling plot can be found.

Moody's has said the report was done 'to address investors' concerns and provide transparency' as US regulators investigate the quality of financial reporting from publicly listed Chinese firms. A report on other Asian countries was soon to follow, it added.

Methodology questions come next. Equity analysts challenge the relevance of some of the 20 parameters Moody's used.

In its report, titled 'Overly Moody', Macquarie questioned why high growth and high margins - characteristics of emerging markets - deserve red flags.

Methodology is subjective. Credit investors, or bondholders - the rating agency's main audience - have a different risk tolerance and attitude than equity investors. A bond investor may be concerned about fast growth and high capital expenditure, but they are welcomed by equity investors.

More real for regulators are the factual errors in the report. Less than two days after it was issued, at least four companies said Moody's got some of its facts wrong.

Developer Kaisa Group said it had not changed its auditor in the past three years, as suggested by the report, which gave Kaisa seven red flags. PricewaterhouseCoopers has been its auditor since its incorporation in 2007.

A similar error happened with Yuzhou Properties. The company has had Ernst and Young as its auditor since 2008. Moody also gave Yuzhou seven red flags.

Another developer, China South City, was given a flag for changing its chief executive or financial controller within three years. But the company said it has had the same financial controller for the past three years. An executive director was appointed chief executive in 2009 after a recommendation by the Hong Kong exchange to split the chairman and CEO jobs.

China Glass Holdings got five red flags. One was for family ownership of over 30 per cent. But China Glass has no family ownership.

Accuracy is a major requirement in the code of conduct that regulates credit rating agencies. According to the code: 'A CRA and its representatives should take steps to avoid issuing any credit ratings that contain misrepresentation or are otherwise misleading as to the general creditworthiness of the rating target.'

Fairness to the rated companies and investors are other areas of concern. The code says: 'A CRA should ensure that it has, where feasible and appropriate, prior to issuing or revising a rating ... [informed] the rated entity of the critical information and principal considerations upon which a rating will be based and afford the rated entity an opportunity to clarify any likely factual misperceptions or other matters that the CRA would wish to be made aware of in order to produce an accurate rating. A CRA will duly evaluate the response.'

Various companies have complained that they knew about the red flags only upon publication of the report, giving them no chance to correct factual errors.

Under existing rules, violations of the code can result in disciplinary action. But will these apparent discrepancies - if they are discrepancies at all - lead to any disciplinary action?

Part of the uncertainty is to do with the nature of the red-flag report. Is it a ratings report or not? If not, the code should not apply.

On the front page of its report, Moody's said: 'The red flags provide further clarity and detail but do not represent a change in our rating methodologies.

'Our rating already accounts for the inherent challenges in assessing these Chinese companies ... We use these flags as an interesting screen to identify potential areas of concern for follow-up and closer scrutiny.'

The report is the first of its kind issued by Moody's and its relationship with actual ratings has yet to be clarified.

Regulators will certainly argue for a broader interpretation of the code that includes the Moody's red flag report.

According to lawyers, the code says the rating agency should initiate a review of a rating when it becomes aware of information that might be expected to result in any rating revision or termination.

Regulators can argue the red-flag approach constitutes a change in ratings methodology or information that might result in a rating revision. If so, they can question why the rating status has not been reviewed and call the agency misleading.

I think the most troubling aspect here is the suspicion that Moody's may want to effectively change the ratings on a company without actually having to do so.

This won't be an easy legal battle for the SFC to win. Moody's will certainly fight with all its might - which may raise its own red flags.

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