CREDIBILITY OF THE IPO GRADING: TIME TO RETHINK

KARTIKEY MAHAJAN
&
MALLIKA ANAND

Prologue
Initial Public Offer (hereinafter as ‘IPO’) in the new regime (which started as an innovation) has
to be mandatorily graded by a Credit Rating Agency (hereinafter as ‘CRA’). This optimization of
the IPO by the Securities and Exchange Board of India (hereinafter as ‘SEBI’) has been seen as a
market innovation to ensure the credibility of the offer and to protect and guide the investor. The
motivation for the proposal of the mandatory IPO Grading by SEBI lies in the legal mandate of
‘investor protection’ cast upon it under Sections 11 and 11A of the SEBI Act, 1992.1 This step of
investor protection if carried out effectively would make India as one of the most transparent and
efficient capital markets of the world. However with the results produced, this is truly not the
case.

Part I analyses the meaning and various dimensions of IPO grading. Part II critically examines
the concept of IPO grading with respect to CRA’s, including the various arguments which the
analysts hold against it and that of the authors. In Part III, the authors brings forth the analysis by
exhibiting the inconsistency in the results of the grading system and the final part is the
conclusion.

I. IPO Grading –Meaning and Importance

SEBI is the first market regulator to introduce the concept of IPO grading. From being an
optional process at its inception it has become a mandatory process from May 2007. IPO grading
is a service that provides an ‘independent’ assessment of fundamentals regarding quality of

1
Tarun Jain & Raghav Sharma, Mandatory IPO Grading: Reflections from the Indian Capital Markets, ICFAI
Journal of Corporate and Securities Law, Vol. 5, No. 4, pp. 8-22, November 2008.

Electronic copy available at: http://ssrn.com/abstract=1609817

equity shares offered to aid comparative assessment that would prove useful as an information
and investment tool for investors.2 This assessment is carried out as already mentioned, by the
independent credit rating agencies. Moreover, such a service is particularly useful for assessing
the offerings of companies accessing the equity markets for the first time where there is no track
record of their market performance.3 This way the investor, by placing reliance on the IPO
grading, can decide whether the particular offer has potential to bring him returns or not. The
grades assigned represent a relative appraisal of the ‘fundamentals’ of that issue in relation to the
universe of other listed equity securities in India.

The grade, reflective of the ‘issue quality’, is based on an indeterminate and non-quantifiable
concept of ‘fundamentals of the issuer’ and is an outcome of the assessment of factors which are
in turn only qualitative guides to the security being graded.4 This grade also helps in
determination of the price of the IPO. The factors on which the grades are being based upon is
however, not exhaustive as the market is a fluid concept. So providing an exhaustive list of
factors which are influential in assigning the grades is a task too tedious and impractical, but an
estimation of the underlying strength of the security requiring gradation has to be based on
certain core factors which are pragmatic to be identified.

The factors identified by SEBI5 in this regard are; (1) business prospects and competitive
position of the company; (2) risks and prospects of new projects; (3) company’s financial
position; (4) quality of management; (5) corporate governance practices; and (6) compliance and
litigation history. While growth prospects of the industry and financial strength are some of the
quantitative parameters, qualitative parameters such as management capability also provide
critical input in determining a grade.6 Furthermore, this grade will not be a recommendation to
invest in or sell- off or hold onto a security7 which is a security-specific assessment essentially
based on liquidity and demand of security. As IPO grading discounts the price of the IPO as a

2
Dr. Siddhartha Sankar Saha, SEBI’s Initiative To Safeguard Investors’ Interest Through IPO Grading, 116 The
Chartered Accountant July 2006.
3
Ibid.
4
Supra note 1.
5
See SEBI, FAQ on IPO Grading, Question 7, available at http://www.sebi.gov.in/faq/ipo.html., last visited at 7th
February 2009.
6
Retrieved from http://www.careratings.com/, last visited at 22nd Jaunaury , 2009.
7
Id¸ Question 10.

