The CRAs tend to cover their weakness under the guise of long-term view of the prospects of repayment in comparison to market indicators, according to a legal report.
I nformation is considered to be a tool in the modern era as has been pointed out in a report, ‘Regulation of Credit Rating Agencies in India’ published by the independent legal policy advisory group, Vidhi Centre for Legal Policy, in 2017.
Credit Rating Agency (CRA) is one such entity in the corporate sector which provides unbiased, objective and independent ‘information’ or opinion of creditworthiness of an issuer and its related risks. CRA has been established mainly with two purposes. Primarily to reduce information asymmetry in credit markets by providing investors with opinions on the ability of an instrument to meet its obligations. Secondly, to increase the rational competition in the debt market by reducing the duplication of efforts by different people.
“The report highlights concerns in regard to regulation of CRAs in India; examines the solutions adopted by regulators in other jurisdictions, and makes recommendations to strengthen the regulatory framework in India.”
From the report, it is corroborated that CRA has divagated a long aloofness as out of the three CRAs, namely Moody, Standard & Poor and Fitch, Moody’s is highly recognised. The history of credit rating originates from John Moody’s rating of rail bonds in 1990s. It underwent a long aloofness which made the entire system not just complex, but also sovereign in respect of debt instruments.
In this report, it has been noted that India initiated CRA with a consensus of leading financial institutions during 1987 namely Credit Rating Information Services of India Ltd. promoted by ICICI Ltd. along with UTI. However, at present CRAs are governed by Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999. The process of rating is based on mainly debt securities, short-term debt instruments and their obligations, loans and fixed deposits.
“Apart from these, CRAs reserve utility for issuers and provide tangible assistance from rated securities. It protects entire financial market regulators in a cost effective manner irrespective of jurisdiction. Since CRA becomes the shield for issuers’ debt, sometimes it is considered to be seneschal of regulatory licenses.”
On the contrary, CRA being hired by the issuers themselves results in a conflict of interest. That is so because CRAs have never been in a position to make independent opinions and they can’t update any information in respect to credit worthiness of the instrument. It has always been considered that since CRA can provide regulatory licenses, they tend to create distortions in the market. However, CRAs tend to cover their weakness in the name of long-term view of the prospects of repayment in comparison to market indicators.
The Working Process of Credit Rating Agencies
Since the regulations of CRAs were resilient till 2007, it hampered the economy and resulted in a financial crisis. Considering the loss of CRA’s identity from the market because of resilient policy, the regulatory was compelled to bring more stringent regulation for CRAs. Soon after the financial crisis, Securities and Exchange Board of India (SEBI) introduced a committee to scrutinise the regulatory framework of CRAs. However, the committee could not achieve its target merely because it was hard to trace any misdemeanor against CRAs.
In Securities Exchange Board of India v. Sujit Karkera, (2017) 15 SCC 1 [it is commonly known as Amtek Auto Case]; wherein legality of ‘non-intermediary front running’ in security market under the Securities & Exchange Board of India (Prohibition of Fraudulent & Unfair Trade Practices relating to Securities Market) Regulations 2003 was questioned. The Hon’ble Supreme Court of India held that by applying the principle of ‘expressio unius est exclusion alterius’ (a Latin phrase meaning where the mention of one thing excludes all others) and relying upon Securities Exchange Board of India v. Kishore R. Ajmera, (2016) 6 SCC 368, it is clear that in order to establish charges against tippee, under regulations 3 (a), (b), (c) and (d) and 4 (1) of FUTP 2003, one needs to prove that a person who had provided the tip was under a duty to keep the non-public information under confidence; such breach of duty was known to the tippee and he still traded thereby defrauding the person, whose orders were at the forefront, by inducing him to deal at the price he did.
Over the passage of time, SEBI issued as many circulars as possible to regulate CRAs in an effective manner. However, in 2016, a significant circular was issued which laid down some important guidelines such as standardised press release for rating actions, disclosing criteria, process of rating, disclosing rating both in case of non-acceptance by issuers and non-cooperation by issuers and disclosing a delay in periodic review of rating. The circular requires CRAs to impose accountability on rating analysts, and improve the functioning and evaluation of rating committees.
“CRAs are subject to conflict and associated harms because of reasons such as lack of competition in the market and the gatekeeper role of CRAs. Lack of competition did not encourage a well-established relationship with issuer and their role in the market is of a “watchdog”, which is bound by regulations of ratings in some cases.”
Although SEBI has adopted several rules to prevent these conflicts, but as a matter of fact without addressing the root causes of conflicts, it is impossible to resolve them. The only way to eliminate this is to find out the root cause of all the above-mentioned problems.
The European Union (EU) recognises the conflict generated by the “issuer pays” model and they are looking for an alternative to the same. The EU has also adopted the mechanism of rotation since the year 2009. However, in 2013, the rotation mechanism for specific classes of particularly vulnerable transactions was introduced by the EU.
In the United States of America, a CRA Board is established which assigns CRAs to the issuers, develops a disclosure mechanism that assigns non-hired CRAs to issue ratings, finally adopting Investor Owned CRAs. No alternate revenue model is adopted by the USA.
In India, different methods to pay the CRAs were adopted which included investor pays model, the government pays model and the exchange pays model. But it was observed by the experts that the investor pays model could result in higher costs of rating and bias against smaller issuers. It was also noted that the government pays model would be against morality and it was concluded that the exchange pays model did not have the required reach. Therefore, it was observed that the alternative methods of payment could not completely replace the issuer-pays model.
“One reason that led CRAs to issue inflated rating was rating shopping, which occurs when issuers asks for ratings from more than one CRA, but only pay for and buy the highest rating.”
Issuer pays model is the only model that is recognised by CRA regulations as investors rely on their decisions. Earlier it was believed that as reputation is a major factor for CRAs, it would ensure that the duty is performed with due diligence and independence, but it didn’t work. CRAs used “opaqueness of ratings” as a tool to cover inaccuracy or stated that their rating is focused on long-term view rather than short-term.
Thus, it was important to hold CRAs legally responsible to its issuers, investors, auditors and the markets. CRAs took the defence for not being held responsible by stating that their ratings are only opinions and they only contract with the issuers to give them a rating and not with the investors directly. Hence, they opined that there is no proximity. Court held that CRAs are always in the position to see that their rating is important as investors will rely on it or at least rely on the facts that the ratings purport to have factored in. Due to all these reasons, various jurisdictions have held CRAs responsible to investors directly and allowed the investors to sue CRAs for civil remedies.
