A Critique of SEBI’s Proposed Amendment to the Credit Rating Regulatory Framework

[Rongeet Poddar is a final year B.A. LLB (Hons.) student at the West Bengal National University of Juridical Sciences]

The objective of credit rating agencies (CRAs) is to reduce information asymmetry by facilitating investors to form an informed opinion on the credit-worthiness of a debt instrument. The Report of the Committee on Comprehensive Regulation for Credit Rating Agencies released by the Capital Markets Division of the Finance Ministry in 2009 had defined the credit rating mechanism as an assessment by a third party to offer an ‘informed’ indication of the likelihood of default by an issuer on a debt instrument. The value of CRAs to the efficacy of financial markets therefore cannot be undermined as their functions shape the decisions of investors. The global financial crisis in 2008 prompted the Committee to recommend the strengthening of the existing credit rating regulations of the Securities and Exchange Board of India (SEBI) based on which the securities market regulator had initiated a review of the existing legal framework for CRAs.

The credit rating framework has come under the scanner of SEBI once again in the wake of the IL&FS crisis. The forensic audit conducted by Grant Thornton under the explicit instructions of the government-appointed board of directors revealed how CRAs consistently provided positive credit ratings to the despite a serious liquidity crunch since 2015. There was a sudden credit downgrade after a prolonged span of high investment grades. It came only after group companies of IL&FS failed to service their debt obligations in September 2018. The failure of CRAs to raise red flags has created a trust deficit in investors which SEBI has tried to address recently.

In a meeting held on 21 August 2019, the securities market regulator has decided to amend the SEBI (Credit Rating Agencies) Regulations, 1999 to restore the confidence of investors. The amendment will incorporate an enabling provision in the rating agreement between the CRA and the client. This will allow the CRA to obtain relevant information about the existing borrowings of the issuer, including potential borrowings in the future. The CRA will also be able to procure details of loan repayment and any delay or default in the servicing of such borrowing either from the lender or any statutory or non-statutory organization which possesses such information.  The audit conducted at the behest of the new government-appointed board at IL&FS had provided sufficient evidence of IL&FS group officials withholding crucial credit information. Therefore, the proposed amendment bears potential to enhance the potency of the CRAs as gatekeepers of financial markets. It would enable the agencies to have a greater outflow of accurate credit information to work with. Regulations 15 and 16 of the existing SEBI Regulations also impose an obligation on CRAs to periodically update ratings based on changes in the ability to meet credit obligations. However, SEBI’s proposed change fails to address the larger issue of conflict of interest that lies with the ‘issuer pays model’.

In the ‘issuer pays model’, CRAs are paid by the issuers of debt to often obtain a favourable rating thereby diluting the interests of investors. This is precisely the credit rating model that was misused in the IL&FS crisis in pursuance of the long-term quid pro quo relationships that employees of the CRAs enjoyed with the defaulting companies. SEBI’s decision to ignore the shortcomings of this model is therefore alarming. Regulation 14 of the SEBI (Credit Rating Agencies) Regulations also endorses the issuer-pays model. In 2017, a report on Regulation of Credit Rating Agencies in India by the Vidhi Centre for Legal Policy had proposed a mandatory rotation of the employees or analysts in CRAs by drawing parallels to the practice of rotating auditors under section 139 of the Companies Act, 2013. The report had also made a case for eventually rotating CRAs in a phased out manner such that their independence is not compromised.

The time has come for SEBI to seriously consider the question of rotating CRAs as information accessibility is not the sole problem that is afflicting credit rating practices and leading to undesirable market outcomes. The IL&FS credit rating fiasco and its detrimental impact on infrastructure funding in the country should implore the securities market regulator to explore an alternative credit rating system based on rotation of CRAs. While this alternative model based on the practice of rotation is implemented in phases, SEBI could adopt an ‘exchange-pays model’ for key sectors of the economy as an interim measure. In this system, the exchange in which the security is traded would delegate credit rating duties to relevant CRAs that are registered under its fold and the regulator would then fund the costs of rating. It is acknowledged that these structural changes would increase the cost of credit rating for the time-being. However, the reconstituted legal framework will eventually give credence to the fiduciary duty of care that the credit rating agencies owe to the investors in the securities market by minimizing conflict of interest in the long run.

Rongeet Poddar

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