The Securities and Exchange Board of India (SEBI), by its order dated September 13, 2023, issued several directions against Brickwork Ratings, effectively replacing its earlier order of October 2022 that cancelled the registration certificate of Brickwork to operate as a Credit Rating Agency (CRA). The cancellation order was issued on the grounds of operational deficiencies found in the functioning of Brickwork as a CRA, such as failure to appropriately ring fence its rating activities from other commercial activities, deficiencies in following proper rating protocols, and failure to promptly recognize credit defaults in its ratings.

It should be remembered that the above order was set aside by the Securities Appellate Tribunal (SAT) in June 2023, which observed that the imposition of the most-severe penalty, i.e. cancellation of the registration certificate, was not warranted in the matter, as the violations arose out of operational deficiencies, and this was not a case of large concerted fraud or wilful misconduct by the CRA. SAT, while setting aside the cancellation order, remanded the case back to SEBI to pass a fresh order against Brickwork for the alleged violations and issue appropriate directions, apart from cancelling its certificate of registration.

The latest directions were issued for the same operational violations observed by SEBI in its October 2022 order. However, in the interim period of 11 months between the two orders, Brickwork had reviewed its internal systems and steps were taken to automate its internal processes and to bring in a more professional management team. While SEBI acknowledged the corrective measures implemented by Brickwork, it remained sceptical about the efficacy of such measures. Putting the above measures to the test, SEBI has barred Brickwork Ratings from taking on new clients till it is fully compliant with its directions.

SEBI also took a serious note of issues of conflict of interest and the fact that Brickwork did not maintain appropriate segregation between its core functions as a CRA and its business development functions. For instance, its Founder Director was found to have engaged in business development activities while also being on rating committees of Brickwork.

SEBI emphasised on the importance of independence of a CRA while carrying out its rating functions and issued various directions against Brickwork to improve its internal governance structure towards ensuring an independent rating process uninfluenced by any business or commercial concerns. SEBI order directed Brickwork to diversify its board by inducting independent or non-executive directors with suitable expertise, limit membership of connected persons to 25% of the board strength, and appoint an independent CEO and chairperson of its board.

SEBI's decision to cancel the CRA license of Brickwork last year came as a shock to many. Cancellation of certificate of registration is synonymous to death penalty for a SEBI registered intermediary, and should be resorted to only in 'rarest of rare' cases involving widespread fraud and manipulation. However, an unusually harsh penalty was imposed against Brickwork for seemingly routine lapses, sounding the death knell for the CRA without any room to take corrective actions. Looking back, the monetary penalty imposed on credit rating agencies for their role in the IL&FS debacle seems like a mere slap on the wrist. Even in previous cases involving CRAs, SEBI had issued much lighter penalties; such as a penalty of Rs 1 crore imposed on Care Ratings in 2020 for delay in downgrading the ratings of RCom (this was reduced to Rs. 10 lakhs by SAT) and a penalty of Rs. 3 lac issued against Brickwork in 2018 for delay in downgrading certain securities.

Guided by the directions of SAT, SEBI in its recent order has taken a more constructive approach and retracted its harsh steps by imposing governance measures on Brickwork. This approach is better attuned to the regulator's role in improving processes and promoting the development of the ratings ecosystem. The regulator should ensure that systemically important market intermediaries such as CRAs work in an independent and efficient manner and if lapses are found in their process- swift corrective steps are taken. While imposing penalties regulator also aims to creating adequate deterrence for other market participants with dodgy practices but should not be to seek a pound of flesh. In the instant case, death penalty was ordered but as it could be seen in a few months, that the entity has reformed its processes and is considered fit and proper to operate as a CRA. SEBI would do better off to impose sanctions on erring officials, as it typically does in other Market Infrastructure Intermediaries such as Mutual Funds, Stock Exchanges etc rather than shutting down institutions such as CRAs that are a handful to begin with.

While discussing actions taken by SEBI, one should not lose sight of the operational deficiencies observed in the activities of the CRA and the impact of these lapses on the efficient functioning of the securities market. CRAs act as gatekeepers and information intermediaries in the securities market, and are expected to provide independent and unbiased opinions on the credit worthiness of the issuer and its securities. The independence of a CRA's rating activities cannot be understated, more so in an 'issuer pays model' where the issuer entity pays the CRAs for rating its securities. It is essential that a CRA ensures quality and integrity in its rating process and its rating decisions are taken in a timely, independent and transparent manner.

The lesson that the industry should learn from this episode is that the regulator is not shy of taking strict actions against intermediaries found to be negligent in its systems or lax in their governance standards. Such harsh orders, although overturned by SAT, tend to leave lasting impressions in the minds of market participants and serve as reminders that a casual approach in the functioning of systemically important agencies, such as CRAs, would not be taken lightly by the regulator.

Previously published by Moneycontrol on September 21, 2023 (linked here).

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