In this two-part series, the authors discuss the role of credit rating agencies (CRA) in the financial system and consider various dimensions to improving their performance in delivering on this role.
Credit ratings have played an important role in the development of debt capital markets as they “help the market to effectively and efficiently evaluate and assess credit risk, price debt securities, benchmark issues and create a robust secondary market for these issues” (quoted from S&P’s statement at US SEC’s public hearings on the role of CRAs in the US Securities Markets, 2002[1]). However, public discourse on the subject of whether CRAs must be held liable for their ratings generally tends to coalesce on a position that CRAs provide opinions and therefore they cannot be held to a higher standard of duty such as that applied on auditors (in their responsibility to shareholders of the audited firm), or investment advisors (in their responsibility to investors).
CRAs as fiduciaries
CRAs provide ratings based on their assessment of publicly available information about the issuer or issuance as well as of non-public information provided to them by management on various aspects of the business, industry, prospects of the company, and management view of the economy and current and impending regulation. The opinion then that the CRA provides is based on non-public information, which implies that now the CRA’s opinion is both based on non-public information and is an opinion that a potential investor would not be able to arrive at given she does not have access to such non-public information. This, therefore, qualifies the opinion made by the CRA to be not just an expert opinion (because it has the expertise to analyse such non-public information), but also one that it has a responsibility to stand by, given investors pay for their reports. If it cannot stand by such an opinion, its purpose of existence must be debated. In the aftermath of the global financial crisis, the Dodd-Frank Act 2010 of the US explicitly introduced a fiduciary duty on CRAs. To quote, “As ‘gate keeper’ of the financial market, securities analysts, auditors and credit rating agencies are responsible for providing consulting services to investors, and since they have the duty of a good administrator, they are collectively called ‘fiduciaries'”. Therefore, we conclude, in line with the position, that CRAs have a fiduciary responsibility to investors to the extent that they must be able to substantiate their opinions and in order to do so, take all efforts to ensure that the opinion is valid and trustworthy.
While it can be argued that a credit rating is not a recommendation to buy/sell/hold a security, nor is it a direct indicator of market prices of the securities or an indicator of the suitability of an investment for a particular investor, this argument still does not absolve it of its responsibility to ensure that its opinions are made based on acceptable logic and are credible enough for investors and their representatives to rely on. The reliance on credit ratings by almost all participants in the financial system, including by the regulator (for instance in Basel II Standardised Approach) has increased manifold. With greater interconnectedness between financial sector participants, there is also increased contagion risk that regulators need to be prepared for and manage for ex-ante. To take an example, the long-term ratings of the parent entity IL&FS were downgraded multiple notches from AA+ to BB on September 8 and then to D on September 17, 2019. Such sudden and sharp downgrades of IL&FS’s counterparty and debt ratings over a period of less than a month had widespread repercussions on the rest of the economy such as the drying up of the commercial paper (CP) market for most NBFCs, spikes in funding costs even for well-run NBFCs, a consequent lending squeeze and its adverse effects on households and businesses in the real economy.
Therefore, there is much to be desired from CRAs to step up and fill shoes for the role of fiduciaries in the financial system. In this note, we discuss the specific issues that need addressing in order to achieve this.
Improving corporate disclosures that CRAs rely on
The Indian credit rating industry is fairly competitive, with seven SEBI-registered CRAs that are also accredited by the Reserve Bank of India as external credit assessment institutions. The big three global CRAs – Standard & Poor’s, Moody’s Investor Services and Fitch Ratings are the majority shareholders in CRISIL, ICRA and India Ratings respectively. CRISIL, the home-grown CARE Ratings and ICRA together dominate the Indian credit rating industry with a market share of about 85%[2]. Notwithstanding their proliferation, their over three-decade track record in assigning credit ratings to Indian debt instruments (CRISIL and ICRA were founded in 1987 and 1991 respectively) and the even more seasoned global ratings majors possessing majority stakes in three Indian CRAs, the domestic ratings industry failed to call out the impending debt servicing crisis in IL&FS, Reliance Communications, DHFL and the Zee group during the last two years. The domestic agencies have failed to learn their lessons from the CRB Capital Markets saga in the mid-1990s.
Global CRAs possessing majority stakes in Indian rating agencies does not automatically translate into the domestic agencies assigning apposite ratings. After all, the role of international CRAs in the 2007-08 Global Financial Crisis and more recently in 2015, their failure in the timely identification of the Asian commodity major, Noble Group’s financial mismanagement and debt-fuelled expansion has been well documented.
