Brickwork's ratings lack transparency, riddled with inaccuracies: Sebi

The Securities and Exchange Board of India’s (Sebi) decision on Thursday to wind down credit rating agency (CRA) Brickwork, is thanks to the firm’s serious violations of its regulatory framework for CRAs, according to the regulator’s official order. Such violations include a failure to document meetings with the management, lack of independent analysis of financial projections given by companies, delays in recognising defaults, as well as conflict of interest, the regulator said.

The Sebi regulations on CRAs were brought to force on July 7, 1999, and include detailed guidelines on the registration procedure, general requirements by CRAs, and grounds for punitive action by Sebi. The latest amendments to these regulations came on January 24, 2022.  With the apex regulatory body’s move on Brickwork Ratings being seen as one of the toughest regulatory actions against any credit rating firm, here’s a look at some of the important Sebi regulations that Brickwork has allegedly violated and how.

Initial inspections and violations

Sebi’s action against Brickwork stems from two separate year-long inspections — the first between April 1, 2014, and September 30, 2015, and the second from April 1, 2017–September 30, 2018.  In August 2018, the Sebi imposed a penalty of Rs 3 lakh for, among other violations, the CRA’s delays in recognising defaulting Non-Convertible Debentures (NCD) and downgrading the ratings of companies with such NCDs to “Default.” Such delays occurred despite the disclosure and notification of defaults by the debenture trustee (DT) for such issues.

In September 2020, related to the second inspection, Sebi imposed another penalty of Rs 1 crore on the CRA. The fines were levied against several violations including a lack of a proper surveillance system for tracking the interest/principal repayment schedule, failure to review the rating of defaulting NCDs, and multiple violations while rating Structured Obligations (SO).

SOs are debt obligations issued by special purpose vehicles and secured directly by, referenced to, or representing ownership of, a pool of receivables or other financial assets of any obligor, including collateralized debt obligations and mortgage-backed securities.

Further Investigations and Joint Inquiry

Sebi considered the third investigation between October 1, 2018, and November 30, 2019, to determine whether the CRA had amended the violations to Sebi’s CRA regulations and found that the irregularities persisted. Following this, the regulator conducted a joint audit of the CRA with the Reserve Bank of India (RBI) in January 2020, which led to an administrative warning and inquiry. Finally, in June 2021, the regulator issued a show-cause notice to Brickwork asking why the CRA should not be closed. Brickworks had sought and was granted interim relief by the Karnataka high court. Sebi then filed a special leave petition before the Supreme Court and was granted permission for regulatory action on 16 September.

Brickwork’s major violations

According to the 50-page order issued by Sebi, the top regulator had listed several violations and irregularities in the show-cause notice issued to the CRA, including a failure to follow proper rating process, improper maintenance of records to support its ratings, following inappropriate rating process, noncompliance with prescribed timelines in 75 per cent of the cases inspected during the 3rd Inspection, a failure to address conflict of interest arising due to rating committee members (other than the Managing Director or  Chief Executive Officer) having business development roles with issuers.

Addressing the specifics of Brickwork’s failure to follow the proper rating process, Sebi mentioned a lack of transparency by the CRA in specifying the fee it charged in its rating agreement with issuers. This is in direct violation of point 15 (2) of Sebi’s 1999 regulations for CRA, which requires rating firms to disseminate information and maintain full transparency regarding their rating assignments.

Even when communicating the particulars of ratings to their issuers the CRA had consistently missed referencing crucial technical details, definitions, and regulatory guidelines, according to the security regulator’s final investigation. The firm attributed such omittances to clerical errors.   

The show-cause notice also notes that Brickwork failed to conduct an independent analysis of projections of ratings provided by issuers. This again violates Sebi’s fourth code of conduct for CRAs, which asks rating firms to “exercise due diligence, ensure proper care and exercise independent professional judgment in order to achieve.”

Besides these, Sebi has also noted the firm's lack of proper records from the agency’s meetings with management and site visits, the lack of feedback from bankers on its rating process, and the absence of not include financials, cash flows, projections, etc. for several issuers.