RATING THE RATING AGENCIES
Winy Daigavane & Pavan Belmannu
In this article, the authors will be discussing the liability of the Credit Rating Agencies (CRA) in the Indian context with the recent instances of failure of the CRAs to identify the threat. Before delving into this discussion, the Authors will first examine the development of CRA liability in the United States. The discussion will then proceed to shed light on the challenges in the US context and seek to draw parallels with the circumstances arising in India. In the Indian context, there have been quite frequent instances of failures of the CRAs. However, reputational risk does not seem to be nearly enough for them to make better the manner in which they function. It has been seen that the CRAs do not adequately capture the stress building up in the enterprise or the scheme until it collapses completely. The authors will be putting forward some suggestions taking a cue from the foreign jurisdiction to avoid the situations of rating shopping and conflict of interest and conclude by stressing on the pressing need to take actions against the CRAs.
KEYWORDS: Credit Rating Agencies, Liability, Suggestions, United States, SEBI.
Credit Rating Agency (‘CRA’) is a body corporate which is engaged in, or proposes to be engaged in, the business of rating of securities offered by way of public or rights issue. They provide an independent assessment and help in the easy understanding of the quality of the creditworthiness of enterprises, issuers, debt instruments, and other financial products. They are key players in the financial markets who help the investors in making an informed decision. The role of the CRAs has grown to be of such a vital nature that they can be termed to be the de facto regulators in the financial market.
Despite its importance in the market, it remained unregulated until the recent financial crises as well as scandals which paved the way for an appropriate legislative intervention on the rating services. In India, the SEBI (Credit Rating Agencies) Regulations, 1999 (‘CRA Regulations’) provides for registration, obligations, monitoring of ratings, compliance, rating procedure, inspection and investigation etc. of the CRAs.
The Backdrop for Recognition of Liability of CRAs in the United States
In order to better appreciate the pressing necessity of making the CRAs liable for their lapses, it is important to understand the evolution of the liability of the CRAs:
Enron’s Collapse: A cause for reflection on the regulation of Rating Services
The collapse of Enron, one of the biggest and most prominent public companies in the USA, led to a loss of confidence in the existing safeguards of the market and prevailing mechanisms for supervision. The severe financial difficulties that the company was facing since 1997 were suppressed by the executives of the company by fraudulently inflating liquidity and profits and further concealing the liabilities of the company by utilising complex accounting tricks. The company’s auditor was also an accomplice to the fraud as no warning signal was spotted in the company’s reports. The major reforms in the field of rating services and also auditing firms were enacted after the collapse of Enron.
The Credit Rating Agency Reform Act
The Credit Rating Agency Reform Act of 2006 (‘CRARA’) was approved after the CRAs drew flak over their functioning when WorldCom defaulted in 2002. The new rules established necessary requisites for a CRA to gain recognition and further increased supervisory powers of the Securities and Exchange Commission (‘SEC’) over CRAs. Transparency and disclosure obligations were also strengthened. However, the rules were extremely vague and unclear and, the issue of compensation for damages caused by inaccurate ratings was not addressed.
The Subprime Mortgage Crisis: A Drive for New Rules
The CRARA was not nearly adequate to deal with the global financial crisis which broke out in the subprime mortgage market around the years 2007-2008. The success of the securitization operations was almost certain after obtaining an investment grade rating. The issuers designed the securitization operations that would be granted the highest assessment of creditworthiness on the aid and advice of the CRAs themselves.
Consequently, the investment schemes were attractive to the institutional investors as well. Further, a standard evaluation method was utilised to judge the merit of the structured and unstructured debt notes. This meant that the creditworthiness of a structured and unstructured instrument was the same if both of them received the same credit score. The lapse on the part of the CRAs became apparent after the investments proved to be disastrous in the United States and Europe.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010
The liability of the CRAs was finally addressed with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (‘Dodd-Frank Act’). It was modelled on the lines of the practices already established for auditors and financial analysts including the rules which introduced civil liability. The Act sought to prevent conflicts of interest, secure a balance against the instruments aimed at reducing the regulatory value of the ratings and encourage the market operators to improve the quality of the rating by making their own assessment of the creditworthiness and employ other tools in this regard.
