[Kashish Jain is a 4th year B.B.A L.L.B (Hons.) student at Jindal Global Law School in Sonipat, Haryana]
A credit rating agency (CRA) is a service provider that assesses the creditworthiness of an entity (issuer) or a debt instrument (e.g., asset-backed securities). Typically, it expresses an opinion that is based on processing information and conducting research. CRAs seek to reduce the information asymmetry that generally exists between the issuer and the investor. In order to ensure that the services rendered by CRAs remain unbiased and independent, there is a need to regulate the CRA sector. This post aims to discuss the restriction on cross-holding in CRAs registered with the Securities and Exchange Board of India (SEBI), as proposed by SEBI in its Consultation Paper released on 8 September 2017. Further, this proposed restriction will be analysed from the lens of various other jurisdictions (i.e., the United States (US), Europe and Russia) to understand the reason for such limitation, and what it wishes to achieve.
Five major CRAs registered with SEBI operate in India, two of which are CARE and Crisil. During the current financial year, Crisil acquired an 8.82% stake in CARE, which appears as an attempt towards acquiring a controlling interest in CARE rather than an investment opportunity in a rival company. Following this, SEBI has proposed in its Consultation Paper that no CRA shall hold more than 10% of shareholding and/or voting rights in another CRA, and shall not have representation on the board of directors of the other CRA. On similar lines, SEBI has proposed to bar a shareholder holding 10% or more shares and/or voting rights in a registered CRA from holding and/or acquiring 10% or more in any other CRA. This restriction is suggested to avoid a situation of conflict of interest and to ensure independence of operation.
A similar crossholding restriction can be seen in the banking sector where a bank cannot acquire more than 10% in another bank’s equity capital. Such limitation is imposed because it is considered to be safe in ensuring the stability of the financial system, owing to the threat of systemic failure. Due to the interdependent nature of the industry, the businesses in the banking sector are so closely tied that failure of one would lead to a domino effect resulting in a cumulative effect on the rest, and hence a systemic failure.
However, why the need for such limit exists in the CRA sector, still remains a valid question. It is important to appreciate that the CRAs have a major impact on today’s financial markets, with the ratings impacting the investors, issuers, and the Government. An investment grade, speculative grade or a downgrade rating action by a CRA has an effect on the capital levels of a financial institution. Investors tend to rely on the independent judgment of a CRA and then decide on the size of investment after analysing the rating given by a CRA, thereby affecting the financial developments in an economy.
The US has witnessed an oligopolistic market with powers concentrated in three major CRAs (Moody’s, S&P and Fitch), making up 95% of the total market. In the wake of Enron and other corporate scandals, there was a confidence crisis that shook the investor and regulator trust in CRAs. CRAs failed to downgrade Enron even when its credit and ability to pay had worsened. In response to the self-regulating CRA sector which failed to a great extent, the Credit Rating Agency Reform Act, 2006 was enacted that created an objective framework for registration. However, this Act did not give Securities Exchange Commission (the financial regulator in the US) the power to “regulate the substance of credit ratings”. Following this vulnerable period, the CRAs played a central role again, in the context of the sub-prime crisis, as witnessed in the US and Western Europe, by overvaluing the complex mortgage-backed instruments and being slow to downgrade them. This revealed the inadequacy in the existing rules on credit ratings, which led to an enactment of the CRA legislation as a form of regulatory mechanism by the European Union in 2009.
In India, SEBI set forth the regulations for CRAs in 1999, which pre-date the financial crisis that hit the global economy, in which case India appears to have been pro-active in its attempt to regulate the CRA sector. Nevertheless, a series of crises indicates that any conflict of interest (such as the cartel of CRAs in the US) will impact the independence of operations in terms of the rating process, resulting in a large-scale impact on the economy. Permitting crossholding in a CRA either by a competitor or through a single shareholder having shares in more than one CRA increases the potential of affecting the quality of ratings leading to a biased rating of the debt instrument. Currently, there is no restriction on crossholding in CRAs in India. European Union, on the other hand, has introduced a limitation of 5% in crossholding of a CRA by an amendment to its regulations in 2013, in order to ensure the diversity and independence of credit ratings and opinions. Similarly, the Russian Federation Law on CRAs has introduced a special disclosure requirement of the CRA ownership structure, in 2015, to ensure that a shareholder is not in a de facto situation of conflict of interest. Article 6 Section 1 therein stipulates that any person (either individual or collective) controlling, directly or indirectly, more than 10% of the voting rights in a rating agency must not invest in another rating agency or exercise any kind of influential power. SEBI’s suggestion for a restriction on cross-holding in CRAs is, therefore, determined from similar approaches that other jurisdictions have taken, and the rational for such proposal, on that account, becomes clear.
Although the reason for such proposed restriction is understood, the next question that comes to mind is – why the specific numerical threshold of 10%. Under the Companies Act 2013, a shareholder holding 10% or more of the total paid-up share capital of a company obtains certain statutory privileges (i.e., certain rights and protections) by virtue of being a minority shareholder. In the case of CARE-Crisil, if the latter assumes the status of a minority shareholder, then it will result in Crisil having a controlling stake in CARE considering that CARE does not have a promoter, with Life Insurance Corporation being the largest shareholder with 9.79% shareholding in the company; hence, an apprehension of conflict of interest hindering the independence of operations.
In any case, lately, there have been instances of corporate battles (such as the Tata-Mistry feud) which have disrupted the internal corporate governance as many minority shareholders have come forth to exert negative control by threating or in some cases actually filing a suit before the National Company Law Tribunal (NCLT) alleging minority oppression and mismanagement. The ideological conflict/differences in managerial lookout, coupled with the fact that the Companies Act empowers the minority shareholders to file for oppression and mismanagement, has paved a way for minority shareholders to create hurdles for smooth functioning of the company. Even though a 10% stake in a company should not affect the management or create shareholder conflicts, however, recent the pragmatic approach to corporate governance would make a compelling argument that minority shareholders can use their statutory rights seeking remedies for oppression and minority mismanagement. Therefore, the suggestion of restricting the crossholding at 10% will hold fort for now, but as and when minority shareholders will determine creative ways of using their rights in strategic manner, SEBI will have to counteract them with appropriate changes to the regulation.
The Consultation Paper issued by SEBI also proposes that “acquisition of shares and/or voting rights in a CRA resulting in change of control may be permitted with the prior approval of SEBI”. The absence of a rigid definition of ‘control’ under the CRA regulations has given SEBI and the Securities Appellate Tribunal (SAT) effective and pervasive authority. The reference to the word ‘control’ without a comprehensive definition in the CRA regulations may plague the CRA industry with similar issues faced by the SEBI regulations governing takeovers (where the lack of a concrete definition and the failure of the bright-line test has created a lot of murky waters). Despite a lack thereof, the requirement of a prior SEBI approval in case of change in ‘control’ should ideally go a long way in ensuring that apparent cases of conflict of interest are scrutinized with a microscopic analysis.
Therefore, in my opinion, SEBI’s Consultation Paper has caught the right nerve by delving into the issue of crossholding in CRAs. The independence of operations of institutions that conduct their own independent study of the market and gain investor confidence, must not be allowed to be compromised. The proposed solution (i.e. a restriction on the acquisition of 10%) may not be the only way to systemically solve the problem as the Companies Act provides a refuge in the garb of minority rights – which if used properly could hinder the functionality of a competent CRA and reduce competition in an already restricted market. However, one cannot deny the fact that SEBI has at least embarked on the journey to amend the regulations with an opportunity to public stakeholders to give their comments on an integral matter.
– Kashish Jain
Excellent analysis!