[Sneha Rath is a 3rd-year student at National Law University, Odisha]
The SAT’s Order in the matter of Care Rating Agency (CARE) was challenged by SEBI before the Supreme Court of India (SC). While hearing the appeal, the SC observed that there was no question of law involved and the appeal was accordingly dismissed. In furtherance of this, the SC ruled that the reduction in penalty in the SAT’s Order "cannot be treated as a precedent in all other cases irrespective of the facts and circumstances of the case". Here, even when it is established that the matter before the SC involving CARE’s dereliction in the rating of Reliance Communication Limited (RCom) securities had no question of law to be discussed, it is of utmost significance to take reference from the IL&FS case to emphasize the probable consequences that could impact the investor market in India due to the SAT reducing the penalty charges despite expression of laxity and oversight by CARE in rating RCom’s securities.
Facts of the Matter
RCom had defaulted in its repayment of the principal amount of Rs. 375 crore and interest of Rs. 9.7 crore on February 7, 2017, and March 7, 2017, against the total amount of Rs. 2000 crore Non-Convertible Debenture (NCD) which was issued by it and was due to mature in February 2019. The delayed payment on April 10, 2017, resulted in the issuance of a show-cause notice (Notice) alleging CARE of having defaulted in timely monitoring the factors that affected the creditworthiness of RCom. The financial performance of RCom in its third quarter was displayed on the Stock Exchange. However, such information was not presented by CARE before the Rating Committee which was responsible for assigning ratings to RCom's securities. The Adjudicating Officer (AO) upon finding CARE at default and in violation of various regulations, imposed a penalty of Rs 1 crore for lack of due diligence. However, SAT ruled against this part of the AO’s Order by reducing the penalty to 10 lakhs and thereafter reasoned that such an instance was that of carelessness but not an oversight by CARE.
In the recent case of Prakash Gupta, the SC ruled that the SAT must provide a speaking order when ruling against SEBI’s opinion, and that deference whenever required should be paid to the regulator’s opinion as well. Emphasis was laid on the need to ensure that any overruling should occur only when a mala fide intention or arbitrariness is apparent in SEBI’s opinion. Although SAT did not entirely overrule SEBI’s Order in the present matter of CARE, its partial dissent has unequivocally raised a bone of contention regarding SAT’s ruling in matters concerning the regulation of Credit Rating Agencies (CRA) in India.
Mandatory Regulatory Compliances
Regulations 3, 15(1)&(2), 29(2)(b) and the Third Schedule on ‘Code of Conduct’ of Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 (CRA Regulation) mandate prudence and reasonableness on the part of CRAs by obliging them to regularly monitor the securities assigned to them and disseminate information on newly assigned ratings while ensuring that efforts are taken to protect the interest of the investors through fairness in rating, reasonable and adequate basis for performing rating evaluations, with the support of appropriate and in-depth rating researches ethically and professionally, and so on. Regulation 29(2)(b) of the Regulation warrant for examination of the appropriateness of the assigned ratings in light of non-compliance with the provisions of the CRA Regulation. Regulation 15 of the CRA Regulation read along with Regulation 8 of the Intermediary Guidelines, puts the onus on a CRA to continuously rate the securities during its lifetime and the need to publicize any information regarding change in the rating of such securities through press releases, websites, etc.
Further, SEBI’s Circular while reiterating the above points, warranted the requirement of minimum information, in writing, for the rating of securities, and the need to contact external entities for the same. One of the provisions of this Circular references the Operation Manual of CARE, which mentions that “a review may also be triggered by a major development in the company or in the industry, which may have a significant bearing on the credit-worthiness of the company”. Simultaneous reading of Point 5 in the Circular clarifies that CRAs must report about the company that does not provide information about its securities, thereby suggesting that such an event is a major development that has a significant bearing on the creditworthiness of the company. Thus, CARE should have notified on its website when RCom did not issue a written statement about the whereabouts of its securities, regardless of CARE’s confidence in RCom which was obtained by means other than a written statement.
Lack of Due Diligence by CARE
The SAT had observed that “the instant case is not to question the appropriateness of the rating given by the CARE but to find out as to whether the appropriate measures were taken timely”. The following findings from the evidence before AO (undisputed by SAT) suggest a lack of due diligence by CARE: RCom did not comply with the existing directions of SEBI to issue an NDS when requested by CARE, and CARE had an obligation to release information on its website about the same. Here, the NDS was an assurance of the fact that RCom was regular in making its debt payments, as this assurance also had a bearing on the creditworthiness of RCom's securities in the market. However, CARE did not follow the provisions of its Operation Manual to publish the same on its website nor verified from a publicly-available source regarding the status quo of RCom's debt payment, but instead telephonically verified with RCom regarding the same. The subsequent decision of CARE to not downgrade the rating of RCom securities based on the telephonic conversation between them was in clear violation of the statutory requirement for having the ratings and information supporting the same, in writing. CARE did not utilize the opportunities available at its disposal to make this issue known to the investors. Thus, it is a case of clear laxity and intentional oversight on the part of CARE.
Lessons from the IL&FS Debacle
The case of default in a timely rating of securities of IL&FS and its subsidiaries IFIN by three CRAs i.e. ICRA, CARE, and India Ratings during 2012-18 had drawn the attention of SEBI to introduce several instructions for the regulation of the CRAs in the Indian securities market. This situation is analogous to the issue in the rating of RCom's NCDs by CARE which is being discussed in the present article. In the case of IL&FS, CRAs (including CARE) were reported to have consistently assigned its securities with high ratings even when concerns were raised for IL&FS financial stress and liquidity position over a significant period. The observations made by SEBI reveal that overdependence of CRAs on the statements provided by IL&FS led to their failure in a timely rating of their debt securities which ultimately resulted in shaking the "investors' faith in the reliability of credit ratings in the context of the corporate debt market". Here, although IL&FS had an established reputation in the construction sector, this could not prevent them from misleading the three established CRAs in India into believing that they were financially stable for a significant period i.e. from 2012-2018. Thus, CARE should have exercised its prudence in the case of RCom, based on its experience with IL&FS.
Analysis & Conclusion
SEBI in the case of IL&FS had ruled that it was the “lethargic indifference and needless procrastination and laxity” of CRAs that led to the IL&FS debacle. In consequence, the faith of the investors in the CRAs had hit an all-time low. Investor protection is a wide array of mechanisms that are aimed at protecting investors against unscrupulous activities in a securities market such as disclosure violations, insider trading, or conduct of intermediaries like CRAs that might be in derogation of the rules and regulations of SEBI.
The securities regulator, SEBI, and the Appellate Adjudicating Authority SAT function to protect investors' rights under the law. However, in the present matter, SAT’s decision to reduce the penalty from 1 crore to 10 lakhs, lacked objective reasoning. CARE's dereliction from its statutory obligations was not a one-off instance, as discussed above. Furthermore, it must be borne in mind that the ratings assigned by CRAs suggest that the securities reviewed by them are of the highest quality and that the information disseminated is true to the best of their knowledge. Investors rely on these ratings that are indicative of the creditworthiness of the companies, thereby allowing them to make reasonable investment decisions that align with their needs and requirements.
Thus, SC’s Order upholding SAT’s observations suffers from a fundamental flaw in its reasoning, as this might set a precedent for market players (here, CRAs) in the securities industry that they can approach the SAT every time the order of AO penalizes them, to avoid serious penalties for dereliction from obligations of much serious nature vested in them.