Can credit rating agencies be liable for defaults? SAT to give its verdict

The Securities Appellate Tribunal (SAT), which hears appeals of securities markets, will render its verdict on liability of credit rating agencies (CRAs) in case of a debt market default. In September, Sebi had imposed a fine of Rs one crore on Brickworks, a CRA for not taking timely action in several instances. In its order, Sebi Said Brickworks had not conducted proper due diligence. Brickworks has now moved SAT seeking relief on this order.

Passing an interim order in the matter SAT opined “questions” arise in the matter whether a rating agency can be held liable for a credit default even if all the internal procedures were followed and there is no ‘mala fide’ intention on the part of CRA. The case would set an important precedent for similar matters in future, say legal experts.

“In this instant case, we find that a specific finding has been given that there is no malafide on the part of the appellant (Brickworks),” noted SAT in its interim order dated December 2. “Nonetheless, the performance of the appellant as credit rating agency has been seen and judged…on basis of the alleged default committed by him (one of the bond issuers),”

SAT stayed the Rs one crore penalty on Brickworks for now and instead has asked the agency to deposit Rs 20 lakh pending final decision which is expected in January.

The development assumes significance as credit rating agencies are currently locked in legal tussles with Sebi atleast in four different cases. Post the IL&FS default, Sebi has gone after the rating agencies for not being able to predict defaults even in cases where there are visible indicators suggesting deterioration in the financial status of bond issuer.

However, the rating agencies have been arguing that their ratings are based on various information collected from debenture trustees and public disclosure documents of the bond issuers. They say, if there is lack of information or if they are fed false information, they shouldn’t be held responsible.

Legal experts say, the current definition of due diligence for CRAs is vaguely worded and SAT’s interpretation on the matter would help the rating agencies.

“A clear definition of the term due diligence will certainly help credit rating agencies in formulating their policies,” said Moin Ladha, partner, Khaitan & Co. “The same will however have to be inclusive and principle based to bring within its ambit all possible situations,”

To be sure, Sebi cannot penalise a rating agency based on a rating call taken. Just like how an equity brokerage cannot be made liable for a buy or sell call it has given on a stock. However, Sebi can take action against a CRA, if it did not follow proper due diligence while arriving upon a rating.

“If Sat upholds the Sebi order in the matter, it would mean CRAs will be required to take a significantly higher degree of care while assigning a rating ,” he said adding “This will also need CRAs to do independent analysis of documents rather than relying on third parties like banks, debenture trustees etc,”

In September, Sebi had pulled up Brickworks after a joint inspection conducted by the market regulator and Reserve Bank of India (RBI) observed several compliance lapses. To be more specific, the adverse findings were in the rating decisions taken by Brickworks in the case of Essel Group Entities, Diamond Power Infrastructure and Great Eastern Energy Corporation.