Corporate Debts: Better on Paper?
[Riya Sharma is a student at Jindal Global Law School.]
A company cannot thrive without a proper inflow of funds – depending on the capital structure of a company, borrowing may be critical to its functioning and can help in meeting its financial requirements. Section 179 of the Companies Act, 2013, empowers the board of directors of a company to authorize borrowing in the interest of the company. Given that a poor rating may significantly hamper a company’s ability to borrow funds, credit rating agencies play an important role in this process. For such companies, there is always a higher borrowing cost to make up for the additional risk that an investor is undertaking in investing in a company which does not have a good rating.
Credit Rating Agencies
A credit rating agency (CRA) is a company which rates the ability of a company to repay its debt. Although the kind of ratings given to companies by CRAs differs to a certain extent from one agency to another, most ratings range from triple A (extremely low risk, least likely to default) to D (high risk, most likely to default). Just like credit rating bureaus provide a credit score to individuals on the basis of which banks consider providing loans to such individuals, a CRA performs the same function for a company which is in need of money. The main purpose of CRAs is to assess the financial strength of a company and its ability to meet the requirements of interest and debt repayment. The factors taken into consideration for this purpose are the nature of the industry, the competitive edge which the company has, any past loan performance in terms of defaults or pre-payments, and financial indicators such as debt-equity ratio, current ratio, turnover and profits. There are only 6 CRAs in India, namely, CRISIL, CARE, ONICRA, SMERA, Fitch and Brickwork Ratings India Private Limited. Under Regulation 3 of the Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 (CRA Regulations), it is mandatory for these CRAs to be registered with the Securities and Exchange Board of India (SEBI).
CRAs are tremendously essential and have had a material influence on events falling within the purview of the financial market. The self reinforcing price rising bubble in the US Housing Market was, in essence, the result of an optimistic rating by such agencies that blew up into a full blown crisis and a failure of the financial systems in the United States.
The CRA Regulations
In India, the CRA Regulations empower SEBI to regulate the operation of CRAs. India was one of the first countries to have a comprehensive regulation for CRAs. The United States did not have such regulations until the year 2007. The International Organization of Securities Commissions (IOSCO) is the international body that sets the standards for all global securities sectors. Any regulations made in this regard must be in line with the international standards of CRAs set by the IOSCO Code of Conduct Fundamentals. These principles require regulations governing CRAs to address 4 main objectives, namely, quality and integrity of the rating process, independence and conflict of interests, transparency and timelines of disclosure as well as the principle of confidentiality of information.
Global Comparison - AAA Rated Companies
India leads the global market as regards the highest number of AAA-rated companies by a colossal margin with 73 companies, which is almost 5 times the number of companies rated AAA in the country ranked second, China. In fact, in the United States, only two companies have a credit rating of AAA – Johnson and Johnson and Microsoft and no country enjoys such status in Germany or the United Kingdom. “Despite a bigger AAA-rated universe here, a typical Indian company is financially weaker and more indebted than Western peers.” CRISIL and CARE themselves have reported that triple A ratings given to Indian companies do not compare with the triple A benchmark set by countries globally. Sovereign debt is normally considered a relatively risk-free debt and companies receive ratings relative to the concerned country’s credit rating. India has a rating of BBB, and all companies receive a relative rating. Credit rating agencies defend themselves by arguing that this is the reason there cannot be a comparison between global and domestic rankings.
The IL&FS Scandal
The IL&FS crisis is the most recent and biggest mishap which CRAs are taking the fall for. Infrastructure Leasing and Financial Servicing Ltd. (IL&FS) credit rating suddenly took a sharp turn downhill, degrading to BB from the earlier AA+. The IL&FS group was trying to keep its holding company and all immediate subsidiaries financially sound, “through an unsustainable, pyramidal funding, routing short-term funds borrowed at the holding company or the subsidiary company level” to their nearly 135 indirectly owned subsidiaries. While the parent company was given a high credit rating, its step-down subsidiaries kept defaulting on loans and, as an ex post facto action, IL&FS’s credit rating was unexpectedly altered to include the impact of its defaulting subsidiaries. Unfortunately, the damage had already been done. This raised a question as to the point in having agencies that predict default rates when all corporate debts look better on paper than in real life. Indeed, CRAs must strive to avoid such sudden changes in ratings for companies!
