SEBI (Credit Rating Agencies) Regulations, 1999

What this chapter covers

This chapter carries 3 per cent of the III-A examination.

LEARNING OBJECTIVES: After studying this chapter, you should know about the: Conditions for getting registered as a credit rating agency · Restrictions on rating of securities issued by promoters · Code of conduct for credit rating agencies · Guidelines for credit rating agencies

21.1 Registration

Credit rating agencies are body corporate that is engaged in, or proposes to be engaged in, the business of rating of securities that are listed or proposed to be listed on a stock exchange recognized by SEBI.

Rating means an opinion regarding securities, expressed in the form of standard symbols or any standardised manner, assigned by a credit rating agency and used by the issuer of such securities, to comply with the requirement specified by these regulations.

An opinion, in standard symbols — which is why the code requires an agency to state that the ratings do not constitute recommendations to buy, hold or sell any securities.

Who may promote a rating agency

SEBI shall not consider the application... unless the applicant is promoted by a person belonging to any one of the following categories:

• (a) a public financial institution, as defined in section 2(72) of the Companies Act, 2013.

• (b) a scheduled commercial bank included for the time being in the second schedule to the Reserve Bank of India Act, 1934.

• (c) a foreign bank operating in India with the approval of the Reserve Bank of India.

• (d) a foreign credit rating agency incorporated in a Financial Action Task Force (FATF) member jurisdiction and recognised under their law, having a minimum of five years' experience in rating securities.

• (e) any company or a body corporate, having a continuous net worth of minimum Rs. One hundred crores as per its audited annual accounts for the previous five years prior to the filing of the application.

Rs. 100 crore, continuously, for five years — the first review question.

Note the two five-year requirements — a foreign rating agency needs a minimum of five years' experience in rating securities; a corporate promoter needs five years of the required net worth.

Eligibility criteria

• a) the applicant is set up and registered as a company under the Companies Act, 2013.

• b) the applicant has, in its Memorandum of Association, specified rating activity as one of its main objects.

• c) the applicant has a minimum net worth of rupees twenty-five crore.

• d) the applicant has adequate infrastructure, to enable it to provide rating services.

• e) the applicant and the promoters of the applicant have professional competence, financial soundness and general reputation of fairness and integrity in business transactions, to the satisfaction of SEBI.

• f) neither the applicant, nor its promoter, nor any director of the applicant or its promoter, is involved in any legal proceeding connected with the securities market, which may have an adverse impact on the interests of the investors.

• g) neither the applicant, nor its promoters, nor any director, of its promoter, has at any time in the past been convicted of any offence involving moral turpitude or any economic offence.

• h) the applicant has, in its employment, persons having adequate professional and other relevant experience.

• i) neither the applicant nor any person directly or indirectly connected with the applicant has in the past been (i) refused by SEBI a certificate under these regulations or (ii) subjected to any proceedings for a contravention of the Act.

• j) the applicant, in all other respects, is a fit and proper person.

• k) grant of certificate to the applicant is in the interest of investors and the securities market.

• l) the promoter of the credit rating agency has a minimum shareholding of 26% in the credit rating agency.

Twenty-six per cent — the promoter must keep real skin in the game, since the promoter's standing is one of the reasons the agency was licensed at all.

Validity and fees

The certificate of registration granted under the regulation shall be valid unless it is suspended or cancelled by SEBI.

Permanent until suspended — the second review question.

Application fee for grant of registration is Rs. 50,000 and the registration fee is Rs. 26,66,700. Recurring registration fee for every three years is Rs.15,00,000.

Rs. 15 lakh every three years — the third review question.

**Registration fees are paid within fifteen days from the date of receipt of intimation from SEBI, and the recurring fee is due for every three years from the sixth year of the date of grant of certificate of registration.

**And: the credit rating agency shall at all times maintain a net worth of Rs 25 crores.

21.2 General obligations

Agreement with the client

Every credit rating agency shall enter into a written agreement with each client whose securities it proposes to rate, containing:

• a) Rights and liabilities of each party in respect of the rating of securities.

