Has SEBI got this one wrong?

In what could be dubbed as an uncharacteristic move, market regulator SEBI has decided to do away with the mandatory grading of Initial Public Offers (IPOs). The grades are typically assigned by rating agencies based on the financial strength of the company and disclosed in the prospectus. However, with grading now becoming voluntary there would be no external watchdog to vouch company financials. 

Before deciding whether this move is beneficial or not to retail investors, let us first try and understand SEBI's motto behind it. The primary reason for making grading voluntary is to boost the inactive primary market. As per a consulting firm, SEBI approved IPO mandates worth Rs 720 bn are yet to hit the market. Voluntary grading would reduce regulatory hurdles and expenses incurred to get one-self rated. This would make the listing process hassle free. 

However, the most important factor in making the grading process voluntary was to reduce the reliance on external rating agencies.Ratings from these agencies are typically fraught with conflict of interest. Rating agencies get paid by the company whom they rate.Thus, there are chances of their ethics being compromised. We know what happened to the sub-prime mortgage debt that was rated AAA by renowned rating agencies. It was effectively a junk debt which saw a series of defaults later. Hence, reducing the role of such rating agencies in investment decision making was a good move in some sense. 

But will excluding them all together do investors good? 

We do not think so. Agreed, there are chances that ratings are fraught with conflict of interest. But a grade at least gives investor a sense of comfort. Not having it all together means that companies which have poor financials can easily escape retail investors' eyes. A rating grade made that pretty evident in the first place. 

Also, if the regulator feels that conflict of interest is a bigger risk and can mis-guide investors it should look for alternatives to assess the financial quality of companies. Here it is giving them a leeway of eschewing the entire process. 

Access to management for such companies is already constrained. By not having someone assess the financial quality the grey area expands. Further, the very rationale of activating the IPO market through voluntary reporting does not seem to gel well with us. 

The duty of any regulator is to protect the interest of investors. At the same time it should make sure that the investing environment is healthy. However, we feel that in an effort to bolster the latter, former agenda seems to have been sidelined.