The hearings have recently concluded in Moody’s appeal of the November 24, 2014 decision of Hong Kong Securities and Futures Commission (the “SFC”) to fine Moody’s HK$23 million1 for its release of a report applying a “red flag” framework to 61 rated Chinese companies. As was the case prior to the appeal hearing, little is known publicly about the specific nature of the SFC’s allegations as neither the SFC’s decision nor the filings for or transcript of the appeal hearing are publicly available.

Given the possible implications of this case not only for regulated credit ratings agencies in Hong Kong but also for analysts advising on securities in the city, we thought it would be a useful and interesting exercise to use this eUpdate as a platform to examine the report itself and the publicly available information regarding the SFC’s position.  We attempt to discern the enforcement standard that could be set if the SFC’s case is upheld on appeal and the potential effects on the functioning of a free and dynamic marketplace in Hong Kong. 


As a result of amendments made on June 11, 2011 to Schedule 5 of the Securities and Futures Ordinance (the “SFO”), Credit Rating Agencies (“CRAs”) are subject to the regulatory oversight of the SFC.

Subsequent to the June 11th amendments, Moody’s Investor Service Hong Kong Limited (“Moody’s”), a CRA, issued a report dated July 11, 2011, Red Flags for Emerging-Market Companies: A Focus on China (the “Report”) that reviewed 61 Chinese non-financial rated companies.  In the Report, five categories of red flags were used to highlight possible governance or accounting risks posed by such companies.2  The release of the Report reportedly caused the share and bond prices of certain of the subject companies to fall and provoked criticism from market analysts who debated Moody’s risk framework and a public response from at least one of the companies disputing the accuracy of one of the red flags attributed to it.3

Following an investigation, on November 3, 2014, the SFC issued a decision notice4 that imposed a HK$23 million fine on Moody’s (the “Decision Notice”).  The SFC’s fine is the first disciplinary action taken by the regulator against a CRA since their activities became regulated by the SFC.5

In an application dated November 24, 2014 to the Securities and Futures Appeals Tribunal (“SFAT”), Moody’s challenged both the findings of culpability made against it and the nature and extent of the penalties imposed.  Moody’s also applied for a privacy direction to keep private all appeal proceedings, orders and decisions arising out of the application. On December 31, 2014, the SFAT released a decision denying Moody’s application for a privacy direction.

On September 12, 2015, the SFAT concluded hearing the appeal made by Moody’s. The decision of the SFAT is due in December 2015.6 

Neither the Decision Notice nor any of the filings for or the transcript of the appeal hearing has been made public and therefore, the means by which the SFC arrived at its decision are unknown.  The only official reference to the Decision Notice and the criteria used was made by the SFAT in its December 31, 2014 decision rejecting Moody’s application for the appeal proceedings to be held in private.  According to the SFAT, the SFC concluded that, in publishing the Report, Moody’s “had breached a number of provisions” of the SFC Code.7  Additionally, according to media reports from the recently concluded appeal, the SFC alleged that in producing the Report, Moody’s had broken three provisions of the SFC Code that require regulated entities to act with “honesty and fairness”, “due diligence” and to have “adequate internal controls.”8

Legal Framework

According to the SFC, the June 11, 2011 amendments to the SFO were intended to create a licensing regime and related legal and regulatory obligations for CRAs.9  The operative amendments include the addition of:

(i)    the provision of credit rating services (Type 10 activity) to the list of regulated activities; 
(ii)    the term “credit ratings”, which is defined as opinions, expressed using a defined ranking system, primarily regarding (a) the creditworthiness of a person other than an individual, (b) debt securities, (c) preferred securities, or (d) an agreement to provide credit; and 
(iii)    the term “providing credit rating services”, which is defined as the preparation of credit ratings for dissemination to the public, or for distribution by subscription, whether in Hong Kong or elsewhere and with a reasonable expectation that they will be so disseminated or distributed.10

As CRAs are now regulated by the SFC, the “Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission” (the “SFC Code”) applies to CRAs.  In addition to the SFC Code, CRAs are also subject to a separate code: the “Code of Conduct for Persons Providing Credit Rating Services” (the “CRA Code”).  The CRA Code guides the SFC in determining whether a licensed or registered person satisfies the requirement that it is fit to be or to remain licensed or registered.  The CRA Code supplements, and is to be read in conjunction with, the SFC Code.