• b) Fees which shall be charged by the credit rating agency.

• c) the client shall co-operate with the credit rating agency in order to enable the latter to carry out periodic review of the rating during the tenure of the rated instrument.

• d) That the client shall co-operate... to arrive at, and maintain, a true and accurate rating and shall provide to the latter, true, adequate and timely information.

• e) The credit rating agency shall disclose to the client the rating assigned to the securities of the latter through regular methods of dissemination, irrespective of whether the rating is or is not accepted by the client.

• f) The client shall disclose, in the offer document (i) the rating assigned to the client's listed securities by any credit rating agency during the last three years; and (ii) any rating is given in respect of the client's securities by any other credit rating agency, which has not been accepted by the client.

• g) The client shall obtain a rating for any issue of debt securities in accordance with the relevant regulations.

• h) The client shall provide explicit consent to the credit rating agency to obtain the details related to their existing and/or future borrowing of any nature, its repayment and delay or default if any... either from the lender or any other statutory/non-statutory organisation.

Clauses (e) and (f) together stop rating shopping. An unaccepted rating is published anyway, and past ratings over the last three years plus any unaccepted rating must appear in the offer document.

Monitoring and review

Every credit rating agency shall, during the lifetime of securities rated by it continuously monitor the rating of such securities unless the rating is withdrawn.

Dissemination: agencies shall also disseminate information regarding newly assigned ratings, and changes in earlier ratings promptly through press releases and websites, and for listed companies such information shall also be provided simultaneously to the concerned regional stock exchange and to all the stock exchanges where the said securities are listed.

Review: every credit rating agency shall carry out periodic reviews of all published ratings during the lifetime of the securities unless the rating is withdrawn.

And where the client will not help. If the client does not co-operate with the credit rating agency so as to enable the credit rating agency to comply with its obligations, the credit rating agency shall carry out the review on the basis of the best available information or in the manner as specified by SEBI. It must also disclose this: if owing to such lack of co-operation, a rating has been based on the best available information, the credit rating agency shall disclose to the investors the fact that the rating is so based.

Non-cooperation is no exit. The review still happens, and investors are told the basis.

Withdrawal is restricted: a credit rating agency shall not withdraw a rating so long as the obligations under the security rated by it are outstanding, except where the company whose security is rated is wound up or merged or amalgamated with another company, or as may be specified by SEBI.

Internal procedures, disclosure and records

Every credit rating agency shall frame appropriate procedures and systems for monitoring the trading of securities by its employees in the securities of its clients, to prevent contravention of The SEBI (Insider Trading) Regulations, 2015, The SEBI (Prohibition of Fraudulent and Unfair Trade Practices...) Regulations, 1995 and other laws relevant to trading of securities.

Rating definitions and rationale. Every agency shall make public the definitions of the concerned rating, along with the symbol; state that the ratings do not constitute recommendations to buy, hold or sell any securities; and make available to the general public information relating to the rationale of the ratings, which shall cover an analysis of the various factors justifying a favourable assessment, as well as factors constituting a risk.

Both sides of the case — what supports the rating and what threatens it.

Submissions to SEBI: comply with guidelines and directions; furnish information within a period specified by SEBI or, if none, within a reasonable time; and at the close of each accounting period, furnish to SEBI copies of its balance sheet and profit and loss account.

Records — Regulation 21. They are kept for a minimum period of five years:

• The balance sheet, profit and loss account and auditor's report for each accounting period.
• Copy of the agreement entered into, with each client.
• Information supplied by each of the clients.
• Correspondence with each client.
• Ratings assigned to various securities including up-gradation and down-gradation (if any).
• Rating notes considered by the rating committee.
• Record of decisions of the rating committee.
• Letter assigning rating.
• Particulars of fees charged for rating.

The agency must also intimate to SEBI the place where the books of account, records and documents... are kept.

Note the rating committee papers — the notes and the decisions, which is how a rating decision can be examined afterwards.

