Credit Rating Agencies In India: A Critique of SAT’s Ruling Against Care Rating

[Sidharth Pattnaik and Sneha Rath are 4th Year B.B.A., LL.B. (Hons.) and 3rd Year B.A., LL.B. (Hons.) students respectively at National Law University Odisha]

In this post, we focus on the developments around Care Rating Agency’s (CARE) alleged dereliction of its duty to rate Reliance Communications’ (RCom) creditworthiness over a period of four quarters, and the subsequent initiation of inquiry proceedings by Securities and Exchange Board of India (SEBI) against CARE. The following are the relevant facts: RCom had defaulted in its repayment of the principal amount of Rs. 375 crore and interest of Rs. 9.7 crore on February 7, 2017 and March 7, 2017, against the total amount of Rs. 2000 crore non-convertible debentures (NCDs) which it issued and were due to mature in February 2019. The delayed payment on April 10, 2017 resulted in the issuance of a show-cause notice alleging CARE of having defaulted in timely monitoring the factors that affected the creditworthiness of RCom. The financial performance of RCom in its third-quarter was displayed on the stock exchange. However, such information was not presented by CARE before the Rating Committee, which is responsible for assigning ratings to a security, here to that of RCom.

Upon finding CARE at default and in violation of various regulations, the Adjudicating Officer (AO)  imposed a penalty of Rs 1 crore for lack of due diligence. However, the Securities Appellate Tribunal (SAT) ruled against this part of the order of the AO and reasoned that such an instance was that of carelessness but not oversight.

This decision leaves the following issues unanswered: whether reducing the penalty charges from Rs. 1 crore to Rs. 10 lakhs will adversely impact investor protection in the market and how the lack of appropriate measures in rating RCom’s securities is a case of laxity and oversight on the part of CARE. These issues will be discussed below.

Deviance of CARE in complying with regulatory requirements: A case of laxity and intentional oversight

In the case of a credit rating agency (CRA), due diligence in terms of prudence and reasonableness can be traced in regulations 13, 15(1) and (2), 29(2)(b) and the Third Schedule on ‘Code of Conduct’ of the Securities and Exchange Board of India (Credit Ratings Agencies) Regulations 1999 (‘Regulations’). Regulations 15(1) and (2) when read with regulations 13 and the Third Schedule of the Regulations enumerate prudence on the part of CRAs by obliging them to regularly monitor the securities and disseminate information on newly assigned ratings. This must be done while ensuring that efforts are taken to protect the interest of the investors through fairness in rating, reasonable and adequate basis for performing rating evaluations, with the support of appropriate and in-depth rating researches in an ethical and professional manner, and so on. In furtherance of the Code of Conduct, regulation 29(2)(b) can warrant for examination of the appropriateness of the assigned ratings in light of non-compliance with the provisions of the Regulations.

Regulation 15 places the onus on a CRA to continuously rate the securities during their lifetime and indicates the need to publicize any information regarding change in the rating of such securities through press releases, websites, and the like. When CARE decided to put RCom’s NCD securities on credit watch, SEBI released a circular in November 2016, which detailed the review procedure and policies to be adopted by a CRA. On a close reading of this circular, it is apparent that basic minimum information is required, in writing, for rating of securities; moreover, external entities must also be contacted for this purpose. The circular detailed the need for CRAs to “provide additional information, while maintaining the basic format of the Press Release on rating of securities”. One of the provisions of this circular references the Operation Manual of CARE, which states that “a review may also be triggered by a major development in the company or in the industry, which may have a significant bearing on the credit-worthiness of the company”. A simultaneous reading of point 5 in the circular dated November 2016 further makes it clear that if the company whose securities are to be rated (here, RCom) does not cooperate in providing information regarding the repayment of its debts or does not comply with any directions, then such developments must also be reported through press releases.