The requirement to act with “honesty and fairness” is the first general principle of the SFC Code.  According to the SFC Code, in “conducting its business activities, a licensed or registered person should act honestly, fairly, and in the best interests of its clients and the integrity of the market.”  Section 2.1 elaborates on this principal, stating “[w]here a licensed or registered person advises or acts on behalf of a client, it should ensure that any representations made and information provided to the client are accurate and not misleading.”

The duty to act with “diligence” is the second general principle of the SFC Code, which states “[i]n conducting its business activities, 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.”  Section 3.4 falls under this principle, and states “[w]hen providing advice to a client, a licensed or registered person should act diligently and carefully in providing the advice and ensure that its advice and recommendations are based on thorough analysis and take into account available alternatives.”

Lastly, the most applicable section that makes reference to “adequate internal controls” is found under the “capabilities” general principle of the SFC Code and section 4.3, which states “[a] licensed or registered person should have internal control procedures and financial and operational capabilities which can be reasonably expected to protect its operations, its clients and other licensed or registered persons from financial loss arising from theft, fraud, and other dishonest acts, professional misconduct or omissions.”  According to the SFC, “internal controls” represent the manner in which a business is structured and operated so that, among other things, reasonable assurance is provided against “the maintenance of proper accounting records and the reliability of financial and other information used within and published by, the business.”11

Certain provisions of the CRA Code could also have application to the SFC’s allegations regarding the Report.  Paragraph 5 states that a CRA “should use rating methodologies that are rigorous, systematic, and, where possible, which result in ratings that can be subjected to some form of objective validation based on historical experience, including back-testing”.  More generally, paragraph 9 provides that a CRA “should take steps to avoid issuing any credit ratings that contain misrepresentations or are otherwise misleading as to the general creditworthiness of the rating target”, and paragraph 20 requires that a CRAS “deal fairly and honestly with issuers, investors, market participants and other members of the public”.

Was the issuance of the Report part of the “provision of a credit rating services”?

Based on media reports, Moody’s argued in the September 2015 SFAT proceedings that its issuance of the report was “supplemental” to its principal business of issuing credit ratings  and, like other media outlets, Moody’s “should be on a level playing field in terms of freedom of speech as Reuters and Bloomberg”.12   As the Report “is plainly not a prepared credit rating service” and was not the result of its regulated activities, Moody’s took the position that its issuance of the Report is therefore not subject to the regulatory control of the SFC and the SFC Code.13 Moody’s also argued, by all accounts, that even if the issuance of the Report was indeed a regulated activity, the Report’s contents did not breach the SFC Code.

An analysis of whether the issuance of the Report was part of the provision of “credit rating services” is beyond the scope of this article, although the contention that it is not does seems to beg the question:  What was it then?  What does “supplemental” to the business of providing ratings mean in this context?  Was it akin to a Reuters or Bloomberg article, as Moody’s counsel seemed to infer, or was it closer to the provision of investment advice regulated by the SFC as a Type 4 activity?

How the SFAT resolves this issue will be pivotal not just for Moody’s but for the impact of the case on the market at large going forward.  If the SFAT were to agree with Moody’s that the issuance of the report was not an activity regulated by the SFC and the SFC Code, they would likely have no need to address the SFC’s substantive allegations regarding the content of the Report, leaving local market participants largely in the dark as to the relevant SFC standards not just for CRA reports, but, because they are also subject to the SFC Code, reports published by Type 4 analysts as well.  Conversely, if the SFAT finds that the Report did constitute a credit rating activity, will its decision on the merits of the SFC’s substantive allegations be limited in application to credit rating agencies only or will it also provide guidance regarding the standards for Type 4 activities?

The SFC’s allegations, the Report and standards

In addition to the reports stating that the issuance of the Report violated the SFC Code’s principles of “honesty and fairness”, “due diligence” and “internal controls”, representatives of the SFC have also made various public statements regarding the Report’s alleged deficiencies.

