1.0 The Committee members decided to include a Chapter in this report examine the desirability of regulating the Credit Rating Agencies (CRAs). It was felt by the members that pitfalls which lie ahead in regulating CRAs should be adequately brought to the notice of SEBI.

The Committee was of the view that ratings are opinions which do not inherently lend themselves to being easily regulated. CRAs should not be regulated because ratings are essentially subjective judgements where two entities, on the same set of facts, can have entirely different views. CRAs, apart from carrying out in-depth financial analysis, are also required to undertake a lot of subjective qualitative analysis on such matters as the quality of management, quality of accounting standards, nature of intra-group transactions, unrelated diversifications, etc.. Ratings are not decided merely on the basis of a final number arrived at by the CRA concerned on the basis of a scale. A regulator, therefore, cannot objectively sit in judgement over appropriateness of one rating or the other.

Because of the subjectivity in the rating decisions , SEBI’s inspections of the CRAs cannot/should not judge the appropriateness of rating analysis by CRA. However, the members of the Committee did agree that the methodology for regulation of intermediaries so far adopted by SEBI essentially involves inspection of records of the concerned intermediary without which the regulatory function cannot be carried out in any meaningful manner.

Another aspect of the normal regulatory methodology is the regulator’s almost unfettered right to obtain information from the intermediary concerned. In case of CRAs, among the information that would be required to be obtained is also information submitted by the clients to CRAs. Some of this information is given by the clients on a confidential basis as the same can be potentially misused. A view has been expressed that the clients of CRAs would feel more hesitant to submit complete information to the CRAs

if the same can be accessed by the regulators. Lack of complete information, in turn, could lead to lower quality ratings. Similar objection is raised in respect of regulator’s right to direct transfer of records of a CRA to another CRA or another place in case of suspension or cancellation of the former.

One purpose of regulating CRAs is to ensure that only CRAs with adequate experience and credentials are in rating business. A view was also expressed that the goal of limiting the ability of additional commentators and rating agencies to enter the Indian market is in direct conflict with promoting efficiency and confidence in the market.

The Committee was also of the view that ideally it should be decided by the market participants whether a CRA is competent and dependable. It was felt that credibility of a CRA does not arise as much out of parentage or capital size, as it evolves as its ratings find acceptance in the marketplace.

The Committee was of the view that for effective regulation, the regulations would need to specify exercise of due diligence by CRAs. But, as is well known, the CRAs typically rely on secondary sources of information relating to market like the Auditors’ reports, market research agencies, commercial data banks and the information provided by the company itself (CRAs, however, carry out the minimum due diligence required for arriving at rating decisions). It may be both unfeasible as well as too expensive for the CRAs to undertake an independent exhaustive due diligence exercise. The requirement of such due diligence would push up the cost of securities issuance and time taken for it.

Credit Rating Agencies are not regulated in the developed markets. However, in United states of America, Securities and Exchange Commission (SEC) does give recognition to CRAs as Nationally Recognised Statistical Rating Organisations (NSROs) for specific purposes. Similarly, in India , presently, the Ministry of Finance has recognised certain CRAs for the purpose of allowing listing of privately placed debt securities only if such securities are rated by these agencies. Reserve Bank of India (RBI) has approved certain agencies for the purpose of rating of Fixed deposits and Commercial Paper issued by Non-Banking Finance Companies (NBFCs).

The Committee’s view is that instead of regulation through registration , SEBI may just recognise certain agencies for particular purposes only such as allowing rating by CRAs recognised by it for inclusion in the public/rights issue offer documents. Such recognition could be in the nature of empanelment of Consultants, Chartered Accountants etc. often carried out by regulatory authorities for which criteria could be laid down by SEBI. In such a scenario, any person would be free to be in the rating business though the ratings from recognised CRAs only would be eligible for certain purposes.

A Rating is neither an investment advice nor is it a recommendation to buy or sell securities that have been rated. CRAs do not fall within the direct chain of the process by which issuers raise money. CRAs only issue their opinion regarding the relative creditworthiness of various instruments that they rate. They neither manage investors’ money nor do they act in fiduciary capacity. Most entities that SEBI regulates either directly or indirectly participate in the process of soliciting investments or hold some fiduciary capacity. There, therefore, does not exist a good enough case for regulating CRAs.

1.7 In view of what is stated above, the Committee strongly recommends that a request may be made to the Government to amend the SEBI Act, 1992 to bring CRAs out of the regulatory purview of SEBI. However, if the Committee’s recommendation in this regard are not accepted, the framework for regulations as described in the following Chapters of the report may be adopted.

3.0 The Committee decided to recommend the following as eligibility criteria for registration of CRAs :

The promoters of CRAs should belong to one of the following categories:

It is felt that such a criterion would ensure that only promoters of repute and/or a track record of consistent performance establish such agencies.

Further, the promoters should collectively hold at least 26% of the paid-up capital of a CRA for a minimum period of 5 years. This condition has been stipulated to ensure that promoter(s) based on the credentials of which, a CRA obtains a registration should continue to be associated with the CRA for a significant period. However, the CRAs in operation before the regulations come into effect are proposed to be exempted from this condition since they already have a track record and changing of capital structure could cause them considerable inconvenience.