Electronic copy available at: http://ssrn.com/abstract=1609817

factor, it will merely aid the naïve investor in forming an independent opinion in making the
investment decision by providing pure information regarding the relative strength of an issue.8

While assigning the grades a scale of 1-5 is taken, the lowermost being for ‘poor fundamentals’,
grade 2 for “below average fundamentals” grade 3 for ‘average fundamentals while on a higher
scale are 4 and 5 for ‘above average fundamentals’ and ‘strong fundamentals’ respectively. The
issuer is provided with an option to choose the CRA to get the IPO graded however, once
grading is done he has no option to reject the particular grade. In fact he can get another agency
to grade it as well but both the grades so assigned need to be mentioned in the prospectus.

II. Critical Appraisal of IPO Grading

The financial gurus, market analysts and the media have all been perceptibly vocal against the
IPO grading and have put the whole concept into scrutiny and time and again questioned SEBI
on the applicability and usability of introducing a complex system of grading which claims to
have been employed for the uneducated and unsophisticated investor. Since the IPO grading is
not equivalent to an investment recommendation, the investor is held between mystifying
numbers and baffling figures.9 Further since the capital market in India, be it primary or
secondary is splurging with the retail investors it becomes necessary that proper guidelines be
provided to them to invest their money which shall work as an investment protection and guide
them to decide without presenting a biased opinion about the same. If the grading only reflects
the fundamentals of the company, then making it mandatory is not required. Moreover, the
underwriters to the issue examine every minute detail thoroughly. Given this, adding one more
layer to the same process seems a bit of a waste.

A. Should CRAs grade the IPOs?

The IPO grading is under debate since SEBI has introduced the concept of rating on the same
principles as exists for the debt instruments. The practical problem involved in such a grading is

8
Supra note 2.
9
See S. Murlidharan, The Wisdom of IPO Rating, Hindu Business Line, April 20, 2006, available at
http://www.thehindubusinessline.com/2006/04/20/stories/2006042000261100.htm., last visited at 10th February
2009.
that the CRA’s involved are used to rating the debt instruments and they have been assigned the
rating of IPOs as well. The factors which are involved in the rating of debt instruments are inter
alia the P/E ratio; the debt-equity structure; financial planning and capital mix; viability of the
business activities purported or being carried out; general trend of the industry and the
environment in which the corporation operates; positioning amongst group companies (if any);
the vision of promoters/directors; the manner of operations etc.10 While, those which are
analyzed in the grading of an IPO are firm future earnings, accounting practices, management of
the firm, foreseeable financial risks and the quality of corporate governance.11 The difference is
thus clear in the approach of both, while one is analysis of the securities available and firm
structuring etc. and measures the downside risk; the IPO grading involves study of the future of
the firm, its future capital and growth and the study of upside gain.12 Companies that are likely to
raise far more equity than they need in an IPO would suffer a depressed return on
Equity (RoE) and are thus likely to be assessed in the IPO Grading. However, they are likely to
be assessed more favorably in a credit rating exercise, as more equity lowers the debt to equity
ratio (D/E ratio) and provides cushion to assume more debt.13

A pertinent factor of dispute which rests in the system is the subjectivity involved and the lack of
uniformity in the system of rating. SEBI has not been able to lay down specific terms and
parameters which the CRAs are to follow while rating, it is not a watertight compartment and
hence with the availability of four CRAs for the grading, it is probable that two different
agencies give a different view, hence there is possibility of such a conflict.

Another practical difficulty which exists is that a fair analysis of IPO based on the past record is
not acceptable as IPO grading is all about the future gains and risks which are tough to predict

10
Tarun Jain and Raghav Sharma , Credit Rating Agencies In India: A Case of Authority Without Responsibility,
Company Law Journal, Vol. 3, pp. 89-109, September 2008.
11
Deb, Saikat S. and Marisetty, Vijaya B, Information Content of IPO Grading (October 1, 2008). available at
SSRN: http://ssrn.com/abstract=1276243, last visited at 10th February 2009.
12
See Sanjeev Choudhary, SEBI makes case for IPO Grading, The Economic Times, Apr. 21, 2007, available at
http://economictimes.indiatimes.com/Sebi_makes_case_for_IPO_grading/RssArticleShow/articleshow/1931697.cms
, last visited at 10th February 2009.
13
The Investors’ FAQs on CRISIL IPO Grading, available at www.crisil.com/research/research-faqs-ipo-
grading.htm, last visited at 10th February 2009.
from past records.14 Further the system of grading is not based on the issue price, which is a
relevant factor for this purpose; even a security with low grading may turn out to be an attractive
investment if offered at the right price.15

