Even for an intermediary that has expectations of having very high standards, and their ratings expected to be relied on like a hallmark stamp on gold, the recent SEBI order asking Brickwork Ratings to shut down operations sounds too harsh, perhaps even ruthless.
Not there wasn’t grave provocation, and serious alleged lapses, and repetitive too at that. But the question that is surely going to be raised in appeals — which are almost certain to be made with the fight long and bitter — is, should not a suspension have been sufficient? Should not, instead, the rating agency be asked to come back after the suspension period, and allow itself be re-examined as to whether it has amended its ways?
Often, there is a perception that credit rating agencies downgrade their ratings when it is too late — when monies are lost, and the barn door is closed after the horses have bolted. They are a pillar of the financial sector, in a manner similar to, say, auditors, independent directors, etc. Decisions relating to investment of trillions of rupees may be made relying on their ratings. Nonetheless, an order that finds a rating agency so guilty that it is being asked to shut down immediately makes one examine what was found so seriously, and incorrigibly wrong.
The Charges
Let us briefly summarise what SEBI’s findings were, as laid down in its 51-page order. SEBI carried out inspection of activities of Brickwork thrice, and the fourth inspection, jointly with the Reserve Bank of India, is yet to complete. SEBI had earlier levied monetary penalty twice, and though each of the penalties was reduced on appeal, the fact remains that the adverse orders were upheld. There was also an administrative warning issued earlier.
SEBI says, though without making this statement a formal part of the order, that even the fourth inspection was revealing similar alleged lapses. So while the earlier two inspections and penalty orders should have made Brickwork learn a lesson, with the third time being the proverbial charm, it instead became the third strike out.
SEBI found repeated violations of its regulations relating to credit rating agencies (CRAs). In all, SEBI listed 36 lapses, and even if it excluded some of them because they were already the subject of administrative warning earlier, it said more than 20 of these 36 lapses needed further action. Some of these, though SEBI did not agree, do sound to be clerical or immaterial. These include, absence of signature on minutes, erroneous mention of a person in both the rating committee and the appeal committee which would, if true, have displayed a serious conflict of interest. Brickwork has argued that this was a clerical mistake. It has said that the person mentioned as having been present in the other committee meeting was in fact on that day in another city. There was also a finding of delay of 15 days in disclosing the performance of the rated pool. SEBI has considered these too as serious violations.
However, there were also alleged lapses that were worrisome. For example, the delay in reporting of material events. There was also a case where Brickwork accepted financial projections of an issuer without due verification, stress testing, etc. SEBI also recorded a finding of Brickwork not carrying out a site visit which its own policy manual required.
What were particularly perturbing were governance issues. SEBI pointed out this in a case of fee reduction to obtain a client mandate where there appeared to be conflict of interest. It also alleged that the process of determining the composition of the committees, each of which are to act independently, was not objective, and appeared discretionary.
While there were several other issues and findings, two of these need particular mention. SEBI extracted the historical average transition rates of Brickwork in comparison with the six other CRAs. SEBI pointed out that Brickwork’s rates compared quite unfavourably with those of its peers. SEBI found, using the data published by Brickwork (as mandated by SEBI), that the probability of default benchmarks had progressively and significantly deteriorated.
SEBI thus concluded — also fortified by the fact that the fourth inspection showed there was no correction in major areas — that Brickwork just could not be allowed to carry on its activities. SEBI rightly said that the CRAs ‘play a critical role as gatekeepers to financial markets as a source of information to investors’. Further, institutions such as mutual funds and even provident funds rely on the ratings. Hence, the CRAs have a huge responsibility in granting ratings with utmost diligence and, of equal importance, to monitor these ratings continuously for material happenings which warrant either disclosure or revision. SEBI opined that Brickwork did not come up to the mark repetitively, and did not correct itself to the satisfaction of the norms.
Remedial Steps
Nonetheless, the concluding pages where SEBI straightaway cancels the registration comes abrupt, and perhaps shocking even to a casual reader of the order. Brickwork said that it has 8,699 ratings that were live, and under surveillance. Even if one argues that Brickwork may not be the only rating agency in all such cases, the impact of cancellation of registration would be significant.
SEBI had several alternative measures for penalising lapses, and also for taking preventive/remedial steps. Apart from the option of levying a monetary penalty, other alternative actions are suspension of registration, debarment for a specified period from taking any new assignments, etc. Granted, if a CRA is persistently aberrant, allowing it to continue even existing work is beset with serious risks. That said, cancellation of registration is the severe most action SEBI would take, if the violations are serious, and repetitive, indicating incorrigibility.
It remains to be seen how this SEBI order is treated by appellate authorities, as, an appeal seems very likely. Nonetheless, on a positive note, SEBI passing such an order shows that it means business, and even if such an order is unprecedented, it creates precedent for action in other areas too.
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