The Committee decided to recommend that no minimum networth be specified for CRAs nor should the regulation prescribe the infrastructure requirements. Credibility of the CRAs is determined on the basis of the quality of their opinion. The adequacy of infrastructure and attendant investment therefore is best determined by the CRAs.

It was felt that networth criterion was not required as an eligibility barrier since the condition specified for promoters would be sufficient eligibility restriction.

Presently, as per the practice in the rating industry, a client subsequent to obtaining its rating from a CRA has the option to accept or not accept a rating. If the rating is accepted, then the rating is disseminated by the CRA. However, if the rating is not accepted, the rating is kept confidential by the CRA and is not used by the client. According to a section of opinion, this practice, has lead to "rating shopping". A company which is not able to get a favourable rating from a CRA approaches another which agrees to give a more favourable rating. The Committee, therefore, deliberated upon the proposal that CRAs should disseminate all ratings issued by it regardless of whether the same have been accepted. A contrary view was expressed that if this proposal is accepted, the clients in the fear of an adverse rating being compulsorily disclosed would not approach a CRA which may be known for not compromising on the quality of its rating decisions. The Committee decided to recommend compulsory dissemination of unaccepted ratings to investors. It was felt that in the long run, the more conscientious CRAs would not stand to loose since the CRAs compromising on quality would be rejected by the market.

The Committee discussed the issue of whether the CRAs should be allowed to rate securities issued by their associates in view of the conflict of interest. Two proposals were discussed -

The Committee after detailed discussion decided to recommend acceptance of second proposal. The Committee felt that acceptance of first proposal could lead to a situation wherein if a CRA with best reputation and credibility in the market happens to be an associate of a company, the company would be deprived of an opportunity to be rated by that CRA with a consequent loss to the marketability of its issue. In the ultimate analysis, for being in rating business, credibility is the most important thing and a CRA doing biased rating of an associate would loose credibility in the market place.

The Committee discussed the desirability of having uniform rating symbols for all CRAs. The Committee felt that imposition of standard symbols would imply imposition of standard of rating scales too which would effectively be an interference in rating methodology which the Committee was not in favour of. In any case, it was observed, ratings by CRAs are not comparable since same rating symbol may be arrived at by two different CRAs on entirely different set of parameters. Without standardisation of methodology, standardisation of symbols would serve very little purpose, if any. The Committee decided not to recommend uniform rating symbols.

The proposed regulations stipulate that CRAs shall carry out periodic reviews at regular intervals and, if necessary, carry out rating changes as are considered appropriate of all ratings as long as obligations on rated security are outstanding in the market of all ratings during the entire term of the rated security. However, withdrawal of ratings is proposed to be permitted if the company is wound up or merged with another company.

It has been recommended by the Committee that SEBI’s inspections of the CRAs should not judge the appropriateness of analysis by CRA for arriving at a rating decision. Inspections for judging appropriateness should be very sparingly undertaken in cases of serious complaints and such inspections should be conducted only by a panel constituted by SEBI consisting of majority of independent experts with relevant experience . The Committee felt that since the rating decisions involve subjective judgement, regular inspections of such nature, if carried out, could lead to hesitation and overly conservative approach on the part of CRAs.

The issue of whether methodology of rating should be standardised across CRAs was discussed by the Committee. The argument in favour of standardisation was that different CRAs coming to an entirely different rating opinion about a security would lead to confusion in investors’ mind. The point against standardisation was that it is not feasible in the first place since rating involves subjective factors like management quality, management’s vision, policy relating to diversification, quality of accounting policy etc.. All of these factors cannot be quantified into numbers. The other issue is while attempting standardisation, it is not possible to prescribe a list of all such non-quantitative factors upfront which may be of relevance to the analysis which a CRA should consider in a particular manner. It would be impossible to lay down guidelines for such disparate situations as fire, death of a dynamic Chief Executive Officer, change in Government at the Centre/State, etc.. Any of such factors can have a decisive impact on the rating finally assigned even though the company may look very good based on financial analysis alone.

Besides the feasibility of standardisation, it is important to consider whether standardisation is at all desirable. The techniques for financial analysis continuously keep evolving. If standardisation was to be done, a CRA would not be able to use what it might consider a superior technique till other CRAs also do so.

It has been provided in the draft regulations that all rating decisions as well as decisions to upgrade or downgrade ratings shall be made or ratified by the rating committee. In India , all CRAs have most of the rating committee members from outside. Internationally, however, CRAs are known to have an internal committee. While having outside members ensures certain degree of impartial and independent decision making, having an internal committee has the advantage of faster decision making which is often very important particularly when decisions to downgrade ratings are taken. It was also argued that sometimes an internal committee has the advantage of decision makers being more properly initiated into the nuances of rating process. In view of the divergent views all of which appear valid, the Committee decided to recommend that composition of the Rating Committee be left to the discretion of CRAs.