21.3 to 21.5 Compliance officer, audit and confidentiality

Every credit rating agency shall appoint a compliance officer who shall be responsible for monitoring the compliance of the Act, rules and regulations, notifications, guidelines, instructions etc. issued by the Board or the Central Government. The compliance officer shall immediately and independently report to SEBI any non-compliance observed by him.

Auditor's report: the agency shall, within two months from the date of the auditor's report, take steps to rectify the deficiencies if any, made out in the auditor's report.

Confidentiality: it shall treat, as confidential, information supplied to it by the client and no credit rating agency shall disclose the same to any other person, except where such disclosure is required or permitted by under or any law for the time being in force.

21.6 The rating process

Every credit rating agency shall specify the rating process and file a copy of the same and any modifications or additions made therein from time to time with SEBI for the record.

The credit rating agency shall, in all cases, follow a proper rating process.

They should have professional rating committees, comprising members who are adequately qualified and knowledgeable to assign a rating, and all rating decisions, including the decisions regarding changes in rating, shall be taken by the rating committee.

Every credit rating agency shall have qualified analysts to carry out a rating assignment · shall inform SEBI about new rating instruments or symbols introduced by it · shall, while rating security, exercise due diligence in order to ensure that the rating given... is fair and appropriate · and shall not rate securities issued by it.

The November 2019 governance circular

MD/CEO of the Credit Rating Agency (CRA) shall not be a member of the rating committee of the CRAs. This aims to ensure enhanced governance and accountability of CRAs.

**And: the 'Rating committees' of a CRA shall report to a Chief Ratings Officer (CRO).

Board composition: one-third of the board of a CRA shall comprise of independent directors if the board is chaired by a non-executive director. In case the board of the CRA is chaired by an executive director, half of the board shall comprise of independent directors.

One-third or one-half, depending on who chairs.

Meeting records: during the rating process, CRAs shall record minutes of the meeting with issuer management and incorporate them in the rating committee note. And CRAs shall meet the audit committee of the rated entity, at least once a year, to discuss issues including related party transactions, internal financial control and other material disclosures made by the management, which have a bearing on the rating of the listed NCDs.

At least once a year with the audit committee — a channel that does not run through the management being rated.

Changes and disclosure: rating definition, as well as the structure for a particular rating product, shall not be changed by a credit rating agency, without prior information to SEBI; and the agency shall disclose to the concerned stock exchange through press releases and websites for general investors, the rating assigned to the securities of a client, after periodic review, including changes in rating, if any.

Shareholding in another rating agency

Regulation 24A: a credit rating agency shall not (a) directly or indirectly, hold 10 per cent or more shareholding and/ or voting rights in any other credit rating agency, or (b) have representation on the Board of any other credit rating agency.

One exception, and it is narrow: an agency may, with the prior approval of SEBI, acquire shares and/ or voting rights exceeding 10 per cent in any other credit rating agency only if such acquisition results in a change in control in the credit rating agency whose shares are being acquired.

An outright takeover is permitted; a stake short of control is not — because a minority holding gives influence without responsibility.

And the rule follows the shareholder too: a shareholder holding 10 per cent or more shares and/ or voting rights in a credit rating agency shall not hold 10 per cent or more shares and/ or voting rights, directly or indirectly, in any other credit rating agency, save that the said restriction shall not apply to holdings by Pension Funds, Insurance Schemes and Mutual Fund Schemes.

21.7 Rating securities of promoters and connected entities

No credit rating agency shall rate a security issued by its promoters.

And where the promoter is a lender: where the promoter is a lending institution, its Chairman, director or employee shall not be a Chairman, director or employee of the credit rating agency or its rating committee.

Connected entities. The agency shall not rate a security issued by an entity, which is: (a) a borrower of its promoter; or (b) a subsidiary of its promoter; or (c) an associate of its promoter if: (i) there are common Chairman, Directors between the credit rating agency and these entities, (ii) there are common employees, (iii) there are common Chairman, Directors, Employees on the rating committee.