Change in Regulations
Soon after this fiasco, the SEBI made its regulations governing CRAs stricter and more transparent, and a circular was also issued to this effect. CRAs must now disclose the liquidity position of the companies and furnish information with respect to a company getting support from a parent company / government and their reasons for believing so. Interestingly, while the SEBI has been conducting checks on the CRAs, the Reserve Bank of India has also begun auditing such agencies jointly with the SEBI.
Issues and Challenges relating to CRAs
There are various issues with CRAs in India which are primarily the leading cause of any unexpected changes in the ratings that affect the capital markets adversely. These agencies sort of operate like an oligopolistic market, which means that they can form long-term relations with companies. On the flip side, this can interfere with their independence. There is, therefore, a possible conflict of interest between such agencies and the purpose they seek to serve. CRAs are being paid by the company and the possibility of them being paid for a good credit rating cannot be ignored. Further, CRAs, while admitting that a ‘conflict of interest’ exists, claim "they have mitigated such conflict through a disclosure of models and ratings”. A study has been conducted to observe the impact of transparency as a means to prevent such agencies from taking the blame of such conflict of interest, and the results have not been in favour of the agencies. These agencies come up with differentiated products, like fund managers, to eventually make comparisons tedious.
Another red flag which was concerning was the absence of universal ratings. It was, therefore, recommended by the Corporate Bonds and Securitization Advisory Committee of the SEBI that it was essential to come up with standardized ratings issued to the companies. This would help ratings to be “more clearly measured against an absolute benchmark.” Essentially, such uniform ratings will help serve two purposes – ensure that investors are able to easily understand the ratings and increase fairness and integrity of CRAs. Globally, this idea has been visited and rejected. The United States securities regulator, Securities and Exchange Commission, concluded in a study that it is not feasible to have standardized ratings “given the number and uniqueness of rating scales and differences in credit rating methodologies used by credit rating agencies”. Additionally, this standardization will also lower incentive of such agencies to improve their surveillance procedures and credit rating methodologies. The International Organization of Securities Commission, although recognizing the benefits of such uniformity, does not recommend the same to member states. On the other hand, in 2011, on the advice of the Corporate Bonds and Securitization Advisory Committee the SEBI issued a circular asking the CRAs to standardize their ratings. Although this seemed to be one step closer towards a more efficient rating system but the function of CRAs is inherently subjective since it includes assessing the financial situation of a company and different agencies use different methods to do the same.
Another aspect of standardization would be to have uniform guidelines in place, in order to give ratings to companies. This would ensure a higher standard of care while rating companies and would make the process a slightly more objective one. That being said, by virtue of the nature of the function of CRAs itself, eliminating subjectivity is a herculean task, and while such solution may seem viable in theory, in reality, such uniform guidelines may not work.
The SEBI has recently taken one step towards being able to conquer this herculean task. In an effort to improve the functioning of CRAs, the SEBI has recently issued a circular laying down enhanced guidelines for such agencies. This circular dated June 13, 2019 (SEBI Circular) aims to make uniform the methodology of calculating default rates by providing a framework for the same. CRAs are now supposed to calculate and disclose such rates on an annual basis “for one-year, two-year and three-year cumulative default rates, both for short-run and long-run”. CRAs and the SEBI will now work together to come up with a consistent Standard Operating Procedure to track defaults in a timely manner. Default probability benchmarks will also be set by the CRAs and the SEBI, together. These changes in the CRA Regulations tackle one of the most important problems of such agencies, that of ‘subjectivity’ and can be seen as a brilliant step towards stricter ratings and lesser unforeseeable defaults.
The recent SEBI Circular is a positive change for CRAs in India. Solving the problems of standardizing the procedure of allotting a default rate is a step in the right direction. While there are flaws in the current working of CRAs that can cause large scale financial trouble and stir up the market, they are extremely essential in aiding investors in being informed, they portray the goodwill associated with the company, heavily influence its stock value and a company’s borrowing cost. Therefore, what is essential is to have more regulation on the part of an overseeing body, which is the SEBI in this case, and encourage investors to not strictly rely on these ratings and engage in their own analysis as well.