According to Benjamin Yu, counsel for the SFC, the SFC did not allege that Moody’s acted dishonestly, but rather that the Report failed to achieve a “certain standard”, was “done in the manner that really doesn’t befit a reputable rating agency that is being regulated,”14 is “shoddy and unprofessional” work that falls short of the SFC’s due diligence and control requirements,15 is a “half-baked” idea that had not been properly tested and which contained mathematical and input errors.16

Mark Steward, then the SFC’s head of enforcement, is quoted as saying that one question in the Moody’s case “will be whether there was a reasonable basis for these red flags [in the Report] – were they actually red flags or was there actually a less alarming explanation – as well as the adequacy of the control process”.17

Attempting to summarize the SFC’s case based on the little we know is difficult.  However, it does seem clear that the SFC is focused on the “red flag” methodology used in the Report—i.e. were the “red flags” fair indicators of possible credit problems at the subject companies and, if so, were the criteria fairly applied to the subject companies?

As for the Report itself, one of our first reactions after reading it in full was to wonder what the big deal was and why the market apparently reacted to it the way it did.  Overall, it didn’t seem to contain a great deal that would have been new information for a reader reasonably knowledgeable about emerging market companies—most of the “red flag” items listed in the Report would be familiar to anyone that has read the “Risk Factors” section in an emerging markets high yield bond offering circular or a typical ratings report on such an issuer by one of the “big three” ratings agencies (albeit they would be called something other than “red flags”).18

Indeed, Moody’s confirms in the Report that the consideration of the factors designated as “red flags” is nothing new, stating that their ratings “already factor in” the factors represented by the red flag categories, that the red flags “provide further clarity and detail” as to their ratings of Chinese high yield issuers but “do not represent a change in our ratings methodologies”, and that they use the red flags as a “screen to identify potential areas of concern for follow up and closer scrutiny”.19 As Moody’s also states in the Report, the existence of some of these factors are the main reasons the companies covered by the Report are rated non-investment grade.20 As a whole, the Report reads as though it was intended as an in-depth explanation of Moody’s basic ratings methodologies for such companies, albeit overlaid with a broad application of these basic methods to many and in some instances quite diverse companies, which is not surprising in that Moody’s states in the Report that it was intended as a means to provide transparency on its rating methodologies in light of investor concerns over potential financial reporting problems at Chinese listed companies.21

That the red flag factors were already an integral part of Moody’s ratings process appears at odds with the SFC’s apparent position that Moody’s analytical methodology in the Report was “half-baked” or untested and indicative of a lack of diligence by Moody’s or deficient in its internal controls.

Alternatively, it may be that the SFC’s objection is not with the red flag factors themselves, but with the context and format with which they were applied in the Report.  Contrary to Mark Steward’s comments quoted above, the Report does provide reasonable and “less alarming” explanations for the existence of circumstances triggering certain red flags, both in its explanation of the individual red flags and its more in-depth analysis regarding the five companies it terms “negative outliers”. These alternate explanations, coupled with the fact that many of the “red flag” circumstances are common to Chinese and other emerging market companies and thus very familiar, contributed significantly to our feeling of “so what?” after reading the report.

However, what if the reader: (a) was not reasonably knowledgeable regarding the usual risks attached to emerging market non-investment grade companies; and/or (b) did not read the whole Report but instead relied on media blurbs?   In such a case, the application of the factors in the Report to many companies at once without the benefit in most instances of individual alternative explanations or mitigating circumstances, combined with the inevitable media sound-bite distortions of the significance of the Report’s numerical red flag tallies, may have made the format of the Report unsuitable for conveying a reasonably accurate comparison of the subject companies.  Similarly, a red flag circumstance that upon closer scrutiny of a particular company’s situation, has a relatively benign explanation or is actually instead considered a positive is arguably no longer a red flag with respect to that company.  However, in more than one instance, despite its acknowledgement of such circumstances, the Report counted the relevant red flag in the company’s tally.22 In addition, the equal weight given by the Report to the red flags, which the Report acknowledges may not be appropriate in some circumstances (“a frequent change of auditors appears more serious than having swings in working capital…that the company’s stage of development can explain”), also seems to have made the tallies of red flags a less meaningful comparative tool.

