Corporate India’s debt crisis has placed its credit rating agencies squarely in the doghouse. In particular, the Infrastructure Leasing and Finance Services (IL&FS) controversy has shone a harsh light on the role of these agencies as gate-keepers of debt financing.
The fact that they were not able to identify financial trouble and inform investors and stakeholders highlights the gaps in the way we regulate such companies.
The same questions were aired in a different scenario earlier this year, when the Essel Group had trouble in repaying the debt owed to various mutual fund companies. While different, this also badly hurt retail investors who parked their money in the seemingly safer option of debt mutual fund schemes.
Role of agencies
To understand what should be the way forward, it’s vital to go back to the role that credit rating agencies play in a market economy. They were first brought in to solve the problem of information asymmetry. Capital market regulators around the world believe that placing more information before the investors through disclosure measures help nudge all parties toward an informed decision-making process. Rating agencies attempt to plug the information asymmetry gap by rating the financial credibility and the repayment capacity of corporate borrowers.
But sadly, the major fact that credit rating agencies were brought into existence as a seemingly independent stakeholder to assess the credit-worthiness, as well as loan servicing capacity, of the borrowing corporates draws less attention from a regulatory governance perspective. This is primarily because of the manner in which the credit rating business works. There is a high level of conflict of interest shrouded in the functioning of credit rating agencies. The payment for the ratings is provided by the corporate organisation whose credit service capability is assessed. Moreover, there is no bar on the credit rating agencies to have the same corporate organisation as its client for other consultancy services being provided by them.
The present “issuer paying” model is widely considered as a major conflict of interest in the independence of functioning for the credit rating agencies.
The Securities Exchange Board of India (SEBI) by way of the ‘SEBI (Credit Rating Agencies) Regulations, 1999’ has attempted to regulate the credit rating agencies. In this regard, it is interesting to note that the present regulatory structure cannot optimise the credit rating agencies to act in an independent manner. With the existence of CRISIL, CARE, ICRA and other major players in the credit rating business, the market has become quite competitive. All these companies are trying to win over the same set of clients in the credit rating service.
The market being saturated, it provides a ‘rating shopping’ opportunity for the corporate organisations whose credit service capability is assessed. Corporate organisations have the option of choosing a rating declared by the credit rating agencies. The present SEBI regulation allows for this due to the loophole of no mandatory prior payment for the rating services.
In fact, this opens the door for corporate organisations to bargain for a better rating. Media reports this week are awash with news of how IL&FS allegedly put pressure and persuaded the top three credit rating agencies to see their ‘point of view’. Or, put simply, it appears that IL&FS was literally ‘shopping’ for a better credit rating.
The classic principal-agent problem exists between credit rating agencies and the corporate organisations rated by them. This raises the pertinent question of accountability of credit rating agencies towards its stakeholders and the broader market ecosystem. The primary responsibility of credit rating agencies must be towards investors, who rely on the rating for subscribing to the debt instruments. Moreover, the credit rating agencies have a responsibility towards the regulator and market as an independent evaluator of debt servicing capability of corporates.
Therefore, it’s clear that for effective discharge of corporate responsibility of credit rating agencies, the SEBI (Credit Rating Agencies) Regulations, 1999 needs further strengthening.
Credit rating agencies are supposed to solve the issue of information asymmetry regarding the debt servicing capacity of fund-raising entities. In a comprehensive study, legal research think tank Vidhi Centre for Legal Policy has provided pertinent suggestions such as re-working of the issuer paying model, moving towards a rotation model of assigning credit rating agencies as in the European Union or payment being done by the investors for rating services. All of this should be seriously considered and viewed as the way forward.
From the perspective of increasing corporate accountability upon the credit rating agencies, it is high time to think about the following regulatory measures by SEBI:
First, a civil liability framework should be evolved for bringing liability upon credit rating agencies for failure in disclosing the risk of default in debt instruments by corporates. This should be ideally understood as a breach of duty of care standard by the credit rating agencies towards the investors. This is in line with the existing regulatory practice in jurisdictions such as the United Kingdom.
Second, the recent issues of IL&FS as well as Amtek Auto’s non-convertible debenture default, where corporate organisations still had very high credit ratings, help in understanding that even due to the lack of periodically revised rating disclosure by credit rating agencies, investors could be adversely impacted. Even though investing in debt instruments is subjected to market risk, the lack of an option to exercise informed consent is a major issue.
Third, the fact that many retail investors also get affected due to the exposure of debt mutual funds – which have invested in IL&FS, Amtek Auto and Essel group – brings in the requirement of grievance redressal and compensation against credit rating agencies.
The failure of credit rating agencies in highlighting the possibility of corporate debt payment default questions the effectiveness of SEBI (Credit Rating Agencies) Regulations, 1999. Hence revamping the credit rating agencies regulation by SEBI is a sine qua non for winning investor confidence.
Regulating the credit rating agencies forms a pertinent regulatory goal for the SEBI, which is yet to be effectively implemented. It is high time SEBI wake up and issue effective regulations to increase corporate accountability of capital market service providers.
Deva Prasad M. teaches business law at IIM Kozhikode.