(The ULIP controversy has stirred an intense debate on the nature of instrument that it represents and consequently as to which regulator has purview over it. Jayant Thakur has previously analyzed the outcome of SEBI’s order in detail (here and here).
Going by the developments following SEBI’s order, the legal issues surrounding ULIPs appear to constitute a classic case where reasonable minds may disagree. They are set to be heavily tested at the appropriate judicial forum, and clear visibility may not be available immediately.
In this background, we now have a post by Abhishek Tripathi who approaches the issue from a different perspective in a two-part series: (i) first, noting the circularity problem within the definitions of ‘mutual fund’ and ‘collective investment scheme’, and (ii) second, examining the issue in the backdrop of the reasoning adopted by courts in the Commonwealth.
Abhishek is an alumnus of National Law School of India University and independent legal practitioner. He has also been a visiting faculty at National Law School of India University on insurance laws. He may be reached at [email protected].)
ULIPs have become the new battleground between two regulators regulating almost similar product. The crisis was waiting to unfold ever since ULIPs entered the fray. It may acquire a fresh twist in a few years from now with the entry of pension funds. SEBI’s war cry may find a hearing with those consumers who appreciate the distinctions between various insurance products; however, its claim to regulate ULIPs is doubtful, if tested legally. Let us see how.
SEBI contends that ULIPs are not merely insurance contracts, but investment products falling within the scope of what constitutes ‘securities’ under the Securities and Exchange Board of India Act, 1996 (“SEBI Act”). It further claims that in ULIPs insurers receive premiums into two categories: risk allocation and investment allocation. Risk allocation is what goes into paying for the risk cover, while investment allocation is invested to provide investment benefits to the policyholder. The return that the investor gets upon death, maturity, or surrender are usually on two accounts: payment for life risk (if the loss of life occurs during the policy period), and net balance (which also represents the returns on the investment) in the investment account. The practice of investment allocation is key to SEBI’s claim that ULIPs are products in the nature of mutual funds, hence SEBI is entitled and in fact, under duty to regulate them.
The investment feature in ULIPs is also found in the typical endowment insurance policies, which have been in existence for several decades. In endowment policies usually the insured does not have the luxury to track the Net Asset Value of her portfolio on a daily basis, and the policyholder usually cannot specify or switch the asset class into which the funds shall be invested. But, those are minor distinctions, if one views insurance as distinct from investment. In fact, life insurance policies have traditionally been recognized as investment instruments, a philosophy that also finds echo in the Indian Income Tax Act, 1961. I find it difficult to accept the argument that a policy, which has an investment component, attached to it is not a ‘contract of insurance’, or rather, from the perspective of regulation, is a ‘contract of insurance’ as well as something else.
Under Section 11 of the SEBI Act, SEBI has been entrusted the duty of protecting the interests of investors in securities. Under Section 11(2), SEBI has been specifically empowered, inter alia, to take measures for ‘prohibiting fraudulent and unfair trade practices relating to securities markets’, ‘regulating the business in stock exchanges and securities markets’, and ‘registering and regulating the working of venture capital funds and collective investment schemes, including mutual funds’. The definition of ‘securities’ in the Securities and Contract Regulation Act, 1976 includes ‘units or any other instrument issued by any collective investment scheme to the investors in such schemes’.
‘Collective Investment Scheme’ has been defined in Section 11AA of the SEBI Act. However, ‘contract of insurance to which the Insurance Act, 1938 applies’ and ‘any scheme or arrangement under which contributions made are in the nature of subscriptions to a mutual fund’, have been specifically excluded from the definition of “Collective Investment Scheme”. Interestingly enough, while the definition of ‘collective investment scheme’ excludes ‘contributions in the nature of subscriptions to mutual funds’ from its scope, in the SEBI Act, the term mutual funds has been used in conjunction with the collective investment schemes as ‘collective investment schemes, including mutual funds’. There are only three exceptions to this rule, which are as follows:
(a) Section 11(2)(i)- which empowers SEBI to call for information from, undertake inspection, conduct inquiries and audit of mutual funds.
(b) Section 11AA (2)(viii)- which relates to the exclusion of contributions in the nature of subscriptions to a mutual fund from the scope of Collective Investment Schemes.
