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Moneylife » Investing » Regulations » Credit rating agencies under fire! It’s time for SEBI & RBI to act

Credit rating agencies under fire! It’s time for SEBI & RBI to act

Gurpur | 23/11/2012 01:17 PM | 

Credit rating agencies are facing the wrath of investors over their rating decisions gone horribly wrong and law suits are being filed against them in several countries. Will SEBI and the RBI act in the interest of orderly development of rating mechanism in our country?


Deepak Parekh, chairman of HDFC, recently said, “Let the raters be rated.” But the moot question is by whom? In India, credit rating agencies (CRA) are approved by two regulators, Securities and Exchange Board of India (SEBI) for capital market operations and by Reserve Bank of India (RBI) for rating of borrowers of banks. And as it is said dual control is no control. The existing regulations in India are not comprehensive enough to take care of the present crisis caused by many of the issuers dragging the rating agencies to courts on grounds of bias, manipulation and lack of transparency or sheer incompetence. And they do not come under the Right to Information (RTI) Act in our country as they are all in private sector, though their activities have a vital bearing on the economy of the country. The rising court cases against rating agencies, not only in India but in many other parts of the world, are indicative of the growing resentment to the arbitrariness of the rating agencies, which calls for serious thought on the part of the regulators all over the world.

 

Suit against Standard & Poor’s in Australia:

A credit rating agency in Australia is facing the wrath of the investors over its rating decisions gone horribly wrong and lawsuits were filed against it by investors who lost money on investments made relying upon the ratings of CRAs.  As per the AFP Sydney report,  Standard & Poor’s (S&P), one of the leading credit rating agencies of the world recently lost a landmark case in Australia over top ratings given to financial products that collapsed following the 2008 global economic crisis.
 

The agency report said that the Federal Court of Australia ruled early this month that S&P’s ‘AAA’ (Triple A) rating of constant proportion debt obligation notes created by ABN AMRO Bank and sold to the councils of 13 Australian municipalities had been ‘misleading and deceptive.’ “S&P’s rating of these derivative instruments was misleading and deceptive  and involved the publication of  information or statements false in material particulars, and otherwise involved negligent misrepresentations to the class of potential investors in Australia,” the judge said.
 

Though the defendants had argued that in all their investment contracts there existed a clause of caveat emptor (buyer beware) and hence there was a contributory negligence on the part of the investors, the judge ruled in favour of the plaintiffs and said that they were misled into thinking that the debt obligations they purchased were safe securities based on the highest rating given to these securities.
 

The judge further said that S&P’s assessment of the products as “extremely strong” had been central to the loss. The judge, therefore, ordered that S&P, ABN AMRO bank and a firm called Local Govt. Financial Services (which sold these investments to the councils) combine pay15.3 million Australian Dollars to 13 Australian municipalities, plus interest and legal costs towards the loss incurred by them on these investments. The total compensation is estimated to reach about 30 million Australian Dollars (equivalent of nearly Rs200 crore).

 

Case against S&P’s and Fitch Ratings in Italy:

As per reports in EU Business, an Italian prosecutor has filed charges of market manipulation against S&P and Fitch Ratings agencies last week over downgrades of Italy’s credit rating that helped fuel the euro debt crisis. Among those charged is Deven Sharma, the head of S&P’s from 2007 to 2011 and an operational director of Fitch, David Michael W Riley, who worked at the time of the alleged crime. Though the charges are yet to be confirmed by a judge for the trial to proceed further, both Fitch Ratings and S&P rejected allegations of market manipulations in an Italian probe into a series of downgrades of the country’s sovereign credit.
 

Early this year, Fitch downgraded Italy to A- from A+, citing financial weakness during the debt crisis, while S&P downgraded Italy’s rating by two notches. Again in July this year, Moody’s downgraded Italy’s sovereign credit rating by two positions from A3 to Baa2.

 

European Union to regulate credit ratings agencies:

As per the Financial Times, London report dated 6 July 2012, the big three credit rating agencies were facing new regulatory scrutiny of the way they evaluate banks of European Union. “The European Securities Markets Authority said that it planned to inspect Fitch, Moody’s Investor Services and Standard & Poor’s to determine whether their bank ratings were sufficiently rigorous and transparent,” the report said.  The report further said that the new European regulator was given authority to regulate credit rating agencies last year and it is said that they would not be “rating the ratings” but rather making sure that each individual ratings were properly researched and thought out. These steps are a said to be a prelude to the European Commission and Parliament imposing further regulations on the rating agencies including limits on their ability to rate sovereign debt

 

Indian corporates too drag rating agencies to court:

  1. Srei Infrastructure Finance Vs Fitch Ratings India: In a first of its kind, an Indian corporate Srei Infrastructure Finance (SIFL) got a stay order from the Calcutta High Court on 20 March 2012 against Fitch Ratings, now known as India Ratings, from publishing its ratings downgrade on the bonds obligations of SIFL, resulting in a series of events following the stay order.

Subsequently the Calcutta High court on hearing the petition on 17 September 2012 allowed Fitch Ratings to go ahead with its rating report subject to satisfaction of SEBI, which is the regulator for CRAs. The court, in its order, said that SEBI was the competent authority to decide whether a credit rating agency can be restrained from issuing a rating and that SEBI, inter alia, had the power to investigate into the complaints received from any person regarding the activity of credit rating agency.

