There are many headlines that pass by us on a daily basis, which we read but we do not sit up and take notice. Here are two examples. In January this year, one headline read: “Moody’s reaches $864 million subprime ratings settlement.” The article said: “Moody’s Corp. agreed to pay almost $864 million to resolve a multi-year US investigation into credit ratings on subprime mortgage securities” and that “investigators in the Congress found after the crash that in some cases, credit rating firms were giving out top grades to junk deals simply to win business from the banks preparing the securities.” (Read the article at: bloom.bg/2kw7Q2N.)
The other headline I am talking about is about 2 years older, from February 2015. It read: “S&P ends legal woes paying $1.5 billion fine to US, states”. It was mentioned that the settlement “will let the world’s biggest ratings company move beyond a bruising legal battle over the top grades it gave to subprime-mortgage bonds, though at a more painful price than those paid by big banks that assembled those securities.”
It also read that S&P had admitted that business concerns had affected its ratings decisions, something it had disputed 2 years ago, when the lawsuit was filed. “To win business, S&P awarded top grades on bonds built out of risky subprime mortgages that investors thought were as safe as debt from the US government,” the article stated. Read it at: bloom.bg/2koIrN0
Alarming, anyone? Well, the standards in India are not so poor. Our rating agencies have not faced such crises of confidence or credibility. The only question that is raised on the track record of our rating agencies is of multiple downgrades at one go or downgrades in quick succession. In such cases, the agency is behind the curve and playing catch up.
To put it more pointedly, in these cases, the agency was tracking fundamentals only and was not aware of corporate governance issues creeping up.
Whenever such an event occurs in India, everybody jumps on to the opinion bandwagon and thereafter things remain as they were and don’t move forward. It is time to discuss accountability of rating agencies.
In November 2016, the Securities and Exchange Board of India (Sebi) issued a circular, applicable from this calendar year. It was titled “Enhanced standards for credit rating agencies (CRAs).” It was about the processes and criteria followed by CRAs and stipulated, inter alia, default recognition norms, review of sharp changes in ratings, and disclosure of ratings not accepted by an issuer. While the regulator is fine-tuning the operation of CRAs, let us discuss a paradigm change in the functioning of the rating process.
There is a conflict of interest, globally, in the rating process. The rating agency is paid by the issuer whereas it is consumed by the investor.
Ideally, the rating agency should report to—and be paid by—the investor. This model has not developed because of practical difficulties in implementation. However, if the issues discussed above are to be really solved, we have to give it a sincere thought, beyond the enhanced norms stipulated by Sebi.
During a primary issue, let the merchant banker appoint a rating agency and let the fees—which should be standardized by the regulator—flow from the escrow account for the issue. It will be charged to the investors, proportionate to the subscription amount, overseen by the merchant banker.
On secondary market transactions, the subsequent investor should compensate the seller for rating fees, akin to compensation for accrued interest in a bond deal.
In the annual general meeting (AGM), the rating agency should report to the bondholders and the message from the CRA should be carried in the annual report. The message should also be carried on the website of the rating agency, for easy access.
Implementation may have some challenges, but we have to make a beginning somewhere. A pilot project may be started with an issuer who is serious about corporate governance.
Another challenge in the proposed new process could be about companies not being serious about corporate governance, for instance, not holding AGMs or not publishing annual reports. The Sebi circular of November 2016 mentions: “Each CRA shall disclose on its website details of all ratings assigned by them, irrespective of whether the rating is accepted by the issuer or not, even in case of non-public issues.”
The circular also states that if the issuer does not cooperate (such as, by not providing the information required for rating), the credit rating symbol would be accompanied by a comment: “Issuer did not co-operate; based on best available information.”
The regulator will fine-tune guidelines for communication in such cases where an issuer is not serious about corporate governance and the CRA needs to inform the investors.
The rating agency also needs to be held accountable. As the Sebi guideline states, the rating committee of the agency has to record, inter alia, sharp changes in ratings. It is not only about recording, but there should be proper explanation given to the investors when the CRA falls behind the curve.
Joydeep Sen is managing partner, Sen and Apte Consulting Services LLP