These are some suggested possible criticisms of the Report, and readers could disagree with our analysis or suggest their own critiques.  However, more importantly, are these types of criticisms of the Report at the heart of the SFC’s case?  Additionally, are these types of critiques sufficient to constitute a breach of a CRA’s duty of fairness, diligence and maintenance of internal controls under the SFC Code, or the more specific provisions under the CRA Code?

Whether the thrust of the SFC’s case is the red flag methodology itself or how the methodology was applied, if the SFC’s decision is upheld, this would set an extraordinarily high enforcement standard for the market going forward, whether applied to CRAs only or more broadly to a report released by a Type 4 analyst.   Absent from the SFC’s action, as far as we now know, are allegations of fraud, dishonesty, conflict of interest, market manipulation or other common factors generally present in enforcement actions of this kind in Hong Kong or other major financial markets.23 The apparent lack of such factors leaves a case based primarily on a difference of opinion as to methodologies, whether on a fundamental basis or as applied in the context, upon which market participants can and do reasonably differ, which inevitably raises concerns regarding the free flow of opinions and ideas in an efficiently functioning market, not to mention the utter unfeasibility of the regulation of ideas and opinions.

1   Equivalent to approximately US$3 million.
2   “Red Flags for Emerging-Market Companies: A Focus on China”, Moody’s Investor Service, July 11, 2011.
3   “Moody’s China red flag report under scrutiny by HK regulator”,  Reuters, July 21, 2011.
4   A decision notice sets out the SFC’s decision and its reasons to take disciplinary action against regulated persons.
5   “Hong Kong tribunal expected to rule on Moody’s case in 3 months”, Michelle Price, Reuters, September 12, 2015.
6   “Ruling on SFC’s fine of Moody’s due in 3 months”, Langi Chiang and Reuters, South China Morning Post, September 13, 2015.
7   SFAT, December 31, 2014 Ruling, para. 3.
8   “Update 2-Hong Kong watchdog says Moody’s broke code of conduct with ‘red flags’ report”, Michelle Price, Reuters, September 10, 2015.
9   SFO (Amendment of Schedule 5) Notice 2011, L.N. 28 of 2011.
10  See note 8 above.
11  SFC, “Consultation Paper on Management, Supervision and Internal Control Guidelines for Persons Registered with or Licensed by the Securities and Futures Commission, August 1, 2012.
12  See note 11 above.
13  “Moody’s argues against fine by Hong Kong regulators over ‘red flag’ report”, Benjamin Robertson, South China Morning Post, September 10, 2015.
14  Id; “Moody’s report “shoddy” and “unprofessional”, Hong Kong regulatory say”, Reuters, September 11, 2015.
15  See note 6 above.
16  See note 6 above.
17  “Moody’s on defensive over Chinese research”, Jennifer Hughes, Financial Times  September 9, 2015.
18  The term “red flags” has, since the case-law that came out of the Worldcom Inc. fraud litigation in the United States, come to be associated, at least in the minds of industry professionals, with telltale indicators of accounting and similar fraud.  One can only speculate as to whether the use of the term “red flags” rather than a term such as “risk factors” had any effect on the reaction to the Report.
19  See the Report at pages 1 and 2.
20  Id. at page 3.
21  Id. at page 2.
22  For example, the Report noted in that a change of CEOs that had triggered a red flag at one of the subject companies was indeed a positive development in that it resulted in a splitting of the roles of Chairman and CEO.
23  For examples, see the SFC’s press release dated December 22, 2014, “SFC commences proceedings in Market Misconduct Tribunal over false research report”, regarding that SFC’s allegations that Citron Research (Citron) published a false research report with respect to Evergrande Real Estate Group Limited (Evergrande) in order for  Citron’s principal, Andrew Left, to profit from a short position in Evergrande’s shares initiated prior to the publication of the report;  see also the press release of the United States Securities and Exchange Commission (SEC), dated January 21, 2015, “SEC Announces Charges Against Standard & Poors for Fraudulent Ratings Misconduct”, in which the SEC announced the settlement of charges against Standard & Poors for, among other things, loosening its ratings criteria for certain structured debt products in order to attract more ratings business while intentionally obscuring the change in its criteria from investors in those products.