B. Analysis of the working of CRA

Apart from the abovementioned drawbacks faced by the CRAs in analyzing the IPO grade there
are other factors which also render it inappropriate. Conflicts of interest seem to be the Achilles’
heel for the CRAs and their identification and management is the most significant concern
currently.16 The credibility of these agencies has suffered adversely in the wake of recent failures
to provide a fore-warning to the incidents involving failure of major corporations. The Enron17
fiasco and the more recent sub-prime mortgage crisis18 speak volumes on the inability of these
agencies to perform their functioning as a watch-dog of the markets.
The conflicts plaguing them can be recapitulated as-19 (1) CRAs are paid by the issuers for the
ratings and thus, to retain the client it is possible that they may issue favourable ratings, slowly
downgrade and quickly upgrade them.20 Further, the rating process becomes more vulnerable
where the analyst compensation is linked with rating fees. With the oligopolistic structure of
CRAs, there being only three key participants i.e. Credit Rating Information Services of India
14
T R Ramaswami, IPO Rating: A Risk Factor?, The Economic Times, May 05, 2007, available at
http://economictimes.indiatimes.com/Opinion/Editorial/IPO_rating_A_risk_factor_ /articleshow/2005912.cms, last
visited at 10th February 2009.
15
See Deepti Bhaskaran, Good Offerings and Bad Offerings, Indian Express, Mar. 24, 2007, available at
http://www.indianexpress.com/story/26434.html, last visited at 10th February 2009; Deepti Bhaskaran & Sandeep
Singh, IPO grading move dismays industry, Indian Express, Mar. 24, 2007, available at
http://www.indianexpress.com/story/26460.html ; Supra note 12.
16
IOSCO Report on the Activities of Credit Rating Agencies, September, 2003 (hereinafter referred as IOSCO
Report), p. 12.
17
Paul S. Atkins, Statement before the Open Meeting regarding NRSRO Proposing Release, Speech by SEC
Commissioner: Statement before the Open Meeting regarding NRSRO Proposing Release, Mar. 03, 2005, available
at http://www.sec.gov/news/speech/spch030305psa2.htm, last visited at 10th February 2009.
18
R Vishwanathan, Who will rate the credit raters?, The Economic Times, Oct. 10, 2007, available at
http://economictimes.indiatimes.com/articleshow/2444050.cms, last visited at 10th February 2009; S. Balakrishnan,
Rating agencies: Fence eating the crop?, Hindu Business Line, Aug. 22, 2007, available at
http://www.thehindubusinessline.com/2007/08/22/stories/2007082250370600.htm, last visited at 10th February
2009.
19
Supra note 16 pp.10-11; U.S. Securities and Exchange Commission, Report on the Role and Function of Credit
Rating Agencies in the Operation of the Securities Markets, January, 2003 , at p.23; Arthur R. Pinto, Control And
Responsibility Of Credit Rating Agencies In The United States, 54 Am. J. Comp. L. 341, 342-43 (2006); Carol Ann
Frost, Credit Rating Agencies in Capital Markets: A Review of Research Evidence on Selected Criticisms of the
Agencies, March 15, 2006, at pp.15-19, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=904077,
last visited at 10th February 2009; Stéphane Rousseau, Enhancing the Accountability of Credit Rating Agencies: The
Case for a Disclosure-Based Approach, 51 McGill L.J. 617 (2006), at pp. 634-637.
20
Arthur R. Pinto, Supra note 19; U.S. Securities and Exchange Commission, Supra note 19 at p.23.
Limited (CRISIL), Investment Information and Credit Rating Agency of India (ICRA) and
Credit Analysis & Research Limited (CARE), the pitfall is sure to be experienced. (2) CRAs
offer ancillary services such as pre-rating consultancy services, credit risk management services,
etc., rendering themselves susceptible to pressure for compromising rating accuracy in view of
prospects of luring the issuers into purchasing these other services by using the threats of lower
rating or unfavourable rating modification.21 (3) CRAs or their directors/promoters/credit
analysts may be associated with the client in the sense of having ownership interest in the
client/securities of the client or being engaged in a financial/business relationship with the client.
(4) CRAs being accessible to non-public information have to be monitored for insider trading
concerns. (5) CRAs may issue unsolicited ratings and keep them lower so as to arm-twist the
issuer into paying them for a more favourable solicited rating. (6) CRAs indulge in ‘notching’ to
maximize rating fee gains whereby they either refuse to rate or threaten to downgrade ratings on
asset backed securities unless a significant part of the asset pool is rated by them. (7) The
inherent complexity of these instruments makes the investors fully dependant on CRAs for
determining the fundamentals which provides a wide leeway for abuse.22