Associates and subsidiaries of the agency itself: no credit rating agency shall rate a security issued by its associate or subsidiary if the credit rating agency or its rating committee has a Chairman, Director or employee who is also a Chairman, Director or employee of any such entity.

One carefully fenced exception. The agency may... rate security issued by its associate having a common independent director with it or rating committee if, - i. such an independent director does not participate in the discussion on rating decisions, and ii. the Credit Rating Agency makes a disclosure in the rating announcement of such associate (about the existence of common independent director) on its Board or of its rating committee, and that the common independent director did not participate in the rating process or the meeting of its Board of Directors or in the meeting of the rating committee when the securities rating of such associate was discussed.

Recusal plus disclosure, and only for an independent director — one who, apart from receiving remuneration as a director, does not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries.

21.8 Code of conduct

Twenty-three clauses under Regulation 13. The agency shall make all efforts to protect the interests of investors · observe high standards of integrity, dignity and fairness · fulfil its obligations in a prompt, ethical and professional manner · and at all times exercise due diligence, ensure proper care and exercise independent professional judgment in order to achieve and maintain objectivity and independence in the rating process.

On the rating itself. It shall:

• Have a reasonable and adequate basis for performing rating evaluations, with the support of appropriate and in-depth rating researches and maintain records to support its decisions.
• Have in place a rating process that reflects consistent and international rating standards.
• Keep track of all important changes relating to the client companies and shall develop efficient and responsive systems to yield timely and accurate ratings, monitoring closely all relevant factors that might affect the creditworthiness of the issuers.
• Disclose its rating methodology to clients, users and the public.

On competition — the clause the fourth review question turns on: the agency shall not indulge in any unfair competition nor shall it wean away from the clients of any other rating agency on assurance of higher rating.

Assuring a higher rating to win business is a violation — the answer is Yes.

On conflicts: disclose to the clients, possible sources of conflict of duties and interests, which could impair its ability to make fair, objective and unbiased ratings, and ensure that no conflict of interest exists between any member of its rating committee participating in the rating analysis and that of its client.

Towards SEBI and the public:

• No exaggerated statement about qualifications, capability or achievements.
• No untrue statement, suppress any material fact or make any misrepresentation in any documents, reports, papers or information furnished to SEBI, stock exchange or the public at large.
• Prompt information to SEBI of proceedings alleging material breach or non-compliance.
• Knowledge and competence, with compliance with the award of the Ombudsman passed under the... (Ombudsman) Regulations, 2003.
• No misuse of any privileged information including prior knowledge of rating decisions or changes.

Two restrictions on other business: the agency shall not render, directly or indirectly any investment advice about any security in the publicly accessible media, and shall not offer fee-based services to the rated entities, beyond credit ratings and research.

Note the difference from other intermediaries — for a rating agency public investment advice is barred outright, not merely subject to disclosure of positions.

Plus:

• Prompt notice to clients of registration or penal changes with transfer of outstanding business.
• Maintain an arm's length relationship between its credit rating activity and any other activity.
• An internal code of conduct extending to procedures and guidelines in relation to the establishment and conduct of rating committees and the duties of the officers and employees serving on such committees.
• Adequate freedom and powers to its compliance officer.
• Senior management access to information.
• Good corporate policies and corporate governance.
• No part in creation of false market, price rigging or manipulation, or dissemination of any unpublished price sensitive information... unless required, as part of the rationale for the rating accorded.

21.9 ESG Rating Providers

Environmental, Social and Governance Ratings (ESG Ratings) means the rating products that are marketed as opinions about an issuer or a security, regarding its ESG profile or characteristics or exposure to ESG risk, governance risk, social risk, climatic or environmental risks or impact on society, climate and the environment, that are issued using a defined ranking system of rating categories, whether or not these are explicitly labelled as "ESG Ratings".

Whether or not explicitly labelled — the substance governs.

