[Param Pandya is a Research Fellow in the Corporate Law and Financial Regulation vertical at Vidhi Centre for Legal Policy. The author is thankful to Prof. Jayanth R Varma, Indian Institute of Management, Ahmedabad for his valuable comments. Views are personal.
This post was first published in the Oxford Business Law Blog]
An illiquid asset may lead to reduced returns and increased redemptions in a money-market mutual fund, where one of the major risks is the inability of the issuer of an instrument (commercial papers, bonds, government securities) to meet the principal payments. If this risk comes to pass—and the Financial Sector Stability Assessment for India Report of the World Bank and International Monetary Fund (December 2017) suggests that it might be high—coupled with information asymmetry, it could leave retail investors in the lurch. To redeem this situation, global best practices suggest the side-pocketing of illiquid assets.
A side-pocket is created when specific assets (mostly illiquid assets) in the fund portfolio are segregated and ring-fenced from the rest. Only investors who hold units on a record date are entitled to share the proceeds generated from the sale of the segregated asset.
Side-pocketing helps stabilise the net asset value (NAV) and reduces redemptions in the long run. If the illiquidity event is sudden, side-pocketing provides a cushion to the liquid portfolio. Further, it protects the interests of retail investors, since all investors, including institutional investors, are treated at par and redemptions are suspended while the side-pocket is in place.
However, side-pockets warrant caution. First, the NAV of the fund is split between two segregated or separate legal investment vehicles, which makes it difficult for retail investors to track. Additionally, NAV of the illiquid asset is not easily discoverable since the valuation of the illiquid asset is contentious. Second, side-pocket terms may make redemptions more onerous by limiting exit. Third, side-pockets might be misused to protect managers’ fees on the more liquid assets or to hide poorly performing assets or poor liquidity management by fund managers.
JPM-Amtek: The Indian case-in-point
In 2015, CRISIL (a rating agency linked to S&P) suspended the rating of Amtek Auto Limited bonds (Amtek Bonds), citing inadequate information from the company. Another rating agency also ultimately suspended its ratings, citing persistent liquidity issues. Amtek Bonds became below investment grade and thus, illiquid.
Two schemes floated by the JPMorgan Mutual Fund (Mutual Fund)—namely JPMorgan India Treasury Fund and JPMorgan India Short Term Income Fund (collectively, Schemes)—had invested in Amtek Bonds. The sudden suspension led to a sharp reduction in the NAV of units of the Schemes, causing heavy redemptions. As an immediate measure, the Mutual Fund gated redemptions to avoid losses to retail investors, and a high concentration of illiquid asset in the Scheme portfolio, due to information asymmetry.
Since there is a time-limit on gating redemptions in India, the Mutual Fund sought the unit-holders’ approval for side-pocketing. Since the Scheme documents did not specifically provide for side-pockets, reliance was placed on general principles of Indian trust law. The exposure of Amtek Bonds was side-pocketed, and unit-holders as on a record date were provided units of the side-pocketed asset. Purchase and redemption in units of the side-pocketed asset were not allowed, while redemption was regularised in the liquid asset exposure.
As per reports, the Mutual Fund sold Amtek Bonds , recovering about 85% of what it invested. In response, the Securities and Exchange Board of India (SEBI) has strengthened the SEBI (Mutual Fund) Regulations, 1996 (MF Regulations) to set out the conditions under which redemptions may be gated and has imposed enhanced investment restrictions. Further, as per a media report, SEBI is not forthcoming to consider the proposal of the Indian mutual fund industry body to standardise side-pocketing in India.
In contrast, global best practices have been more receptive of side-pocketing. In 2014, a South African bank, which was the biggest provider of unsecured loans, failed. Ten South African money-market funds ‘broke the buck’. They side-pocketed illiquid assets which was communicated to the investors. As per the Peer Review of Regulation of Money Market Funds: Final Report, International Organization of Securities Commissions (IOSCO) (2015), the large outflows stabilised due to side-pocketing by the market funds.
There is a wide range of regulatory approaches, as suggested by an IOSCO Report. Regulations usually cover two main aspects—the kind of fund for which side-pocketing is permissible, and the disclosures that must be made.
In the United States, side-pockets are not allowed for open-ended or closed-ended funds and only hedge funds can exercise this tool. Italy allows side-pockets for non-retail funds, provided the interests of the funds’ participants are upheld. In the United Kingdom, side-pockets can be used for alternative investment funds only. However, Australia, Brazil, France, Hong Kong, South Africa, and Singapore allow side-pockets to be used irrespective of the category of funds. Certain nations also allow side-pockets in normal circumstances, subject to a clear disclosure in fund documents.
In terms of regulatory oversight, while most countries leave it to the respective fund managers to determine, they require that the use of tools like the side-pocket be disclosed in the fund documents. However, Ireland requires prior notification to the regulator for the use of side-pockets and France has issued specific regulatory guidelines regarding various liquidity management tools, including side-pockets. In November 2017, the Securities and Futures Commission (Hong Kong) published conclusions of the consultation for amending (a) the Fund Manager Code of Conduct and (b) the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, to clarify key aspects governing side-pockets. Generally, regulators do not have the power to activate side-pockets unilaterally, although Spain is an exception.
Way forward for India
In January 2017, the Financial Stability Board released the ‘Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities‘, where it suggested side-pocketing as a post-event measure to address structural vulnerabilities in money-market mutual funds. However, IOSCO, in the Consultation Report on Open-ended Fund Liquidity and Risk Management – Good Practices and Issues for Consideration (July 2017), states that side-pocketing could be a disruptive tool which restricts access to investor capital and recommends greater regulation to avoid abuse.
Arguably, unless tapped in a regulated manner, a side-pocket is a double-edged sword, with the potential to protect and harm investors’ money, particularly retail investors. The Indian regulatory framework does not regulate side-pockets, as is evident from the JPM-Amtek matter.
Therefore, it is essential that SEBI considers broadening the liquidity management toolkit for asset managers by allowing side-pocketing with clarity on operational dynamics. After consultation with all stakeholders, it should amend the MF Regulations to lay down the criteria and the process of creating side-pockets. SEBI should require disclosure to investors in the scheme documents to side-pocket illiquid assets. It should set out whether a prior approval from SEBI and/or unit-holders will be required. SEBI may also consider scenarios where it might have to direct the fund manager to resort to side-pocket in the public interest.
Further, aspects such as valuation and price discovery in the case of illiquid assets should be clearly specified and fund managers should not be allowed to charge fees greater than stated in the scheme documents. Additionally, whether side-pocketing constitutes a ‘change in fundamental attributes’ under the MF Regulations is also an issue that SEBI must address. SEBI should sensitise investors regarding side-pockets and monitor their use to realise its objective of investor protection.
– Param Pandya