On February 3, the Mumbai police denied bail to Partho Dasgupta, a former CEO of Broadcast Audience Research Council, calling him “the mastermind” in the TRP ratings scandal. Clearly, in the eyes of law, any attempt to mislead the public is so grave.

Then what of the credit rating agencies (CRAs)? Indian debt markets, although nascent, have displayed a ferocious appetite for AAA/ AA rated securities which sometimes lead to ‘rating shopping’ by the issuers. Given the limited number of CRAs – seven —and the preposterous premium currently placed on a AAA rating, an unholy nexus seems to have developed between CRAs and issuers over time.

Regulators in India and across the world have been grappling with identifying and dealing with this conflict of interest stemming from the fact that the issuer ends up paying for ratings of its own securities – popularly known as the ‘issuer pays’ model. Therefore, a robust framework for CRAs is indispensable to ensure investors make neutral and informed decisions

Regulatory framework

To mitigate the risk of potential conflict of interest, India’s market regulator, SEBI, which regulates the credit rating agencies, has imposed stringent disclosure norms which includes placing restrictions on cross-holdings between CRAs, segregation of credit rating from other business activities of CRAs, restrictions on offering fee-based services to rated entities, disclosure of ratings that have not been accepted by issuers, etc.

SEBI has also laid down the procedure relating to functioning and evaluation of rating committees/ sub-committees, laying emphasis on managing conflict of interest. For instance, a CRA cannot rate securities issued by it or its promoters, borrowers, subsidiaries, associates, chairman, directors or any of its employees. Analysts working in CRAs are also prohibited from participating in marketing and business development so as to ensure remuneration from CRA activities does not affect their independence.

Warning imminent defaults

Despite the existing strict regulatory framework, there have been instances when CRAs could not warn about imminent defaults by companies such as IL&FS, DHFL and Zee group. In fact, in the case of IL&FS, CRAs paid no heed to the burgeoning debt levels of IL&FS group even while one of its own group companies had defaulted on redemption of its securities.

A similar situation was witnessed during the peak of the sub-prime crisis in 2007-08 when a series of structured finance offerings were issued AAA/ AA ratings by CRAs in the US. Due to the very nature of these securities – being derivatives of an underlying asset – default in one had a cascading impact on the entire financial market leading eventually to the global financial crisis. To avoid recurrence of such a crisis, the US Securities Exchange Commission brought in the Dodd-Frank Wall Street Reforms and the Consumer Protection Act. That said, suggestions relating to identifying an alternative to the issuer pays model have still not been implemented and the risk of rating shopping is still very real.

Penal provisions for CRAs

SEBI has powers to suspend or ban a CRA, or impose penalties. It did penalise three CRAs—ICRA, CARE and India Ratings—for lapses in rating to Non-Convertible Debentures (NCDs) of IL&FS, and on Brickwork Ratings, for lapses in rating NCDs of the Essel group.

SEBI has also slapped penalties on Brickwork Ratings for lapses in rating NCDs issued by Essel Group of Companies.

However, unlike other statutory provisions in India relating to corporate laws, securities regulations and tax laws, there are no criminal provisions envisaged under the current legal framework for CRAs. (Pertinent to note that the Mumbai police has arrested Dasgupta under the Prevention of Money Laundering Act.)

Considering the potential impact that an inaccurate rating can have on small investors both directly and indirectly, there is a need to hold CRAs responsible for dereliction of their solemn duty.

Not implemented

In 2019, the Standing Committee on Finance, in its report on ‘Strengthening of the Credit Rating Framework’, suggested some changes. These include mandatory rotation of CRAs once in three years to avoid any nexus between the issuer and the agency and mandatory rating from more than one agency for issues exceeding ₹100 crore (the least rating would be ascribed to the security). Another interesting suggestion is ‘engaging clearing houses as intermediaries between issuers and CRAs’. Under this alternative payment model, the issuer may approach the clearing house for ratings. The clearing house may then assign a CRA for issuance of credit rating to the issuer after due verification of the background antecedents of the CRA for any potential conflict of interest.

However, these recommendations have not yet been implemented. Ascertaining the capability of an issuer to repay debt forms the bedrock of the modern financial system—only if that is firmly established would India have a robust corporate bond market.

(The authors are Partner and Director at Nangia Andersen LLP, a law firm)

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