Emerging Liability Regime for Rating Agencies
In theory, CRAs would liable to the investors as well as the rated entities or issuers. The CRAs undertake to determine the creditworthiness of the rated entity as whole or of a particular bond issue based on a service contract entered. Similar is a situation with a single investor or a group of investors which engage the CRAs to assess the creditworthiness of a third party (usually a prospective partner) or to access the information available in the reserved area of the CRAs by way of subscription. Therefore, liability to the rated entities or issuers is usually based on the contractual provisions between the parties and would be regulated under its domestic laws. However, these theoretical principles are not being applied practically and there are various defenses that are being availed by the CRAs:
Rating Agencies’ ‘Duty to Care’
In many cases, the issue of liability of rating agencies with regard to negligence have been raised. For example, in case of credit reporting in Crist v. Bradstreet , the plaintiff sued a mercantile agency for defamation on the ground that a certain report published contained malicious statements. The plaintiff alleged that the confidential publication of allegedly false statements was in furtherance of an effort to injure his reputation and credit as a business man. The issue revolved around the standard of negligence required to attribute liability.
It was admitted by the defendant that the credit report was circulated by it. However, it denied doing so with malice or intent to injure the plaintiff. The Court of Appeal held that “Negligence in some degree might be evidence of malice, but it is not itself malice”. Furthermore, defence of ‘qualified’ or ‘conditional privilege’ has also been availed in cases such as Johns v. Associated Aviation Underwriters to rescue from liability under similar circumstances. However, the aforesaid principle is not applicable in case of proven malice.
Rating as ‘Opinion’
Another defence that is usually adopted by the CRAs is that of ‘free speech’. The foundation of this defence is that the ratings are ‘opinions’ which is issued in ‘public interest’ and deserve to be protected under free speech. Such defences have been consistently accepted by the federal courts. Abu Dhabi Commercial Bank v. Morgan Stanley & Co. Inc. would be an apt case to illustrate the special duty of care and regard that has to be given in case of commercial speech. However, this is not unconditional and some exceptions have been elucidated in cases such as M&T Bank Corp. v. Gemstone Ltd. This defence has its origin in the case of N.Y. Times Co. v. Sullivan. The U.S Supreme Court exempted publishers from liability for defamation claims due to the absence of actual malice. This decision was based on the reasoning that reporting on the matters that concern the public must be protected by such a standard for liability.
Thus, we can infer that in addition to the protection of the freedom of speech of the CRAs, if the CRAs have made a reasonable investigation into ascertaining the risk that was rated, the agencies cannot be held liable even if the rating was wrong owing to the standard of ‘actual malice’.
Challenges with Respect to Indian Context
Quality and Disclosure of Ratings
The Indian credit-rating market is oligopolistic in nature with high barriers to entry. This leads to exposure of CRAs to high-forward looking risks for immediate gains due to desperate measures on the part of CRAs to rate every possible instrument based on low analytics and superficial research. This creates issues with the quality of the ratings. Moreover, another issue that comes up is with regard to lack of appropriate disclosure from the companies. CRAs try to gather as much information as they could from company but reluctance on the part of the company to share essential information leads to manipulation of the ratings and making it confined only to the documents available or presented to CRAs.
Conflicts of Interest
The Regulation 14 of the CRA Regulations only recognises the issuer-pays model. It is highly ironical and absurd that the agencies which are supposed to mete out an independent assessment of the credit merit obtain a remuneration from the very same entities that benefit from their ratings. Thus, the financial information ceases to be independent and could be manipulated due to potential arrangements between the parties, utilizing the imprudence in regulations.
CRAs were initially set up to provide independent evidence. It meant that they had to give out a research-based opinion on the ability and willingness of the issuer to meet debt service obligations. Consequently, it attached a probability of default to a specific instrument. However, with the limited number of CRAs in the market, companies tend to fancy the one quoting the lowest price or promising a better rating and this leads to a faulty rating at the very outset. In essence, this implies that if a company is not satisfied with the rating provided to be as high as expected, it could approach another CRA and fish for a better rating.
The Failure of CRAs
The most recent and significant instance regarding the CRA failure was noted when Infrastructure Leasing & Financial Services Limited (IL&FS), an Indian Infrastructure development and Finance company, defaulted on various payment obligations. Pursuant to this, the CRAs like ICRA and CARE, which had rated IL&FS as ‘A1+’ and ‘AAA’ respectively in the first week of August 2018, changed it to ‘D’ on September 17, 2018. The ratings did not capture the stress building up in the IL&FS group and were too late in identifying the same. Furthermore, it also assumed a level of support from the shareholders, which was not forthcoming when the funding was needed. There was a major short-term asset-liability mismatch in the company and liquidity was affected at various systemic levels. The crisis also spread to NBFCs as it halted its funding to the real estate development sector, which resulted in a domino effect of liquidity crunch. RBI was forced to supply liquidity in the economy with open market operations and relaxation of norms on the securitization of NBFC loans.