That the analytical rigour of Indian CRAs is on a par with their global counterparts is borne by personal experience and anecdotal evidence. But the disappointing aspect is that the three Indian CRAs that have global rating agencies as majority shareholders and the homegrown CRAs who have real-time access to the research output of global agencies and CRAs incorporated in other countries failed to adopt and establish international best practices. This stems from both the quality of public financial and other information available on a periodic basis from listed companies, as well as those from unlisted companies who are trying to get their securities rated. On the former, recent updates include SEBI’s acceptance of many of the recommendations of the SEBI Committee on Corporate Governance (Chair: Uday Kotak). The SEBI Listing Obligations and Disclosure Requirements (Amendment) Regulations, 2018, makes it mandatory with effect from April 1, 2019, for listed companies to report on a semi-annual basis standalone and consolidated accounts including a statement of cash flows. In doing so, “the listed entity shall ensure that, for the purposes of quarterly consolidated financial results, at least eighty percent of each of the consolidated revenue, assets and profits, respectively, shall have been subject to audit or in case of unaudited results, subjected to limited review. The listed entity shall disclose, in the results for the last quarter in the financial year, by way of a note, the aggregate effect of material adjustments made in the results of that quarter which pertain to earlier periods”. Additionally, a secretarial audit report of all material unlisted Indian subsidiaries of listed companies is to be provided annually along with annual reports (which is already applicable to bigger companies under the Companies Act, 2013). However, this does not apply to the remaining universe of standalone unlisted companies, including RBI-regulated NBFCs, who get rated by CRAs.
While SEBI’s regulations improve the quality and frequency of the disclosures of listed Indian corporates, the reporting of India Inc falls short of the quality of disclosures of listed companies in the ASEAN, especially in the areas of segment reporting and debt profile. However, on this front, very recent progress has been made with SEBI requiring all listed entities to disclose the quantum of defaults (beyond 30 days) on loans from banks and financial institutions and on unlisted debt securities on a quarterly basis from January 1st 2020[3]. The ICAI, vide the new accounting norm IndAS 116, requires companies to report the debt equivalent of leases on the balance sheet is a step in the right direction as it aligns Indian accounting policies with global best practices and eliminates the subjectivity associated with off-balance sheet reporting of leases that existed thus far. For unlisted companies, while information on ‘indebtedness of the company’ was required to be disclosed under ‘annual return’ filing by companies under the Companies Act 2013, this section (namely Section 92 (1) subclause (c)) was removed in the Companies (Amendment) Act, 2017 (although this is yet to be notified, implying that this requirement has to be met currently).
To further strengthen transparency outcomes on debt reporting, the MCA ought to also make it mandatory for corporates to provide a granular disclosure of debt including year-wise maturity of debt and leases, key terms and conditions of major borrowings outstanding and the composition of debt in terms of fixed and floating-rate debt and local and foreign currency debt. These measures can make it possible for investors, independent analysts/activists, and journalists to exercise pressure on CRAs if they believe that the outstanding credit ratings are not an apposite view of corporate debt servicing ability.
India Inc must embrace better disclosure practices if it wishes to attract international portfolio and strategic investors, diversify its funding profile to includes bonds, securitised paper, and hybrids and benefit from a liquid and vibrant secondary market for bonds. Information asymmetry is a key reason for India Inc not being able to achieve the scale and strength that corporates catering to a large and diversified nation like India ought to and reliable credit ratings are important to address this asymmetry.
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[1] “Role and Function of Credit Rating Agencies in the U.S. Securities Markets”, Standard & Poor’s Ratings Services, US SEC, Public Hearing on 15th November 2002. Accessible at https://www.sec.gov/news/extra/credrate/standardpoors.htm
[2] “What next CRISIL?”, by Tamal Bandyopadhyay, Livemint, August 10th, 2017. Accessible at: https://www.livemint.com/Opinion/w9Z4vyihDNLkwHCGBuKOqN/What-next-Crisil.html
[3] Disclosures by listed entities of defaults on payment of interest/ repayment of principal amount on loans from banks / financial institutions and unlisted debt securities, Circular dated November 21, 2019, SEBI. Accessible at https://www.sebi.gov.in/legal/circulars/nov-2019/disclosures-by-listed-entities-of-defaults-on-payment-of-interest-repayment-of-principal-amount-on-loans-from-banks-financial-institutions-and-unlisted-debt-securities_45036.html
