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Fixing India's creaky credit rating systems

In an unprecedented move with far-reaching implications, Sebi is about to cancel the licence of a credit rating agency
  • A credit rating agency’s licence can now be cancelled and executives barred from working for other rating agencies. This is a departure from the old stance of plugging loopholes in regulations
  • Sebi’s stance that ratings are an important input for any debt market investor is the driving force behind the proposed penal measures. (Photo: Mint)Premium
    Sebi’s stance that ratings are an important input for any debt market investor is the driving force behind the proposed penal measures. (Photo: Mint)

    MUMBAI : The role of failures on the part of credit ratings agencies (CRAs) in causing losses and wider financial turmoil has been under scrutiny in recent decades both at home and abroad. From the global financial meltdown of 2008, fuelled partly by sophisticated debt instruments whose ratings did not accurately reflect their risk, to more recent debacles in India, at companies such as IL&FS, DHFL and Subhash Chandra-led Essel group, it has been evident that when CRAs don’t do a competent, honest and independent job, it can have wide-ranging consequences.

    CRAs evaluate the creditworthiness of individuals and companies. In the debt market, they play a critical role because investors make decisions based on the ratings assigned to debt instruments by various ratings agencies. If the ratings aren’t accurate, investor money is in jeopardy.

    Despite repeated failings, they have attracted limited penal action globally and virtually none in India.

    That’s about to change dramatically.

    Markets regulator Securities and Exchanges Board of India (Sebi) has decided to cancel the license of one CRA—Brickwork Rating—and ban from the markets two former senior officials of another—CARE Ratings—multiple persons aware of the regulator’s decision said. They asked not to be named as they are not authorized to speak to the media.

    At Brickwork Ratings, the regulator found egregious violations on two counts—lack of independence of the rating committee and lapses in following procedures while rating instruments.

    CARE Ltd’s two former senior officers—former managing director Rajesh Mokashi and former chairman S.B. Mainak—will be barred from the securities markets owing to the lack of independence and checks while they rated the debt instruments issued by IL&FS group or its subsidiaries.

    There are seven registered credit ratings agencies in India—CRISIL, CARE, Acuité Ratings & Research Limited, Brickwork Rating, India Rating and Research and Infomerics Valuation and Rating. The global biggies—S&P, Moody’s and Fitch—don’t rate Indian corporate bonds. CRISIL is majority owned by S&P.

    Such severe action on a credit rating agency is rare globally. The only big example is a 2013 ban by US Securities and Exchange Commission on Egan-Jones Ratings Company and its president for 18 months. Even then the bar was for omissions in statements while seeking registration and not for lapses in the ratings process. “Only up to a certain extent can regulators accept the explanation that rating actions are based on public information. If despite overwhelming public information of stress in certain instruments, ratings are not assigned accordingly, strict regulatory action is needed," said a person familiar with the regulator’s thinking.

    Such strict action sends a strong message. Sebi’s stance that ratings are an important if not the most important input for any debt market investor is the driving force behind such drastic penal measures.

    “Cancelling a CRA’s license is a much-needed action considering the track record of incompetence and/or complicity. This should be combined with banning the senior executives from being employed with any other credit rating agencies or with any entity which raises funds from the public," said Hemindra Hazari, an independent research analyst.

    Amit Tandon, chief executive of Institutional Investor Advisory Services (IIAS), said that such an action is unprecedented.

    “If this is indeed true and comes to pass, (it) will be (a) markedly different approach towards ensuring compliances by third parties and entities which are supposed to give an independent assessment. It’s to be seen whether this is a one-off instance or a trend of (a) much mightier regulator," said Tandon.

    In an emailed response, Brickwork, a Bangalore-based company promoted by Canara Bank, said it had taken corrective steps. “A few months back, the regulator had pointed out some lapses and we had thereafter taken active steps and complied with all the requirements. Clarifications were given where needed. It is important to note that no malafide intent was pointed out by the regulator. Our company has appealed against the original order as per the legal options available. We have faith in our country’s regulatory framework and judicial systems and hope to resolve the matter in appropriate time frame."

