SEBI's order in the CARE Ratings scandal tackles the symptom, not the cause

The recent SEBI order on the allegedly dubious role of the top management of Care Ratings Limited (“CARE”) is illuminating.

Corporate governance and the system of checks and balances in securities markets rests on several pillars. These include Independent directors, the Audit Committee, and independent auditors. Another important check are the Credit Rating Agencies (“CRAs”) who give rating on instruments on the basis of which entities raise funds. Such ratings are an important criteria relied upon by many large and small investors as an indicator of financial health of the entity and safety of the securities. The 2008 financial crisis particularly in the West taught us how the failures of CRAs in doing their job can undermine the foundation of financial systems, leading potentially even to systemic collapse.

In this context, the recent SEBI order on the allegedly dubious role of the top management of Care Ratings Limited (“CARE”) is illuminating. More importantly, the SEBI Order reveals the bare bones of the internal workings of CRAs. And while the order is largely on factual allegations and which are very likely to be litigated, it is worth reading to remove many misconceptions on how CRAs function.

The typical reaction, often a valid one, when there are large corporate failures and even scams, is what were the auditors, the Audit Committee and independent directors and Credit Rating Agencies, doing? Have they slept on the job? Or worse? While the question of independent directors and auditors have often been raised, discussed and even ruled on, though not always to the satisfaction of everyone, this case discussed in detail the internal working of CRAs and how the internal checks and balances are laid down.

Issuer-Pays Model’s Troubles

An important concern from the 2008 financial crisis was that CRAs were perceived to be negligent, to the extent of even complicity, in giving high ratings to dubious products and securities. A primary cause for this was the issuer-pays model (which incidentally plagues the pillars of independent auditors and independent directors both, but that discussion is for another time).

This means that the entity which seeks an independent opinion on securities it plans to issue from an independent CRA is itself selecting the CRA and negotiating and paying the fees for such opinion. But, as in the case of others, here too, the regulators have not been able to find an alternative to the issuer-pays model. But as mitigating measures, some checks have been put on how the rating process at CRAs function.

A major measure is that the business/marketing teams of CRAs who seek and get business of issuing ratings should have no say whatsoever in the rating process. The rating teams of the CRAs should remain strictly independent. Even top management shouldn’t have any influence on the rating process. And in the present case, this was the core question. Did the top management – the Chairman and the Managing Director, actually meddle with and influence the rating process? The obvious motivation would be to give a better rating that would help get and keep business and earn higher fees.

Why Ratings Matter

SEBI received several whistleblower complaints that, in the case of CARE, there was influencing and meddling by top management with the rating process of certain large issuers. This included the decision taking on delaying the downgrade/revision of ratings even where there were negative developments in the issuing entity.

The importance of rating couldn’t be more evident than this one. A high rating enables issuers to raise huge amounts of funds by issue of such rated securities. Investors would rely on such ratings on making decisions on whether or not to invest, interest terms, etc. Importantly, the investment is often made by funds who typically manage public money. For them the primary and objective check for prudent investment is the high rating of the securities. If ratings were high, the backs, so to say, of the fund managers, were largely covered.

As SEBI emphasised in the order, this placed all the more responsibility on the CRAs. They get huge amounts as fees – often in crores of rupees – for issuing such ratings. Yet, their fees were still a minuscule portion of the tens of thousands of crores of monies that are raised on the basis of their ratings. On the other hand, such clients giving hefty fees are a source of profits of CRAs. Arguably, high profits also become the basis of evaluation of performance and determination of remuneration of top management and also returns to their shareholders.

Conflict Of Interest

Thus, this conflict of interest within the CRAs is so glaring as to be self-evident. Should the CRAs take a firm stand if the issuer does not deserve a high rating or, if rating is already given, deserves a downgrade? Or should it bend a little backwards, for the sake of retaining the clients and the hefty fees? Hence, the question here is whether CARE followed, in letter and spirit, the separation of business seeking teams and the rating teams and their processes.

SEBI findings can be summarised as follows (which findings may be contested). SEBI received complaints that the rating process in CARE was meddled with by top management. SEBI first asked the company to carry out an internal investigation. There was considerable back-and-forth in this process. These included an audit by an independent firm, a forensic audit, consultation of a law firm on findings, and even examination by an independent committee of the Board. They all largely gave a clean chit to the management though with some reservations.

However, one aspect that SEBI noted was that while the conclusion was that even if there was interference, it did not influence the final rating. However, the core purpose of maintaining the distance was that there should not be even interference. SEBI gave a finding that the Managing Director did influence in some cases. The primary basis of this ruling was feedback from some persons in the rating team about alleged pressure and influence from the MD in various forms.

Interestingly, WhatsApp chats amongst the rating team became useful to SEBI in making their case. SEBI concluded that the MD did indulge in acts to influence. It is also noteworthy that the ratings that were investigated were related to companies like DHFL, Yes Bank and ILFS. The issues by these companies raised huge sums of monies. Tampered ratings then would cost these investors who may otherwise may not have made investment.

SEBI debarred the MD for two years from being associated with stock market intermediaries. In any case, before SEBI presented its findings to the company, the Board of CARE had itself terminated the employment of the MD.

Some Unresolved Issues

The takeaways of this case then are several. One is how to ensure effectively that the rating and business team keep their distance. In this case, complaints brought matters to attention of SEBI. Helpful also were statements of rating team members who had expressed their frustration, as also evident from WhatsApp chats. Concern expressed also was that if there was a pushback by rating team members to such pressure, their jobs and further jobs prospects in this narrow industry would be hampered.

However, all in all, the SEBI order merely tackles the symptoms and not the cause. The core issue of conflict of interest of issuer-paying remains unresolved. If clients are paying large fees for the certificate, which represents profitable business for the CRAs, scope for subtle influence will always exist.

As stated earlier, this dilemma exists even for appointment of auditors. Here too, appointing companies pay, and so also for independent directors. The foundations of these pillars continue to be weak. And if 15 years after the 2008 financial crisis, a proper solution is still not found, such cases can be expected to recur and looking at it from a sense of cynicism would suggest that similar misdemeanours are going undiscovered.

Jayant Thakur is a chartered accountant. Views are personal and do not represent the stand of this publication.