Moody's Hong Kong Breached Code of Conduct over "Misleading and Confusing" Red Flag Report

In one of the first cases of its kind, the Hong Kong Securities and Futures Appeals Tribunal ("SFAT") has affirmed the decision of the Securities and Futures Commission ("SFC") to reprimand Moody's Investors Service Hong Kong (Moody's). It has fined the ratings agency HK$11 million for failures relating to the preparation and publication of a report concerning Chinese companies. 

Moody's was found to have breached the Code of Conduct for licensed firms by publishing a report in circumstances where there was a "lack of due care and diligence". This had an adverse effect on the Chinese companies mentioned in the report and caused their share price to drop substantially. 

The tribunal found that Moody's had published the report, thinking that the information did not constitute a form of credit rating and knowing it had errors, but had been indifferent to the damage it might.


In July 2011, Moody's published a report entitled "Red Flags for Emerging Market Companies: A Focus on China". The report contained serious errors and unfairly "red flagged" a number of Chinese companies, whose shares fell by between 10 and 16 percent after the report was made public. The SFC took regulatory action against Moody's for breach of the Code of Conduct and the failure to have proper controls and procedures in place. 

Moody's appealed the original decision of the SFC on the ground of jurisdiction, in that the preparation and publication of the "red flag" report was not a regulated activity as the report was not part of its credit-rating services and was therefore not an activity to which the Code of Conduct applied. 

The SFAT affirmed the SFC's findings that Moody's, in preparing and publishing the report:

  • Failed to provide sufficient explanations for the red flags assigned by it to the Chinese companies and failed to set out relevant justifications for the red flags in the report, which resulted in an unfair and misleading picture of the companies.
  • Chose to list the red flags assigned to each company and to highlight six Chinese companies with the largest number of red flags in the report as "negative outliers", and to publish despite an assessment carried out by its analyst showing that there was no significant correlation between the number of red flags and a company's credit risk.
  • Failed to ensure the accuracy of the red flags assigned to the companies.

Tribunal's Decision: Code of Conduct Application

The regulator had determined in its decision that Moody's had acted in contravention of the Code of Conduct by failing to have in place adequate controls and procedures concerning the preparation and publication of the report. On appeal, Moody's fundamental submission was that the publication of the report was not part of its regulated activities and therefore was not subject to the code. That submission was rejected outright by the SFAT, which found that, "even if it was unintended in its preparation and publication of the report, Moody's was carrying on its regulated activities", and therefore the Code of Conduct applied.

Failure to Recognise that the Red Flag Report Constituted a Form of Rating

The SFAT was critical of Moody's and said it had clearly failed to recognise that, in its publication of the red flag framework report, it was very much publishing a form of credit rating or some form of guide to credit risk so closely allied to a rating that it might itself be considered to constitute a rating.

The evidence was that the Moody's team which began working on the report before the licensing regime came into force simply did not turn its attention to whether what they were doing was a regulated activity. As a result, it produced the report wrongly thinking that its work did not constitute a credit rating. 

On this point, SFAT concluded: "It may be that the Moody's team ... simply did not turn its attention to the matter. Nevertheless, while that is a mitigating factor, it cannot divert from the fact that it was a failure by the Moody's team of very damaging consequence."

Insufficient Procedures

The SFC contended that Moody's did not have in place sufficient internal control procedures to ensure that its business activities, which were related to its "regulated activities", complied with the Code of Conduct. In other words, the SFC was concerned not that Moody's had insufficient internal controls and procedures in place to regulate its core activities, but rather that it did not have such procedures in place for "all forms of ratings that fell under the definition contained in the Ordinance were subject to those existing procedures". 

The Moody's team failed to recognise that the red flag publication was not one of its core activities and did not have specific procedures in place for dealing with such non-core types of publications.

In this case, the SFAT thought that the SFC had overstated the issues about Moody's insufficient controls and procedures. Instead, the SFAT found that Moody's did have sufficient procedures for its regulated core activities of providing ratings – what it described as the "classic kind" – but did not have sufficient procedures for other types of ratings, such as the publication in question, that also were a credit rating as defined in the Ordinance.

Moody's Failure to Deal with the Regulator

Moody's embarked on litigation with the SFC even though its "red flag" report was clearly misleading and had serious recognised flaws. The SFAT has said that those who prepared the report "came to understand that the red flag framework was not as accurate as originally had been anticipated and in that lay the potential for issuing a publication that was misleading and confusing. 

It appears that by the time the misgivings were being recognised the forward momentum, to have the report published, was determinative. Qualifications were therefore inserted but, on any ordinary reading of the publication as a whole, those qualifications acted more to compound the confusion rather than to set it aside."

The case has shown that Moody's, one of the largest credit rating agencies in the world, had to have the definition of a "credit rating" explained to it, and to be told what kinds of behaviour were regulated by the Code of Conduct. 

At the very least, Moody's must have known that the report would be relied upon to the detriment of the 20 Chinese companies whose shares significantly decreased in value as a result of what it said. 

On any reading of the information, Moody's conduct on this occasion fell well short of international standards. The agency then litigated with the regulator on technical issues which were destined to fail, and appeared reluctant to deal amicably with the regulator and put up its hand to acknowledge its "careless" conduct.

Concluding Remarks

The failure of an international rating agency to understand that it had breached the Code of Conduct principles has raised serious questions about the culture within the organisation and the extent to which the agency's senior managers understood its obligations to act ethically in accordance with the Code of Conduct, especially where it could potentially have such a devastating effect on the companies upon which it reported. 

The outcome of the appeal has shown that the SFC took the correct approach and has emphasised that credit agencies have responsibilities regarding the data which they publish.


Niall Coburn is the Asia-Pacific regulatory intelligence expert for Thomson Reuters. He is a barrister and former director of enforcement at the Dubai Financial Services Authority and senior specialist adviser to ASIC. He is based in Brisbane, Australia.