Rationale required for all the recommendations by SEBI Research Analyst

Recently, I conducted the compliance audit for an individual research analyst for FY 21-22. One of the observations was that my client did not maintain any research report or rationale for arriving at “sell” recommendations.

My client explained, “What is the point in maintaining rationales for sell recommendations when the only reason why this recommendation is given is that the stock is not performing well”.

Maybe, he has a point, but that is not what is mentioned in the SEBI regulations.

I mentioned the observation in my audit report and explained to my client that the regulations do not distinguish between “buy” or “sell” recommendations when it comes to maintenance of records.

And what a coincidence!

On October 18, 2022, SEBI issued an adjudicating order against a SEBI registered Research Analyst, for non-compliance of provisions of the SEBI (Research Analyst) Regulations, 2014. One of the key observations was non-maintenance of rationale for recommendations.

The order included observations for non-compliance of provisions of SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 (PFUTP Regulations).

To give you a brief, an inspection was conducted against 24 Carat Financial Services (24 Carat). SEBI carried on an inspection for the period from April 1, 2018 to October 1, 2019.

This was the second inspection for 24 Carat, the earlier one being in the year 2017.

Here are the key observations in the order.

#1 – Non-maintenance of rationale for arriving at the recommendations

As per Regulation 25(1) (ii), a Research Analyst shall maintain records of the research recommendations provided.

As per Regulation 25(1) (iii), a Research Analyst shall maintain records of the rationale for arriving at a research recommendation.

As per Clause 1 of the Code of Conduct – Honesty and Good Faith, Research analyst or research entity shall act honestly and in good faith.

As per Clause 7 of the Code of Conduct – Compliance, Research analyst or research entity shall comply with all regulatory requirements applicable to the conduct of its business activities.

SEBI observed that there were instances of recommendations where the rationale was not recorded, including for “Sell” recommendations. Also, the rationales behind the recommendations maintained were incomplete and did not capture the supporting data mentioned in the rationale.

24 Carat, in its reply, submitted that it maintains rationale only for calls / recommendations in which the customer is in a position of taking any action or executing any trades.

SEBI mentioned that no distinction is made in the RA Regulation between recommendations which were acted upon or not acted upon and that rationale has to be maintained for all the recommendations.

#2 – Non-fulfillment of the certification requirements by the employees

As per Regulation 2(u): “research analyst” means a person who is primarily responsible for, –

1. preparation or publication of the content of the research report; or
2. providing research report; or
3. making ‘buy/sell/hold’ recommendation; or
4. giving price target; or
5. offering an opinion concerning public offer,

with respect to securities that are listed or to be listed in a stock exchange, whether or not any such person has the job title of ‘research analyst’ and includes any other entities engaged in issuance of research report or research analysis.

Explanation. -The term also includes any associated person who reports directly or indirectly to such a research analyst in connection with activities provided above.

As per Regulation 7(2) ….individuals employed as research analysts shall have, at all times, a NISM certification for research analysts as specified by the Board or other certification recognized by the Board from time to time.

SEBI observed that, 24 Carat had employed 15 persons out of which only 1 had NISM certification.

24 Carat mentioned that the staff was deployed for sales, marketing, IT & Back-office purposes and had no role in preparation of research analyst reports.

SEBI observed that the definition of research analyst includes any associated person who reports directly or indirectly to such a research analyst in connection with activities provided above.

To consider a person employed as a research analyst, the person should directly or indirectly report to the said research analyst in connection with the activities mentioned in the definition.

The SEBI officer could not establish violation of Reg. 7(2) read with Reg. 24(5) of RA Regulations against 24 Carat, since no activity undertaken by said employees was brought forward to suggest that they were involved in research activities.

#3 – Guarantee of returns and assuring profits

The SEBI officer sought the call records of the research analyst and employees of the research analyst interacting with the clients.

SEBI observed that the conversations were manipulative as the representatives were promising guaranteed returns. The representatives were luring the investors by making assured profit commitment, presenting misleading information to clients to influence their decision to invest and making false commitment of profits to their clients.

24 Carat was in violation of certain provisions of the PFUTP Regulations and Clauses 1 and 7 under the Code of Conduct for Research Analysts read with Regulation 24(2) of the RA Regulations.

After taking into consideration the nature and gravity of the violation established, a total penalty of Rs. 6 lakhs was levied on 24 Carat.

To conclude:

As the number of persons or entities obtaining investment advisers and research analyst licenses from SEBI increases, the frequency of inspections conducted by the watchdog will also increase.

These inspections are either voluntarily conducted or when a complaint is filed against an investment adviser or research analyst. And yes, the inspection can be conducted again by SEBI, as was the case for 24 Carat.

One of the interesting points to note is that SEBI also checks the call records of the employees interacting with the clients.

I have observed that most of the orders have common observations i.e. non-maintenance of records and non-fulfillment of qualification and certification requirements by the employees hired by the research analyst.

Hence, for compliance of RA regulations:

1. Ensure the research analysts fulfill the qualification and certification requirements
2. Train the staff interacting with the clients and give them specific dos and don’ts.
3. Maintain records of all the recommendations, including giving in the public media or on social media.
4. Maintain records of rationales for arriving at all the recommendations.

And most importantly, get the annual audit done regularly so that the non-compliances are reported on time and action can be taken before SEBI knocks on your door.

If you are looking to get the audit done, please write to me at kruti@cskruti.com

Click here to download the order.