Several challenges in making CRAs financially liable to investors: Experts

Even as legal and regulatory experts mull over the need to impose civil liability over credit rating agencies (CRAs), the experience of several countries in this regard has been mixed. 

“It is difficult to hold credit rating agencies liable for mistakes they have been making,” says Matthias Lehmann, director, Institute of Private International and Comparative Law, University of Bonn, Germany. Lehmann says it not easy for investors to prove — without full access to rating methodology — that the rating agency has committed a mistake. It is equally difficult for an investor to prove that the damages suffered were because of the mistakes of the agency, given the many influences that are at play in deciding the price of securities.

However, many experts still feel imposing litigation risk, along with reputational risk, will help discipline CRAs better. Experts point out that the Companies Act, 2013, has provisions to impose civil liability on auditors. “I don’t see why a similar civil liability regime should not apply to CRAs,” asks researcher Pratik Datta. 

Shreya Prakash, research fellow, Vidhi Centre For Legal Policy, says the market regulator — Sebi — already has wider powers to regulate CRAs. “However, the missing piece in the Indian context is creating a timely and efficient mechanism for investors who rely on credit ratings, and make these agencies liable for compensation to them,” she adds. 

Sandeep Parekh, founder-managing partner, Finsec Law Advisors, explains why many credit rating agencies have been found wanting in their advice to investors in recent months. “In India there has been a hole in the regulation of companies which is now being corrected. The light touch regulations, till recently, meant that companies and banks were not obliged to accurately report defaults,” he says. As a result, rating agencies found it difficult to find events of default. However, as the regulatory noose tightened, the sudden unravelling of massive defaults — hidden for years as off the book re-structuring — lead to drastic changes in ratings, taking investors by surprise. 

“Rating agencies should indeed be penalised for incompetence, but not where they have been starved of correct information by the companies,” says Parekh. The problem, he adds, needs to be resolved on three fronts — banks, companies and rating agencies.

Vaibhav Kakkar, partner, L&L Partners Law Offices, too, feels it is best not to be reactive and look for a scapegoat. Instead, one should introspect to strengthen the existing processes and procedures that regulate credit rating agencies.

Experts say there are several practical challenges when one makes CRAs liable to investors. Ratings are only opinions on the creditworthiness of the securities, and do not constitute advice to invest in a security. “Therefore, CRAs in some jurisdictions argue that they cannot be held liable for merely giving an opinion or it would be contrary to their freedom of speech,” says Prakash.

Under the ‘issuer pays’ model, CRAs enter into contractual obligation with the issuer to assign a rating. CRAs argue that they cannot foresee who will rely on the rating and the fee earned by them is not commensurate to the potential liability. Making CRAs liable to investors would result in imposing unforeseeable liabilities on them, say experts.

“While appropriate legislation can tackle these challenges, the practical challenge that CRAs will stop rating activity still remains,” says Prakash.

Till now the experience of other countries in making CRAs liable has not been very positive. Experts say that in the United States, the imposition of liability was not accepted well by the market, and CRAs refused to provide ratings in the registration statements of asset-backed securities. In response, the US Securities and Exchange Commission suspended the implementation of this part of the legislation. Experts say no civil liability claim by investors has been successful in the UK since the tests to prove liability towards investors are hard to establish.  The experience has been similar in the European Union. “The private cause of action provided for in the European credit rating agency regulation has rarely been used,” says Lehmann.

If the regulator decides to make CRAs liable, the provisions, say experts, have to ensure that liability should be imposed only in the cases where the agency has not performed its duty as envisaged in the law or did not comply with the standards of its own rating methodologies. “Civil liability must be imposed on CRAs for blatant factual or procedural negligence but not merely for giving an opinion which with the advantage of hindsight has been found to be wrong,” says Datta. Such provisions should be used only in extreme cases, he adds. However, this is easier said than done.

First, it becomes important to identify contraventions. “Specific contraventions of duties should be identified that could lead to compensation,” says Prakash. Experts say there should be clarity on whether the CRA committed the contravention with intent, or if negligence is enough. Some jurisdictions, like the UK, require that the CRAs should have committed the infringement intentionally, or with gross recklessness, for the matter to be liable. 

Further, as the burden of proof lies with the investor, there should be clarity on the conditions for the investors to sue and claim compensation. “Jurisdictions, such as the EU, require that the investor should have suffered a loss caused because of the reliance on rating,” says Prakash.

It is also important to identify the limits on liability. Experts say the compensation that CRAs would have to pay in event of contravention should be limited in accordance with the foreseeability of damage, etc. “The UK gives an exhaustive list of such situations,” adds Prakash.

Many experts feel that India could well pick up few lessons from the experience of other jurisdictions. Lehmann’s advice is to adopt a much more straight-forward and simple to use cause of action with extra-territorial reach. “Do not copy the European model which is way too complicated. Introduce a burden of proof in favour of the investor who has bought or sold wrongly rated instruments,” he says. Datta is in favour of exploring alternative policy solutions for making CRAs more accountable to investors. Prakash argues that if the primary goal (of making CRAs liable) is to deter misconduct, perhaps the Securities and Exchange Board of India should consider increasing its own capacity to proceed against such errant agencies and look at broadly improving the investor litigation culture in the country.

Experts add that it is also prudent to deal with this issue as part of a package of reforms looking to remedy issues that inflict regulatory environment for CRAs. This includes issues surrounding conflict of interest in the underlying model of rating. Some feel that treating CRAs on lines similar to that of auditors could do the trick. “Remove conflict of interest situations arising from rating and non-business; put a cap on the number rating clients, or make it mandatory for companies to change rating agencies every three years,” suggests a legal expert who has several CRAs as a client. The sum of these reforms is likely to improve the overall regulatory environment for CRAs, say experts.