    A Sebi spokesperson did not respond to a request for comment. Mokashi and Mainak did not respond to messages.


    If Sebi bans Brickwork, it could spell trouble for the issuers it is rating currently. They may need to find alternatives. To be sure, Sebi orders are typically not disruptive and even in this case the instruments currently being rated by the rating agency will continue to be rated by Brickwork till their maturity.

    Bonds issued by Adani group, SREI group, IIFL, Edelweiss among others are currently rated by Brickwork.

    A spokesperson for CARE ratings said that they are not aware of any regulatory developments pertaining to the former senior officials. However they highlighted the course correction that has happened at the rating agency in the past two years.

    “CARE Ratings has embarked on a deep transformational journey. To start with, we began with putting a new top management in place. With our new CEO, chief rating officer, chief financial officer, head of legal, compliance & secretarial and chief culture officer at the helm, we now have a right blend of new professional management along with existing highly experienced skilled personnel," said a company spokesperson in an emailed response.


    So what went wrong at the two ratings agencies?

    “It isn’t that such an action is being taken (on the) basis (of) one or two lapses. In the case of Brickwork, there is a case of repeated lapses and lack of independence," said a second person with direct knowledge of the matter.

    The Sebi investigation report in the matter, which will form part of the impending order, cites issues in ratings of papers issued by companies such as Diamond Power, Great Eastern Energy Corp. and firms that are part of the Essel group—namely Essel Corporate Resources and Zee Entertainment Enterprises Ltd. The issues ranged from delay in downgrading to not assigning any rating while the ratings were withdrawn due to so-called non-cooperation by the company.

    Brickwork’s conduct in rating papers of Essel and Zee deserves a deeper examination.

    It again goes back to the controversial agreement between mutual funds and Zee promoters in January 2019. Seven mutual fund houses who held Essel group papers in their various debt schemes came to an agreement that although the companies were unable to stick to the repayment schedules of the debt papers, they will be given a lifeline. The funds would not invoke the underlying shares and dump them into open market. They instead extended the maturity dates of the papers from these companies.

    The market regulator has been particularly angry at this. Kotak Mahindra Mutual Fund and HDFC Mutual Fund have both faced regulatory orders over this. While HDFC MF settled the matter, Kotak Mahindra MF was slapped with a 50 lakh fine and a ban on launching fixed maturity plans for six months. The regulator in its investigation report has noted that the rating agency downgraded the two instruments only by one notch when ordinarily such breach of obligations should result in a multi-notch downgrade or default.

    “It was clear that it was neither possible for the borrowers (Essel papers) to bring in additional money or shares to maintain the security cover. A breach of covenant dealing with security cover would normally result in multi-notch downgrade or default," said the first person cited earlier in the story.

    Another major area of concern has turned out to be in the rating of debt instruments backed by shares—instruments known as structured obligations. As promoters started borrowing against their shares and the so-called loans against shares (LAS) extended by shadow banks and debt mutual funds started becoming commonplace, the ratings of these instruments also came to be widely relied on.

    Bulk of such structured obligations (SO) were rated by Brickwork and CARE. Sebi’s investigation notes how Brickwork “was not independently assessing the enforceability, revocability and other important aspects of the underlying assurance while undertaking rating of SO".

    In no less than 12 such SOs, Sebi found that support provider or promoter themselves had previously defaulted in their credit obligations.

    “When a company restructures debt obligations and if it was done to avoid default, this reflects very poor credit quality and the revised rating should indicate the actual picture. It is important that all stakeholders like investors, regulators and media are informed of the seriousness," said the second of the two people quoted above.