This was not the first time that CRAs downgraded their previously rated companies all of a sudden. For instance, in cases of DHFL, Amtek Auto, Zee Group and Reliance Communications as well, the ratings were suddenly downgraded as compared to their earlier ratings.
After the IL&FS crisis, Grant Thornton was appointed to conduct a forensic audit of the firm’s accounts and look into the role of auditors and CRAs between 2011 and 2019 who raised a suspicion that the CRAs had intentionally manipulated rating procedures. Unfortunately, due to a lack of alternative service providers, even such grave and recurring failures of the CRAs have not impacted their business.
Steps Taken by SEBI
As a consequence of these crises, the Securities & Exchange Board of India (SEBI) has tightened disclosure norms for CRAs. They will now have to disclose the liquidity position of the company being rated and any linkage to external support while analyzing the deterioration of liquidity and checking for the asset-liability mismatch.
SEBI has also looked into the issue of maintenance of quality and disclosure of ratings vide its amendment in September 2019, by incorporating the concept of “explicit consent” whereby the company would provide all the details related to their existing and/or future borrowing of any nature, its repayment and delay or default about the company from all its sources. However, the issues of rating shopping and conflict of interest still exist and require attention.
Imposing a penalty will always give room to the CRAs to work dishonestly and buy their way out by paying a fine, and therefore that is not a tangible solution to the issue. More concrete solutions should be explored like – removal the profit motive interest of the CRAs so as to allow them to undertake independent reviews to rate a company as compared to waiting for the companies to approach the CRA. Alternative arrangements like investor-pays and exchange-pays models can be explored for a few instruments as suggested by the Committee on Comprehensive Regulation for Credit Rating Agencies in 2010.
This would substantially eliminate the problems associated with rating shopping and conflict of interest. Another way to resolve this issue can be to introduce a rotation mechanism. The employees or analysts of CRAs rating a particular entity or instruments of a particular entity would require to be rotated after a determined time period. This will help to reduce the possibility of collusion. Further, CRAs can operate on a fixed fee structure so that the competition is restricted to quality and not pricing amongst various entities.
Further steps have to be taken to increase accountability of CRAs towards the investors. With the existing laws in place, certain actions can be taken against the CRAs in case of default like suspension or cancellation of registration etc. as per Regulation 27 of the SEBI (Intermediaries) Regulations, 2008, and even penalties can be imposed as per S.15 of the SEBI Act. However, since reputational risk has been proven to be insufficient, there is a need to promote credible litigation risk by increasing awareness in the market about the use of available remedies against CRAs. A direct remedy for the investors in the form of a grievance redressal mechanism is necessary.
SEBI must create a sound basis of classification for different instruments and entities and issue directions to deal with the related special concerns that might arise. This will ensure that the uniform parameters for rating do not apply on instruments and entities which must be examined differently due to the dissimilarity in the purpose that each of them serves. Furthermore, CRAs should refrain from providing advisory services to the rated companies, even via subsidiaries, to avoid conflict of interest. They can also avoid arriving at ratings in case of insufficient information so that a faulty rating is not given at the outset. Stricter measures can also be taken by SEBI to ensure that CRAs are not vested with excessive powers under the veil of de facto regulators.
At present, there is no comprehensive law to attribute requisite liability to CRAs. The Indian legal system has not yet experienced judicial developments like the US in determining this issue. Even though the SEBI has introduced certain Regulations, a more strengthened mechanism is required to curb the rising difficulties of the financial market. It is the need of the hour to ensure quality and that rating agencies can be made accountable for any manipulated rating.
Only then can there be a role fulfilment of the CRAs in a true sense which, in turn, will be beneficial for the entire financial market. A need to “Rate the Rating Agencies” has now emerged, and it needs to be fulfilled as effectively as possible.
Further, it is essential that the CRAs act diligently during these troubling times of a pandemic. SEBI has also relaxed the default recognition guidelines for the CRAs amid the pandemic and loan moratorium being granted by the RBI. The CRAs hold an onerous burden of pulling the Indian economy out of the crisis by providing accurate information of the rated instruments and the companies.