(c) Section 15E- which prescribes a penalty on asset management companies of mutual funds registered with SEBI, if they fail to adhere to the regulations imposing restrictions on their activities.
A classic understanding of the word ‘including’ would lead us to believe that the word or the words following the word ‘including’ are subsets of the words or the phrase immediately preceding it. But there are exceptions to the rule, and in certain circumstances the word ‘including’ can be read as ‘and’. The exclusion of in Section 11AA(2)(viii) may validly provide credence to the argument that mutual funds are not a subset of ‘collective investment schemes’, but is a category in itself.
It is a mystery to me why mutual fund schemes have been excluded from the meaning of collective investment schemes. One of the reasons why contributions to a mutual fund have been excluded in Section 11AA(2)(viii) is probably because there was a set regime in place governing mutual place when ‘collective investment schemes’ were introduced in the SEBI Act, and the intent was not to disturb the existing regime, while providing for a regulatory regime for investment products that were not mutual funds. Very clearly, collective investment schemes were meant to cover the expanse left out of the regulatory regime covering the mutual funds.
‘Mutual funds’ have not been defined under the SEBI Act. The definition under SEBI (Mutual Funds) Regulations, 1996 defines mutual fund to mean as ‘a fund established in the form of a trust to raise monies through the sale of units to the public or a section of public under one or more schemes for investing in securities including money market instruments or gold or gold related instruments or real estate assets.’ The structure that qualifies as a mutual fund is implicit in the above definition, i.e. the fund should be established in the form of a trust.
SEBI’s response when this provision is brought to their attention is that under Section 12(1B) ‘no person shall sponsor or cause to be sponsored or carry on or cause to be carried on any venture capital funds or collective investment schemes including mutual funds, unless he obtains a certificate of registration from the Board in accordance with the regulations.’ It is claimed that registration by anyone who sponsors ‘a collective investment scheme including a mutual fund’ is a pre-requisite notwithstanding who the person is. It is a different matter that such person cannot obtain registration unless the structure is organized as a trust.
An extension of this logic means that all categories that have been excluded (such as chit funds, NBFCs accepting deposits, nidhi companies etc) in Section 11AA(3) from the scope of ‘collective investment schemes’ are also mutual funds, without reference to the structure and the manner in which they operate. A rather expansive interpretation will suggest that all collective investment schemes are also mutual funds, as the purpose of all collective investment schemes is to pool investments and distribute profits (similar to the objective of mutual funds), and hence should be regulated as mutual funds. This would make the inclusion of ‘collective investment schemes’ as a distinct category, an exercise in redundancy. It is an established rule of statutory interpretation that no provision of a statute is redundant and effort should be made to give it some meaning. Also, since exceptions to the general provision have the role of limiting the scope of the general rule, they ought to be given a narrow construction, unless special circumstances exist for taking a view otherwise. The only manner in which one can harmonise these rather expansive yet probable view is by contending that there are regulatory regimes that regulate the categories (such as collective investment schemes) that are not mutual funds.
‘Mutual funds’ is a term not defined under the SEBI Act, while ‘Collective investment schemes’ are. Save on account of specific exceptions, ULIPs satisfy all the requirements of collective investment schemes set out in Section 11AA(2). ULIPs can be taken out of the purview of ‘collective investment schemes’ The only manner in which one can argue that ULIPs are not ‘collective investment scheme’ if one can establish that it falls under one of the exclusions. Before claiming that ULIPs are ‘mutual funds’, SEBI ought to inquire whether ULIPs satisfy the definition of ‘mutual funds’ set out in its own regulations, laid down before by the Parliament. Since ULIPs are not operated as mutual fund schemes, SEBI’s claim can stand only if ULIPs are not ‘contracts of insurance’. Even the investors understand that ULIPs (which are marketed as insurance products) are different from mutual funds.
Even if one were to extend SEBI’s logic that the definition of ‘mutual fund’ sets out the eligibility criteria for registration and is not an exemption from its categorization as a mutual fund, mutual funds in the Indian context have a distinct meaning. The mutual fund structure, which envisages a trust, an asset management company, and a sponsor are inherent to the understanding of what constitutes a mutual fund. Every form of investment vehicle does not become a mutual fund merely on account of the similarity in the products offered – there are other regimes (envisaged under the SEBI Act itself) that take care of such products.
(To be continued)
– Abhishek Tripathi