The CRAs in their defense against the above allegations and concerns have taken refuge of the
‘reputational capital’ theory which pre-supposes that the reputation of the grading agency
crucially depend upon accuracy and veracity of its grading23 and thus they are obliged to come
out with their best performances each time they grade. Portraying their role as reputational
intermediaries24, the CRAs have embarked upon the fact that indulging in a false or high rating
would directly affect their reputation for a small time monetary gain. However, the postulate
which nullify this claim are derived form the fact that these agencies have a oligopolistic
structure which discredits the notional apprehension of substantial decline in future fees from an
inaccurate grading as there isn’t much competition amongst these agencies and therefore they

21
Claire A. Hill, Regulating The Rating Agencies, 82 Wash. U. L.Q. 43 (2004).
22
Report of the Committee on the Global Financial System (BIS), The Role of Ratings in Structured Finance: Issues
and Implications, January, 2005, at p.23.
23
See CRISIL Supra note 13; Stéphane Rousseau, infra note 25, at 624; Frank Partnoy, infra note 25, at 629-31.
24
That is, one which interposes and offer its own reputation to supplement that of the issuer as a guarantee of the
quality of his issue.
can continue to enjoy the luxury of laxity in grading.25 Moreover, these watchdogs have refused
to bear any legal responsibility of their ratings as they are providing only theoretical results of
the data issued to them. It is a mere representation of the study of various factors put together
and a comparative analysis which has no legal responsibility and undertaking attached to it. Thus
the investor cannot solely base his decision of investment on these ratings.

III. Inconsistency in the grading results

There are various positive sides of an IPO grading. The most significant factors that go in favour
of IPO grading are: (a) Professional and independent appraisal, (b) Removal of information
overload, (c) improving investors’ sophistication,26 (d) Grading can determine the liquidity of the
IPO during the post issue period. Additionally benefit of the IPO grade, in the eyes of the rating
agencies, is particularly significant for the smaller firms. While the large and well known
companies would not find it difficult to raise the funds, the middle rung
companies would like their equity to be graded such that they could access funds without much
track record of their performance.27

Although IPO grading is a novel method used to safe guard retail investors it has the following
potential negative aspects, apart from the criticism already discussed: (1) Grading discourages
small entrepreneurs as they are bound to get lower grading due to their relatively poor back
ground; (2) The cost of grading is borne by the issuer. Technically SEBI has to bear the cost of
monitoring the quality of IPOs. With grading, SEBI shares these costs with the issuers and hence
grading may discourage entrepreneurs to raise equity in the public market; (3) Grading equities,
unlike debt where the cash flows and time horizon are defined, is much difficult as the cash
flows and time horizon are not certain.

25
See Frank Partnoy, Barbarians At The Gatekeepers?: A Proposal For A Modified Strict Liability Regime, 79
Wash. U. L.Q. 491, 498 (2001); John C. Coffee, Jr., Understanding Enron: “It's About The Gatekeepers, Stupid”,
57 Business Lawyer 1403, 1414-15 (2002); Stéphane Rousseau, Enhancing the Accountability of Credit Rating
Agencies: The Case for a Disclosure-Based Approach, 51 McGill L.J. 617 (2006), at 629.
26
Supra note 2.
27
IPO grading likely to gain acceptance with growth in primary market, Financial Express, April 30, 2006,
available at http://www.financialexpress.com/news/ipo-grading-likely-to-gain-acceptance-with-growth-in-primary-
market/165078/, last visited at 10th February 2009.
However, the present growing concern which has brought the issue of the mandatory IPO
grading at the trial is that the issuers which have been assessed at a high grade are not performing
as per the expectation while those graded low are performing better than these. Many analysts
believe that mandatory grading requires amendment since grading does not reflect in the
performance of issues in the market. Even the performance of nine IPOs that were given four
grades out of five (highest) is worse than those graded at three points.28 No doubt the retail
investors have been benefited by this regulation but the criticisms as mentioned above are not
being able to be handled.

