Reevaluating the Independence of Credit Rating Agencies: Time for Stricter Norms?

[Akanksha Dutta is a final year student of the 3-year LLB course at Government Law College, Mumbai]

Credit Rating Agencies (“CRAs”) in India play a very vital role in determining the overall financial health of a company as well as the safety of the securities issued by such companies. The assessments made by CRAs assist investors, both large and small, in evaluating the risk linked to the securities and determining the most suitable matches for their investment portfolios. The CRA regulations define the term “rating” as “an opinion regarding securities, expressed in the form of standard symbols or in any other standardised manner, assigned by a credit rating agency and used by the Issuer of such securities.” Credit rating is, thus, in essence, a process for evaluating the relative degree of risk associated with the timely servicing of debt and then presenting this information in a standardised format.

In a recent order by the SEBI in the matter of CARE Ratings, the interference of the top management in the rating of securities was brought to light. More importantly, the order threw fresh insights on the internal working of top rating agencies in India. It demonstrated the veto powers enjoyed by the directors of such entities and how a rating is manipulated. Such orders reinforce the dire need for a more independent and transparent rating system for Indian securities.

The Shortcomings of the CRAs and the SEBI Regulations

A key issue with the regulatory framework governing CRAs is the issuer-pay model wherein the issuer of the security selects the rating agency and then enters into a rating agreement on payment of an upfront fee. The payment arrangement entered between the issuer and the CRA compromises the quality and objectivity of the rating assigned. Therefore, there is a need for the SEBI to determine a more objective and independent fee structure. The SEBI vide circular dated  3 May  2010 specified additional “Guidelines for Credit Rating Agencies”, attempting to resolve this conflict of interest in the issuer-pay model. It directed the separation of the business development and the rating vertical of the CRAs. The restriction intended to separate the employees involved in the fee negotiation from other employees who are involved in the rating analysis to mitigate the possibility of the rating being affected by the fee charged. Additionally, a circular dated 1 November 2016 restrained the Managing Director and the CEO of the CRA from being part of the rating committee if a majority of the members of such committee are not independent. However, these provisions lack stringency and have not been able to completely strike off the bias.

Also, there was a recommendation made by the Standing Committee on Finance in its report titled “Strengthening of the Credit Rating Framework in the Country” that the regulator must consider options such as “investor-pays Model” or “regulator-pays model” to remove the conflict of interest. The investor pay model, specifically, could provide a fairer rating to the investors based on their needs. However, this model was used abundantly prior to the 1970s but was found to be unsustainable. This is because a general publication can be easily copied and also, the issuers are generally willing to pay a higher amount for the service as it helps them improve the cost of capital. The regulator-pays model on the other hand, can potentially improve contractibility and foster competition. If the regulator is in charge of selecting the CRA, it can effectively evaluate the quality of the ratings and reward this choice. However, both these options will require a lot more study and improvements before they can be given effect.

In addition to the shortcomings of the issuer-pay model, the agency after entering into the agreement, analyses the company and the security based on the information received by the client and other reliable sources available to the public. A review note is then prepared which is sent to the client for approval. The agency’s independence is impeded by this approach, and it would be preferable for the CRA to reveal the initial rating instead of first sending the rating for the client’s approval. It was seen during the IL&FS fraud, that even after having adequate knowledge of the company’s deteriorating financial position, the ICRA, CARE and India Ratings and Research Private Ltd. failed to downgrade the rating of the company. The disparity in the press release of IL&FS and the disclosures made to BSE, was reason enough for the CRAs to be more prudent in their approach and yet, higher reliance was placed on the submissions made by the company. Moreover, it is the regulator who must authenticate the documents sent by the company to the CRA and must play a more active role in the rating process.

Currently, there are about six major rating agencies in India namely, the ICRA, CRISIL, CARE, Infomerics Valuation and Rating Private Ltd., India Ratings and Research Pvt. Ltd. and Acuite Ratings & Research Ltd. Even though there are several other small rating agencies, given the high barrier to entry in the credit rating industry, it becomes difficult for the smaller rating agencies to compete with the established agencies. Consequently, this creates a cartel like environment which provides a passage for inefficiency and corruption. Due to their dominant position in the market, the major CRAs have significant bargaining power. This can potentially result in exploitation, as they may use this power to negotiate fees or other favorable terms with their clients. It was seen in the matter of Brickworks Rating Private Ltd, wherein the fee charged by the CRA was lower than that agreed in the contract. This deduction was after a meeting of the issuer with the founding director of the agency. It is a clear principle of the CRA regulations, that a person involved in the analytical process cannot engage in the business development. However, this is only one of the many instances that have come to light. Another factor contributing to limited competition is that corporate issuers tend to trust and rely on one or two rating agencies, making them reluctant to be rated by others. Corporate issuers prioritize the ratings that investors trust the most, as this facilitates placement and results in the lowest spread, creating a natural oligopoly. It is a given, that the market for CRAs shall always remain an oligopoly, but the market competition even between a small number of CRAs should be based on reputation for quality ratings.

There are two ways to address the abuse of power. First, is for the new entrants in the credit rating landscape to focus on the quality of the rating rather than inheriting the bigger market share. A reputation for quality created over a period of time will help curb the conflict of interest in the issuer-pay business model. Secondly, the regulator-pay model, as discussed above, could bring more entrants into the industry as the SEBI could incentivize the quality and independence rather than merely the reputation or the relationship built over the years. Another possible solution could be to have a framework for mandatory rotation of CRAs for a single issuer. This would aid in avoiding the negative consequences that arise from long term associations between the issuer and a CRA.  This is particularly significant considering the recent instances of failure of CRAs identifying trouble in their client-entities. Further, the Finance Ministry may also provide for ratings to be compulsorily carried out by more than one agency.

Lastly, the provisions of the SEBI regulations seem to be unduly liberal. There needs to be enhanced disclosures norms for the CRAs. This could include mandating disclosures of the methodology used for rating, disclosure of the conflicts of interest, and disclosure of the track record of the rating agency. Further, the SEBI should also consider stricter enforcement of the existing regulations and rules governing the CRAs. This could include more frequent inspections and audits of the rating agencies, as well as stricter penalties for non-compliance, perhaps linked to the size of the issue rated. A rating fee cap could also be an impactful amendment to provide a level playing field to the smaller agencies.


The highlighted discrepancies in the issuer-pay model have constantly been an issue, and the first major step towards a discrete credit rating process would be to amend the model or to suggest an alternate model for selecting the agency. Even though the SEBI through its frequent circulars is constantly trying to bring about a transparent and investor-centric rating system, we need a radical change in approach before we can have a “conflict of interest-free” rating system.

Akanksha Dutta

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