The Quest for Liquidity – Recent Measures to Curb Discretionary Restrictions on Redemptions of Mutual Fund Units

[The following guest post is
contributed by Arka Saha, who
is a 4th Year B.A.LL.B. (Hons) & Executive Student in CS (ICSI) at National
Law University Odisha (NLU-O)]
One of the key
objectives of mutual fund investments, along with returns and security, is
liquidity – the ability to liquidate holdings and withdraw investments in units
as per the needs of the holder. Even closed-ended schemes, which refer to
schemes having a fixed maturity period as opposed to open ended schemes, are
mandated to provide liquidity in investments either through mandatory listing
on a stock exchange, or through a repurchase facility as per Regulation 32 of
the SEBI
(Mutual Funds) Regulations 1996
. However, the regulations permit for
certain conditions pertaining to redemption via repurchase, without specifying
any guidelines as to how these restrictions are to operate and the
circumstances under which they can be placed. Through its circular dated May
23, 2008, SEBI posited that such restrictions on redemption were to be placed
only with due consent of the board of directors of the Asset Management Company
(AMC) and the Trustees of the fund. Recent developments, especially the fiasco
pertaining to the JP Morgan Asset Management Company which denuded investor
confidence in the mutual fund industry due to liquidity issues, has forced the
regulator’s hand in doing away with widespread discretion available to the AMCs
as to restrictions on redemptions.
The Trigger
In August last
year, two debt funds of the J.P. Morgan AMC, namely the JP Morgan India Short Term Income Fund (JSTI) and JP Morgan India
Treasury Fund (JTF)
, which had
combined exposure to debt papers of Amtek Auto to the tune of around Rs. 200
crores representing 10.78% and 5.87% of the funds’ respective total corpus,
imposed restrictions on redemptions of units in light of increased redemption
pressure due to a sharp fall in the Net Asset Values, via gating of redemptions
at 1% of  total outstanding units on any
given day. Unit holders were thus stopped from redeeming their investments, and
had to wait to liquidate, while the Net Asset Value of the schemes fell further
due to continued sell pressure in the debentures and stocks of the company in
light of a credit downgrade by Care Ratings, default in interest payments, and
weak fundamentals. The restriction imposed was in light of the increasing lack
of liquidity in the debt papers, which made it difficult for the schemes to
reduce exposure in proportion to redemption pressure. Gating of redemptions had
the effect of nurturing a market wide distrust in the mutual fund industry, as
it distorted the fundamental feature of liquidity.
Subsequently, the AMC had to resort to ‘side-pocketing’ , a practice
previously unheard of in India and thus unregulated, which refers to the
segregation of illiquid or toxic assets from the total body of assets and cash
holdings of the scheme into separate units, before allowing redemption of those
units in the two schemes that had no exposure to debentures of Amtek Auto. The
newly created, segregated units that contained exposure to debentures of Amtek
Auto exclusively were closed for subscription and redemption until they were
disposed of at a loss of around 15% to PE Investors in December 2015, thus
finally according some liquidity to unit holders with regard to the monies
caught up in these units. This episode brought upon the scrutiny of the
regulator, which on 31 May 2016 came out with a circular laying down guidelines
pertaining to the placement of restrictions on redemptions.
Recent Measures
The Circular stipulates
certain circumstances under which restrictions can be placed on redemptions in
extant schemes from 1 July 2016 and in all schemes coming into
existence after 31 May 2016. The general tone of the circular establishes that
restrictions can now be placed upon systemic risks to the markets resulting in
high redemption pressure and not due to bad investment decisions by AMCs
resulting in a drop in the Net Asset Value of schemes of funds. The circular states
that restrictions can be placed only in case of markets becoming illiquid in
general, unexpected occurrences which inter alia are related to political,
economic, military, monetary or other emergencies resulting in the closure of
stock exchanges, or irregular functioning of the same, and in operational
issues arising due to unpredictable circumstances such as force majeure and
technical failures – given that they occur in spite of reasonable appropriate
diligence of third parties and adequate disaster recovery systems.
Therefore, restrictions cannot be placed on redemptions due to
illiquidity or other defaults in specific securities held by a fund. Further,
such restrictions can be placed for a maximum of ten working days in a three-month
period, with the same having to be sanctioned by the board of directors of the
AMCs and the trustees of the fund in question. The circular further imposes a
duty to disclose any restriction thus sanctioned to the regulator. In addition,
in a move that will most benefit retail investors, no restrictions can be
imposed, notwithstanding any reason, for redemption requests amounting to Rs. two
lakhs. For redemption requests above the two-lakh rupee mark, only that part
exceeding the Rs. 2 lakh threshold is to be subjected to the imposed
restrictions.
Conclusion
The conditions mandated by the circular, in the opinion of the author,
which are extended towards benefiting small investors by protecting them from
draconian restrictions that can at present be placed by AMCs due to failure on
their part in picking out fundamentally strong investments, are in tune with  international best practices.[1]  In effect, the guidelines on restrictions
will ensure that AMCs do not take unnecessary risks without conducting proper
due diligence, instead relying on credit rating agencies which will soon
be subject
to more stringent regulations themselves to increase
transparency and accountability in light of them not providing adequate reasons
while suspending ratings. However, these guidelines will only prove to be
conducive to the needs of the small retail investors if they are further
educated about risks associated to their investments, (the practice of gating
or placing absolute restrictions on redemptions is done to prevent large falls
in NAVs due to redemption pressure, ensuring that all existing unit holders
face the brunt of investments gone bad equally by not allowing anyone to pull
out), as more often than not they lack the sophistication to know when to pull
out, thus giving rise to risks of falling NAVs due to quicker redemptions in
large scale by more educated and experienced investors such as other funds.
– Arka Saha



[1]    The Securities and Exchange
Commission, the securities regulator in the United States of America which has
a more vibrant mutual fund industry, allows restrictions on redemptions only
under exceptional circumstances as the one permitted by SEBI under the current
circular.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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