Summary: The revised guidelines for Credit Rating Agencies (CRAs) by SEBI focus on addressing the classification of “technical defaults” to improve accuracy and consistency in credit ratings. Historically, CRAs have been required to recognize even a one-day delay in debt payments as a default, potentially leading to misinterpretation of an issuer’s creditworthiness due to minor operational issues. SEBI’s new consultation paper, released on July 25, 2024, proposes the omission of “technical defaults” from the guidelines, following recommendations from the Working Group on CRAs for Ease of Doing Business (EODB). This change aims to standardize the application of CRA policies, ensuring a fairer assessment of credit risk and preventing unnecessary market panic. CRAs will be required to conduct more thorough investigations into payment delays, distinguishing between genuine financial distress and minor operational issues, thus enhancing transparency and building greater trust among investors and issuers. The amendment, which is still under consultation, is expected to promote market stability and fairness, while also providing issuers with the opportunity to maintain credibility and investor confidence despite minor technical hiccups. Public feedback will be essential in refining and implementing these changes effectively.
Introduction
It is widely acknowledged that rating systems are useful for evaluating the credit risk attached to debt or bank loan instruments. The best way to assess a credit rating agency’s (CRA) performance is to look at its default and transition data, which are based on the rated debt’s “event of default” and how default was recognised.
As per Annexure 11 of the SEBI Master Circular for CRAs dated May 16, 2024, definition of default for debentures/bonds is specified as “A delay of 1 day even of 1 rupee (of principal or interest) from the scheduled repayment date”.
SEBI in its Master Circular provides that After a default is cured and payments regularised, A CRA may upgrade the rating from default to non-investment grade after a period of 90 days based on the company’s satisfactory performance. It may deviate from the said period of 90 days, subject to formation of detailed policy, which may include scenarios like ‘technical defaults’ among other things.
Technical defaults typically refers to situation where an issuer fails to fulfil certain monetary or non-monetary obligations that do not project issuers’ overall creditworthiness. Examples include system failures, bank strikes, force majeure events etc. Classifying issuers under “default” in case of technical defaults may result in unintended consequences like sending the wrong impressions to the market regarding the credit worthiness of the issuer. As submitted by Working Group on CRAs such events are unpredictable and are not/cannot be foreseen by CRAs in their forward-looking assessment of business, financial and management risks to arrive at credit ratings and will not show a fair representation of the CRA’s default statistics.
Question arises as to why not include a period of forbearance after the scheduled payment date in understanding of default by CRAs when the default is technical, such as due to operational issues, incorrect information of the investor’s account, a bank strike or any notice received from government to freeze the investor’s account.
The answer to this is two fold. Firstly, the recognition of default is crucial considering the systematic effects of a default on the financial system. A rating of 5 out of 10 in a system where default is defined as one day’s late payment requirement will be interpreted very differently from a rating of 5 out of 10 in a system that takes a grace period into account. Early recognition of default, even if it is on account of some operational failure or technical default, is crucial as it will support higher levels of post default recovery. Secondly, “Technical defaults” cannot be defined in this ever changing financial infrastructure and regulation to include every aspect. There will always be scope for confusion and inconsistencies. So, from the investor’s perspective, the best way available is to recognise a delay in payment as default and then upgrade the rating based on policy as framed by CRAs in compliance with post default curing period guidelines as given in Master Circular on Credit rating Agencies dated May 16, 2024.
SEBI’s consultation paper
Accordingly, SEBI on July 25, 2024 released a consultation paper proposing the omission of ‘technical default’ from the previously issued Master Circular for Credit Rating Agencies (CRAs). The amendment so proposed is based on the recommendations of the Working Group of CRAs for Ease of Doing Business (EODB). It aims to standardise the policy application of CRAs and ensure prevention of unintended market consequences arising from technical defaults. This will ensure uniformity in policy application of CRAs in upgradation of default rating to investment grade rating in a timely manner, limiting the scope for confusion and making it easier for CRAs to deviate from the 90 days waiting period before upgrading the rating.
When a company defaults , its credibility in the market is significantly damaged because of reduced ratings. Timely upgradation in ratings of the company acts as a incentive for the company to address the cause of default promptly. CRAs will need to conduct more thorough investigations into the reasons behind payment delays or defaults, distinguishing between genuine financial distress and minor operational issues. By providing detailed reasons for default occurrences and rating actions, CRAs can enhance transparency and build greater trust with investors and issuers. The amendment provides for fairer assessment of the issuer’s credit risk. Issuers can maintain their credibility in the market, avoiding unnecessary panic and retaining investor confidence even in the face of minor operational hiccups. This aligns with broader goals of market stability, fairness and promotion of ease of doing business.
Conclusion
The SEBI’s proposal to omit ‘technical default’ from the Master Circular for CRAs represents a significant step towards improving accuracy, consistency and fairness of credit ratings. This amendment addresses the key concerns raised by Working Group and aims to prevent unintended market consequences and enhance trust. For CRAs , issuers and investors alike, this promises a more stable and reliable environment. This amendment is under consultation, public feedback will be crucial to ensure its effectiveness and to ensure any emerging challenges.
Key Words: Financial Markets, SEBI, Regulation
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