Mutual funds vs the Sebi

Looking at the headlines over the past few weeks if one gets the impression that all is not well between the Securities and Exchange Board of India (Sebi) and the mutual funds, one wouldn’t be too off the mark. The question is, why is it so when both have a similar objective — that is, to develop the mutual fund industry, while protecting investor interest. The crux lies in a crucial difference: MFs have a commercial objective as well — they not only earn for the investor but also for themselves. The Sebi has no commercial objective. 

At the root of the present spate of show-cause notices issued by the Sebi to various MFs lies the failure of promoters of Zee Media to honour their repayment obligations upon the maturity of debt instruments, where the security were the shares of the Zee Group. While the Sebi as a regulator understands that risk of failure cannot be ruled out in any transaction, it had problems with the actions of the MFs, before and after the default. The MFs, however, claim they had acted in the best interest of the investors and that their actions speak volumes about their commitment to the investor and to the need to avoid losses.

While the argument of the MFs appears genuine and in accordance with the role expected from trustees, questions are being raised on the Sebi’s lack of “sensitivity”. It is believed that any other action by the MFs would have been against the interest of the investors. Does the Sebi want investors to suffer? The answer is a big no. While the Sebi is being made out to be the villain of the piece, it certainly is not — at least not in this case.

The question is whether investors were made aware of the risks involved and the consequences. This is more of a case of disclosures, transparency and procedure. Were the investors aware that investments by MFs could become bad debt? Can MFs enter side agreements with borrowers and roll over maturity of a fixed maturity plan (FMP)? It must have come as a shock to investors to find out one fine morning that the maturity proceeds of their FMPs, which were due in the coming days, won’t be coming, and that if at all they did, the investors did not know how much they could expect and when.

The Sebi’s objections concern the roll-over of maturity (extension of maturity) and a private deal to allow time to the borrower without proper disclosure in the scheme to investors. The argument from the MF side is that not all situations can be envisaged and that many MFs had offered various options to investors. The question is, whether a notice or information to investors post an event is as good as prior information and disclosure. The answer is, post event information or disclosure has no meaning and is just fait accompli.

It is not as if the Sebi hasn’t made provisions in the law for such a contingency. Way back in 2002, the Sebi had envisaged that such events might happen, and that on or before maturity date an asset might turn illiquid or an NPA. Sebi circular clearly laid down what MFs can to do in such an eventuality. In fact, the said circular provided two-years’ time to realise and distribute proceeds, if any, from the NPAs.

Based on the demand from the industry and realising that instances of default and illiquidity could rise, the Sebi in December 2018 permitted side-pocketing of money market and debt instruments in case of a credit event. The circular detailed the conditions and the procedure. The heart of the circular was facilitating MFs while protecting the interest of the investors and ensuring transparency. One condition was that the scheme document must have enabling procedure for side-pocketing. All that was required was an amendment in the scheme document enabling MF trustees to create a side-pocket portfolio, if the eventuality so narose. Obviously, this enabling provision was required to be incorporated before and not after the event. 

Ironically, the MFs failed to create side-pocketing provisions in their schemes and when they got hit by a credit event, they took decisions in desperation, which might have been in the interest of the unit holders, but were technically non-compliant. 

While the Sebi needs to be complemented for providing a legal framework to deal with a credit event, MFs will get their share of bouquets as well as brickbats. Bouquets because notwithstanding the chance of facing regulatory ire, they chose what they felt was in the best interest of the investors. Trustees behaved in the manner they would have done if they were dealing with their own investments. They had the choice of ignoring investors' loss and liquidate investments at whatever value possible and honour the commitments. While this could have saved them from regulatory ire, they would have had to face agitation from investors and possible loss of reputation and confidence. Reputational loss due to regulatory action was a risk they chose to accept. It is well-known that when a problem is an industry-wide problem, adverse impact of regulatory action is minimal. So this was a calculated gamble. 

The industry deserves brickbats for the simple reason that it failed to visualise that in the prevailing atmosphere the chances of a credit event crystalising were real. So why did the industry fail to act and incorporate a simple side-pocketing provision? It is not difficult to guess. If it was mandated and was done by the entire industry, investors would have been agnostic. Any fund taking the first step would have given out a wrong signal — of an inherent problem — and run the risk of avalanches of redemption request, potentially having a cascading effect. This business risk is too big to take. The industry or its associations have not developed the wherewithal to take up issues with the regulator. 

My experience tells me that we have yet to mature and establish a healthy regulator-regulated relationship, where communication can flow without fear of reprimand. I can almost definitely say that the fear in the minds of the regulated entity is absolutely misplaced. Most of the time, choices offered are not taken up and everyone waits for the other to act first, a la “pehle aap” (you first). My conversations during my stint at the Sebi gave me the impression regulated entities were hamstrung by the “please make it mandatory and we will do” syndrome. Culturally, we want regulatory fiat in everything.

While the Sebi is technically right in pulling up the MFs, it must also take into account the intent of the MFs. They must  not work at cross-purpose. The Sebi must take into account the phenomenal growth that the industry has achieved over the past few years, where the industry-level assets under management have almost tripled. With reduced avenues to deploy incoming funds, the risk for both the investor and the industry have multiplied. Unless safe profitable avenues for deployment are available/created both the investor and the industry are at risk.

While accepting that challenges exist, non-compliance cannot be brushed away and the Sebi has to take an action, which may even be symbolic. Going forward, the industry and its association, the Association of Mutual Funds in India or the AMFI, must improve their communication with the Sebi. The AMFI must become a vehicle to ensure compliance as well as good governance. Every crisis is an opportunity to become better and the industry must not miss it. The Sebi and the MFs might be at the cross-roads, they are certainly not at cross-purposes. The regulator must support MFs as much as the latter support investors as both can only exist and prosper together and not in isolation.
 

The author is MD, Stakeholders Empowerment Services