    In a previous order on Brickwork in August 2018, Sebi had found a flagrant conflict of interest. It found that D. Ravi Shankar, founder director at Brickwork, was both involved in rating as well as in approving the fee charged for this service—a practice deemed a complete no-no in the ratings industry. This practice happened in 71 cases involving a rated amount of around 86,842 crore.

    Another stunning instance involved the rating of debt instruments issued by Cox and Kings. On 24 June 2019, both CARE and Brickwork reaffirmed their highest rating of A1+ for Cox and Kings’ commercial paper (CP) issue. Brickworks even highlighted high receivables.

    Both CRAs also gave a ‘Stable’ outlook, which indicates a low possibility of rating change over the medium term. Yet a mere 3 days later, on 27 June 2019, Cox & Kings defaulted on 150 crore of payments on CP. It was only after the default that ratings were downgraded by several notches to default.

    In the case of CARE, some of the conflicts were first highlighted by a July 2019 audit report by Grant Thornton.

    As per CARE’s shareholding pattern between 2007 and 2013, IL&FS Ltd and ILFS Financial Services (IFIN) were equity shareholders and held a 5-9% stake. During the same period, CARE was rating instruments of IFIN, IL&FS and IL&FS Transportation Networks Ltd.

    “It appears that the rating agencies were potentially aware of the issues in the IL&FS group. However, the various strategies deployed by the then key officials of IL&FS group and certain favours/gifts provided to rating agency officials suggest the possible reasons for consistent good ratings provided to IL&FS group during the period June 2012 to June 2018," said Grant Thornton in the audit report.

    Sebi in its own probe has found merit in the audit findings and issued notices to CARE and two former officials citing ‘lack of independence, conflict while rating IL&FS instruments and not putting in place adequate checks to prevent such rating conflicts’.

    Spring Cleaning

    Even as the investigation has been ongoing, a lot of behind-the-scenes housekeeping has been undertaken by the regulator. Many CRAs have cleaned up their act.

    First was the recognition of what could go wrong in ratings. The process might be broken or might not be laid down well enough. Or an agency might be using untested rating methodologies.

    More importantly, there could be unchecked business practices, compromised individuals who wield too much power in rating processes and finally lack of transparency.

    The regulatory scrutiny has increased by several notches. Over the last 2-3 years, a team of 7-8 specialists from across several regulatory bodies—mainly Sebi and RBI, visit the rating agencies together for a week-long inspection.

    “During these visits they meet the rating committee members, leadership teams across functions and grill them to understand the culture and compliance orientation of the team apart from checking data and processes. Then the regulatory bodies issue detailed observations on what is wrong with the processes and data and instructs the rating agency to make necessary changes and report back. The rating agency management must submit the findings to its board and send Action Taken Reports to both regulators and the board," said a senior official at a rating agency.

    Sebi has been mindful of ensuring complete independence of rating committee from the management as well.

    “Rating agency CEOs cannot be part of rating committee anymore. Rating analysts cannot report to the CEO anymore. In fact, some agencies have gone one step ahead to break down the rating quality, control and administration process under Chief Rating Officer who is in charge of rating committee while the people who prepare the rating notes and do management meetings report to Chief Analytical Officer… Nobody has too much power anymore," said Sankar Sankar Chakraborti, group CEO, Acuité Ratings.

    Rating agencies now also follow standardized processes and when there is a deviation, they have to disclose it. For example, it is impossible for one rating agency to recognize default and another to not recognize it for the same instrument of the same company.

    Sebi is combining a determination to ensure independence of rating agencies with the stomach to impose strong penal action. That’s an approach that might just work.

    Jayshree P Upadhyay
    Jayshree heads a team of reporters focussing on legal, regulatory, investigative stories. She has worked for over a decade, reporting on financial scams, legal stories and the intersection of corporate and regulatory issues. She is based in Mumbai and has previously worked with Business Standard, Mint, The Morning Context and Bloomberg TV India.
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    Updated: 12 Oct 2021, 01:24 AM IST
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