An example in this regard can be seen from the following: both Allied Computers and Orbit
Corp were given grade 1, the lowest grade. But Allied shares rose 75% over their issue price,
while Orbit rose almost 330%. Gammon Infrastructure, however, got a high grade of 4. The
stock is now 4% less than the issue price.29 The following is the table30 which tells the
performance of the shares of some of the companies along with their grades:
COMPANY IPO ISSUE OFFER *CURRENT % CHANGE
GRADE CLOSE PRICE PRICE (OVER ISSUE
DATE PRICE)
Varun Industries 1 31 Oct 60 68 12.5%
2007
Allied Computers 1 23 Oct 12 25 105.4%
International 2007
(Asia)
Saamya Biotech 1 28 Sep 10 8.7 -12.7%
(India) 2007
Ankit Metal & 1 22 June 36 80 123%
Power 2007

28
Jagannadham Thunuguntla, (equity head of Nexgen Capitals) quoted saying, available at: PTI: Mandatory IPO
Grading to Continue: SEBI , Wednesday, January 21, 2009, available at
http://www.livemint.com/2008/12/17174107/Mandatory-IPO-grading-to-conti.html, last visited at 10th February
2009.
29
Tanvi Varma, Do we need IPO grading?, June 26, 2008, available at
http://moneytoday.digitaltoday.in/index.php?option=com_content&task=view&id=3698&issueid=45, last visited at
10th February 2009.
30
Ibid.
Celestial Labs 1 22 June 60 48 -19%
2007
Orbit 1 23 Mar 110 463 320.6%
Corporation 2007
Gammon 4 13 Mar 167 145 -13%
Infrastructure 2008
Projects
IRB 4 5 Feb 185 188 -1.7%
Infrastructure 2008
Developers
OnMobile Global 4 29 Jan 440 605 37%
2008
Reliance Power 4 18 Jan 450 191# -18%
2008
Precision Pipes & 4 20 Dec 150 82 -45%
Profiles Company 2007

Transformers & 4 12 Dec 465 384 -17.5%

Rectifiers India 2007

Jyothy 4 27 Nov 690 504 -27%

Laboratories 2007

Edelweiss Capital 4 20 Nov 825 673 -18%

2007

* Price as on 17 June, 2008; # Adjusted for 3:5 bonus issue

We can see how the beans have been spilled in the case of IPO Grading during the impact of
sub-prime crisis on India last year, as the companies which have been graded high i.e. 4 (which
has been a fairly high grade since 5 is a rarity) have suffered a negative percentage change over
issue price.31 Hence the grading is not all that credible since the fluctuations in consistency are
witnessed. In this series of doubt over the credibility of IPO’s it becomes difficult to digest the
views of SEBI that present system of grading is required for investment protection.

IV. Conclusion

We have looked at the efficacy of the IPO grading from several angles. The
qualitative arguments along with the quantitative regression analysis reported, provides for some
useful insights in deciphering the usefulness of this initiative to market transparency. In
the absence of sufficient experience to vouch for the current system of mandatory grading or to
counter it, SEBI has decided to maintain the status quo.32 While no doubt the approach should
continue, more groundwork needs to be undertaken in analyzing the pros and cons of the issue.
We need to understand that a bad rating can shake investor confidence, create panic in the
market and can really paralyze the system.

The oligopolistic model of the CRA’s does serve as a major impetus for them to detour from the
road of good governance. As pointed above in the form of contradictory results between the
grades of IPO and that of their performance, this phenomenon has shown the glaring shortfalls of
the regulatory system in this area. The issues involved herein needs to be understood completely
by SEBI and reforms by means of better scrutiny of the CRA’s need to be undertaken.

31
Ibid.
32
Supra note 28.