Now, reiterating the SAT’s observation in the present order, “the instant case is not to question the appropriateness of the rating given by the CARE but to find out as to whether the appropriate measures were taken timely”.  In this case, RCom did not comply with the existing directions of SEBI. For instance, it did not issue a No-Default Statement (NDS) when requested by CARE. CARE had an obligation to release information on its website about the non-issuance of the NDS by RCom. Here, the NDS was an assurance of the fact that RCom was regular in making its debt payments, as this assurance also had a bearing on the credit-worthiness of RCom’s securities in the market. In consequence of the non-issuance of NDS, CARE did not follow the provisions of its own Operation Manual to publish the same on its website nor verified from a publicly-available source regarding the status quo of RCom’s debt payment, but instead telephonically verified with RCom regarding the status quo of its debt payment. The subsequent decision of CARE to not downgrade the rating of RCom securities based on the telephonic conversation between them was in clear violation of the statutory requirements for rating of securities by CRAs. It is prima facie apparent that CARE did not utilize the opportunities available at its disposal to make this issue known to the investors. Thus, it is a case of clear laxity and intentional oversight on the part of CARE.

Raking through the Supreme Court’s order upholding SAT’s ruling: need for due diligence & investor protection

The SAT’s order in the matter of CARE was challenged by SEBI before the Supreme Court of India (SC). While hearing the appeal, the SC observed that there was no question of law involved in this appeal and the appeal was accordingly dismissed. In furtherance of this, the SC ruled that the reduction in penalty made in this case “cannot be treated as precedent in all other cases irrespective of the facts and circumstances of the case”. Here, even when it is established that the matter before the SC involving CARE’s dereliction in the rating of RCom’s securities had no question of law to be discussed, it is of utmost significance to take reference from the IL&FS case to lay emphasis on the probable consequences that could impact the investor market in India in lieu of SAT reducing the penalty charges amidst expression of laxity and oversight by CARE in rating RCom’s securities.

The case of default in the timely rating of securities of IL&FS and its subsidiaries IFIN by three CRAs i.e. ICRA, CARE and India Ratings during the period of 2012-18 had drawn the attention of SEBI to introduce several instructions for the regulation of the CRAs in the Indian securities market. This situation is analogous to the issue being discussed in the present post. In the case of IL&FS, CRAs (including CARE) were reported to have consistently assigned its securities high ratings even when concerns were raised with respect to IL&FS’s financial stress and liquidity position over a significant period of time. The observations made by SEBI reveal that overdependence on the statements provided by IL&FS by CRAs led to their failure in the timely rating of their debt securities which ultimately resulted in shaking the “investors faith in the reliability of credit ratings in the context of the corporate debt market”. Here, although IL&FS had an established reputation in the construction sector, this could not prevent it from misleading the three established CRAs in India into believing that it was financially stable for a significant period from 2012-2018. Thus, CARE should have exercised its prudence in the case of RCom based on its past experience with IL&FS.

Over the last few years, there has been a large number of appeals before the SAT. This could be attributive to the fact that SAT has been reducing the penalty measures even when it has confirmed that parties (here, CRAs) had shown dereliction from the established rules and regulations by the SEBI. Here, it is acceptable if two authorities like SEBI and SAT differ in their final decision, as long as such decision is supported by a speaking order. However, in the present case, it does not appear to be so. SAT reduced the penalty of CARE from Rs. 1 crore to Rs. 10 lakhs stating that this violation was not of serious nature and did not warrant a serious penalty. However, SAT did not provide any objective reason(s) for arriving at the figure of Rs. 10 lakhs.

Observing these developments, we are of the opinion that while SAT is a competent authority to determine the reduction in penalty under sections 15HB, 15(J) and 15(I) of the SEBI Act, 1992 upon appeal in a dispute, it may be useful to introduce objective guidelines that could be taken into consideration by SAT and SEBI in arriving at their respective decisions. This is to ensure that neither of them relies on subjective factors. In consequence, this might set a precedent for market players in the securities industry to not approach the SAT against the order of SEBI’s AO at every possible instance to avoid serious penalties for dereliction from obligations of much serious nature vested in them.

Sidharth Pattnaik & Sneha Rath

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