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Hong Kong – US And HK Regulators In Pursuit Of Credit Rating And Research Firms.

4 February, 2015


Legal News & Analysis – Asia Pacific – Hong Kong – Regulatory & Compliance


On 21 January 2015, the United States (US) Securities Exchange Commission (SEC) announced sanctions against credit rating firm, Standard & Poor’s Rating Services (S&P), which include payments in the total sum of USD 58m and an undertaking by S&P to take a one-year timeout from rating conduit fusion commercial mortgage-backed securities (CMBS). S&P further agreed to pay an additional USD 19m to settle parallel cases announced by the New York and Massachusetts Attorney General’s offices.


Separately in Hong Kong, the Securities and Futures Commission (SFC) recently commenced enforcement actions respectively against, (i) another credit rating firm, Moody’s Investors Service Hong Kong Limited (Moody’s), and (ii) Andrew Left (Left) of Citron Research (Citron), which is a US-based publisher of research reports on listed companies.

This bulletin provides a brief summary of these actions by the regulators in the US and Hong Kong.


United States – Proceedings Against S&P


Further to the settlement as announced on 21 January 2015, the SEC published three orders relating to:


  • S&P’s practices in its conduit/fusion CMBS ratings methodology;
  • publication of a misleading article relating to new ratings criteria; and
  • internal control failures relating to the rating of residential mortgage-backed securities (RMBS).


The SEC found that S&P violated the anti-fraud provisions in Section 17(a)(1) of the Securities Act of 1933 and internal controls and books and records provisions under the Securities Exchange Act of 1934and Rule 17g-2 thereunder. S&P neither admitted nor denied wrongdoing in the settlement. The SEC announcement and the three orders can be accessed here.


The SEC’s order in relation to (a) above concerns S&P’s application of the debt service coverage ratio (DSCR) when rating CMBS transactions. In gist, S&P changed the way in which it calculated DSCRs; resulting in a decrease in the level of credit enhancement necessary to achieve a particular rating. Reports published by S&P failed to describe this change in methodology, meaning that the ratings appeared to be based on more conservative assumptions than was in fact the case. Apart from agreeing to pay a total sum of USD 42m, S&P undertook to refrain from providing ratings regarding conduit fusion CMBS transactions for a period of twelve months.


As regards (b) above, new ratings criteria that S&P used were published by it and the parameters of these new criteria were also outlined in a different publication. These publications purported to show that the criteria could withstand Great Depression-era levels of economic stress. The SEC found that the research quoted in the publications relied on “flawed and inappropriate assumptions” and that certain aspects about the new rating criteria were inaccurately described.


In relation to the order described at (c) above, certain assumptions set out in its published criteria for the surveillance of ratings of certain RMBS were no longer applied by S&P, but it failed to follow internal control policies and procedures with regard to such change. The change in assumptions resulted in the ratings in question being less conservative than would otherwise have been the case. This issue was reported to the SEC by S&P and the SEC notes that this self-reporting led to a reduced penalty.


United States – Proceedings Against Former S&P Employee


In a separate order dated 21 January 2015, the SEC instituted litigated administrative proceedings against Barbara Duka, the former head of S&P’s CMBS Group. It alleges that Ms Duka fraudulently misrepresented the way in which S&P calculated certain CMBS ratings in 2011. The hearing in this matter is currently scheduled to commence on 23 February 2015.


Separately, Ms Duka filed an action in federal court challenging the constitutionality of the SEC’s administrative proceedings regime. Ms Duka has applied for an injunction to stay the SEC’s case while the federal court considers her action; at the time of writing this briefing, the judge had yet to give judgment on this matter.


Hong Kong – Proceedings Against Moody’s


On 31 December 2014, a rulingi of the Securities and Futures Appeal Tribunal (SFAT)ii reveals that Moody’s was subject to disciplinary proceedings commenced on 3 November 2014 by the SFC. The case concerns a red flag report published in 2011 which SFC alleged was done by Moody’s in breach of the provisions in the Code of Conduct for Persons Licensed by or Registered by the SFC. The SFC decided to issue a public reprimand and a penalty totaling HKD 23m (about USD 3m).


The SFAT’s proceedings was commenced by Moody’s to challenge the SFC’s decision. Based on information in the SFAT ruling of 31 December 2014, Moody’s argued that the relevant red flag report was not the result of its regulated activities, namely, the conduct of a credit rating serviceiii, and is not therefore subject to the regulatory control of the SFC. The substantive hearing of the matter is scheduled in September 2015.


Hong Kong – Proceedings Against Andrew Left Of Citron Research


Separately, on 22 December 2014, the SFC announced the commencement of Market Misconduct Tribunal (MMT)iv proceedings against Left, who lives in the US. The SFC alleged that on 21 June 2011, Left published a report on Citron’s website that contained false and misleading information about a Hong Kong listed company. It was further alleged by the SFC that Left short sold the relevant shares shortly before publishing the report which resulted in notional and realized profits of HKD 2.8m (about USD 360k) and HKD 1.7m (about USD 220k) respectively.


Under Section 257 of the Securities and Futures Ordinance, Chapter 571 of laws of Hong Kong (SFO), the MMT has power to make the following orders:


  • cold shoulder order;
  • cease and desist order;
  • disgorgement order up to an amount equal to any profit gained or loss avoided as a result of the market misconduct in question; and
  • payment order in relation to the related legal and investigation costs.



The conduct of credit rating and research firms is a matter that regulators are closely monitoring and scrutinizing. It is expected that regulators in the US, Hong Kong and the rest of the world will not hesitate to take enforcement actions against any misconduct by credit rating and research firms.


Financial institutions must also pay special attention to the research reports that they regularly publish (whether publicly or to their own clients). Regulators will expect financial institutions to be in full compliance with all legal and regulatory requirements.


Herbert Smith Freehills’ New York and Hong Kong offices regularly advise clients on compliance matters as well as investigations by US and Hong Kong financial regulators. We also have extensive experience in representing clients (both corporations and senior executives) to defend criminal, administrative, disciplinary, civil and other proceedings commenced by financial regulators.


End Notes:


i The SFAT’s ruling of 31 December 2014 is an interlocutory decision regarding the issue whether a privacy direction should be made.


ii The SFAT is a review body established under the SFO to ensure that regulatory decisions made by SFC and the Hong Kong Monetary Authority are reasonable and fair.


iii Providing credit rating services (as defined in the SFO) is a Type 10 regulated activity.


iv The MMT is established under the SFO to conduct civil proceedings and, where appropriate, imposes civil sanctions against those it determines to have committed market misconduct, namely, (i) insider dealing, (ii) false trading, (iii) price rigging, (iv) stock market manipulation, (v) disclosure of information about prohibited transactions and (vi) disclosure of false or misleading information inducing transactions in securities and futures contracts.


herbert smith Freehills


For further information, please contact:


John O’Donnell, Partner, Herbert Smith Freehills

john.o’[email protected]


William Hallat, Herbert Smith Freehills

[email protected]


John Siu, Herbert Smith Freehills

[email protected]


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