"ESG Rating Provider" means a person which is engaged in or proposes to engage in the business of issuing ESG ratings, and under Regulation 28C, SEBI grants a separate Certificate of Registration as "ESG Rating Provider", with a separate Code of Conduct for ESG Rating Provider in Seventh Schedule of the Regulations.

Case 21.1 — SEBI orders against three rating agencies in IL&FS

The background. The crisis at diversified IL&FS, whose board was superseded by the government, came to light in September 2018. The case concerns the default by IL&FS and its subsidiary IL&FS Financial Services on their obligations in respect of commercial paper (CP), inter-corporate deposits (ICDs) as well as on interest payments related to non-convertible debentures (NCDs).

**In December 2019 SEBI imposed a fine of Rs 25 lakh each ICRA, CARE Ratings and India Ratings and Research Pvt Ltd in the matter saying the default by IL&FS occurred due to "lethargic indifference and needless procrastination and laxity" of these rating agencies.

Then SEBI reviewed its own order. It observed that the penalty levied by AO appeared to be erroneous and not commensurate with the overall impact these violations had on the market, and issued show-cause notices to rating agencies, "calling upon the reasons why the penalty amount should not be enhanced".

The findings. IL&FS is a "systemically important" Non-Deposit Accepting Core Investment Company registered with RBI which operated through more than 250 subsidiaries across engineering and construction, financial services, transportation, energy etc., and the scale, diversity of operations and business model of the IL&FS group makes it a kind of a unique company with no real comparable peers in India. As at March 31, 2018 it had a consolidated borrowing of over Rs 91,000 crore.

The rating failure. NCDs, which were given the highest rating by the rating agencies and which continued till August 2018, were abruptly downgraded to default grade in September 2018, and the default by IL&FS and its steep downgrade by the rating agencies in a matter of 25-40 days has completely changed the risk perception of the corporate bond market.

From highest rating to default in 25–40 days.

The exposure. As on the date of downgrading the ratings of NCDs and CPs of IL&FS and IFIN to 'D' on September 17, 2018, the outstanding amount of securities so rated by ICRA, India Ratings and CARE amounted to Rs 11,725 crore, Rs 16,270 crore and Rs 20,942 crore, respectively.

The reasoning on penalty. The lapses have resulted in real and severe financial loss to investors and shaken the investors' faith in the reliability of credit ratings in the context of the corporate debt market. "Had the rating agencies downgraded the ratings at the appropriate time and thereby forewarned the investors, the impact of the default on investors who invested in AAA-rated instruments, could not have been this severe."

And the sentence worth memorising: the role of a CRA (credit rating agency) is that of a financial 'gatekeeper' and any inaccuracy in the rating processes adopted by the CRA has a significant negative impact on the securities market.

**The impact is not limited to the monetary loss caused to the investors of NCDs issued by IL&FS but has had wider and larger ramifications on the investor confidence, the financial sector and the securities markets as a whole; the adjudicating officer has failed to give due weightage to the magnitude of the loss caused to the investors, despite the same being a specified parameter under the SEBI Act; and imposition of lighter penalties on these rating agencies, tends to create a disadvantage for the other CRAs who may have complied with the law.

"The Board needs to safeguard market integrity, and when scams of this size occur, which questions and challenges the regulatory and supervisory framework put in place with respect to CRAs, it is but imperative, to subject the conduct of CRAs to tight scrutiny and restore investor confidence by enhancing the penalty."

The substantive finding: the three failed to exercise proper skill, care, and due diligence while discharging its responsibilities as a credit rating agency and violated the provisions of the code of conduct of the CRAs.

Order: by orders dated September 22, 2020, SEBI enhanced the penalty amount to Rs 1 crore each on three rating agencies, ICRA, CARE and India Ratings.

The chapter's review questions confirm that a corporate promoter needs a continuous net worth of Rs. 100 crores for the previous five years; that registration is valid permanently until suspended; that the renewal fee is Rs. 15 lakhs; and that assuring clients a higher rating than competitors is Yes, a violation of the code.