 

Following the court order and the letter from SEBI confirming that the rating action by India Ratings (Fitch) was generally conforming to the SEBI regulations, the rating agency released the rating downgrade of SIFL on 6 October 2012. SIFL, however, said that the rating given to the company was based on inaccurate conjecture, and that it would represent the facts to the high court again.

 

  1. Videocon Industries Vs India Ratings: (Formerly Fitch Ratings, India)  Another Indian corporate, Videocon Industries, obtained a stay order from the Calcutta High Court on 20 September 2012 restraining India Ratings from publishing a rating of its debt due to a dispute with the rating agency. Videocon Industries contented that India Ratings had not made any ratings for the last two years, and questioned “the eagerness of the rating agency to rate the company’s debt now” and alleged ulterior motive in trying to help its rival company in Mozambique in Africa. India Ratings, however, claimed that it continues to be under contractual obligation to rate Videocon as there were outstanding loans that needed to be rated.

The court after hearing both the parties has on 10th October, finally ordered that the stay will be continued only till 16 December 2012, or until further orders, whichever earlier. The entire case is expected to be heard and decided before that date when the final position will be known, and this will have a far reaching affect on the rating business in India.    
                                                           

What should SEBI do under the circumstances?

It is pertinent to mention here what justice IP Mukerji of the Calcutta High Court observed while delivering his judgment in the Srei Infrastructure Finance Vs Fitch Ratings India (P) Ltd on 26 July 2012.
 

The judge said “… Two points are very important. Credit rating is being done by a private agency, approved by SEBI. Although the work is very technical and highly specialised, there may be a chance of error. Sometimes, there also may be a chance of arbitrary ratings by a particular agency. In that case, the financial institution should not and cannot be without remedy. But it is also of paramount importance that the public in general should be notified about credit ratings by their publication in the print and electronic media and that this credit rating should not be easily withheld.”
 

This in essence should be the job of SEBI. The two important points that the judge highlighted should be implemented by SEBI both in letter and spirit, so that the rating agencies do their job with utmost honesty and integrity and the issuers have a remedy when they find that something is amiss in the rating proposed by the rating agency.
 

It is of great importance that the rating agencies themselves should not only be competent enough but also display highest levels of corporate governance standards to sit on judgment over the affairs of other corporates and appropriate guidelines should be put in place to generate trust and confidence in the rating mechanism itself. The rating agencies should not only be fair, but appear fair to the outside world in all their dealings so as to inspire faith in their actions. SEBI and RBI, which have approved the rating agencies as the regulators for capital market and the commercial banks respectively, have a responsibility towards the issuers and the banks on the one hand and the investors and bank borrowers on the other to ensure that CRAs meet the aspirations of all the stakeholders, without in any way jeopardizing the delicate web of financial integrity that should be ingrained in every report of a rating agency.

 

Will SEBI and RBI wake up before it is too late and act now in the interest of orderly development of rating mechanism in our country, more so when our country’s rating itself is threatened with  downgrade in the foreseeable future?
 

(The author is a banking analyst and he writes for Moneylife under the pen-name ‘Gurpur’.)


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3 Comments
nagesh kini

nagesh kini 2 years ago

The issue of the rating agencies is very much akin to our grandmothers' telling us of "The Fence eating the grass". The Agencies have failed. Not to forget the so-called Regulators who are expected to be watch dogs,but in fact have turned out to be tooth less tigers that can neither bark/roar leave alone barking any warning - classic case of Stock Guru where 2,50,000 fell for fast money. Surely many must have been from educated city middle classes driven by greed.
Rightly said "Duniya Jhukti hai, Jhukanewala Chahiye"! They were school dropouts.

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Anil Agashe

Anil Agashe 2 years ago

Nice article indeed.
High time the role of CRAs is scrutinized especially after 2008. It is interesting to read that a court in Australia has penalised a CRA, in India i believe SC has ruled otherwise.

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M G WARRIER

M G WARRIER 2 years ago

Copied below is a letter addressed to Business Standard on December 23,2011, for information of readers:

Credibility of rating agencies

As you have rightly said in your editorial (December 23), after the recent experiences, major credit rating agencies of the world are themselves making efforts to recapture their own credibility. This is a healthy impact of globalization. It is slowly dawning on those who were used to serve only one master, namely the United States, that there is a world outside capable of checking their homework. Mr Gopalan’s responses have to be seen in this context.
The outside agencies are comparing the non-comparables. India, without denying the ‘political mismanagement’ part of the story has to be given credit for managing the affairs fairly well despite several constraints like late entry into the developing nation status, one-third geographical area of US with three times population, low literacy rate and inadequate infrastructure and resources to meet minimum/basic needs and so on.
Viewed in this context, time is opportune for India to think in terms of setting up a rating agency of international standard which will understand India and advise stakeholders about the health of domestic financial institutions and the financial institutions and governments abroad with which India has dealings. Agencies like Standard and Poor and Moody’s are doing their work within their limitation and even they would be benefited if an internationally acceptable rating agency comes into being in India.

Also, we have to learn to read beyond the glossy marketing literature in the form of draft agreements and treaties supplied at international forums, to understand what is best for our own economic development. Instead of always depending on the expertise of the developed world, we should spend more time and resources for study and research to improve our own skills and capabilities. One gets a feeling that we are going for outsourcing in areas like processing and manufacturing in certain sectors where we can do better by developing indigenous capacities. Self-reliance is not a bad word.
M G Warrier, Thiruvananthapuram
December 23, 2011

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