[Anukrati Mishra is a final year B.A. LLB (Business Law Hons) student at Institute of Law, Nirma University, Ahmedabad]
On 16 January 2020, the Securities and Exchange Board of India (SEBI) undertook the first overhaul of the regulations governing portfolio management services (PMS) in over two decades by issuing the SEBI (Portfolio Managers) Regulations, 2020. The new regulations have been introduced considering the recommendations of the working group constituted to review the erstwhile SEBI (Portfolio Managers) Regulations, 1993. Need for the reform in the law was felt as the industry witnessed a growing demand for more customized and diverse investment portfolios. As the working group noted, between 2012 and 2019, the assets under management (AUM) of portfolio managers as well as the client base grew significantly. The main objective behind the new development is to enhance the regulations in the largely unregulated industry and bring in more transparency with the dual aim of protecting investors and maintaining the attractiveness of the industry.
This post discusses the major changes introduced by the new regulations and their effect on portfolio managers, their clients and the portfolio management industry, along with the challenges that lie ahead.
Major Changes Introduced and their Analysis
Minimum investment by client
The minimum investment amount per client has been increased to Rs. 50 lakhs from the previous limit of Rs. 25 lakhs. The purpose of this change was to ensure that PMS is adopted only by high net-worth individuals (HNI), and that retail investors should come through the mutual fund route. As compared to mutual funds, PMS are a sophisticated investment choice with riskier and complicated products. Increasing the limit is judicious to the extent that retail investors with limited understanding of the risk will not deal with the product and be protected under the mutual funds regime as they are subject to tighter regulation. However, the change will slow down the growth of the PMS industry since the market consisting of investors will reduce with the doubling of investment amount. Thus, despite making the services more investor-friendly, it is not clear if the stellar growth thus far will continue.
Minimum net worth requirement for managers
The minimum net worth required for portfolio managers has been increased to Rs. 5 crores from the previous requirement of Rs. 2 crore. A grace period of 36 months is provided to existing registered portfolio managers to increase their net worth. The increased threshold will limit the number of new or existing businesses that want to obtain or retain their registration. The requirement is far away from the net worth required for investment advisors, which is Rs. 25 lakhs, though the services provided by both service providers are similar in nature. The change has been introduced with the objective of deterring the non-serious players, but it may also end up restricting other players who fulfill other criteria but do not reach the threshold for net worth.
Investment in unlisted securities
Portfolio managers offering non-discretionary or advisory services to clients may invest or provide advice for investment up to 25% of the assets under management of such clients in unlisted securities, in addition to the securities permitted for discretionary portfolio management.
Standardization of fee and distributor’s commission
A portfolio manager shall charge an agreed fee from the client without guaranteeing any return, but it shall not charge an upfront fee. Usually, 100% of up-front fee or set up fee charged is paid as commission to distributor. Thus, the working group has recommended that the commission shall be paid on trail basis. Under trail basis, distributor will be paid the fee continually until the investment is withdrawn. This recommendation is not considered by SEBI in its new regulations. This move could have incentivized distributors to be interested in duration of agreement rather than only subscription of service.
Under the previous regulations, a periodical report had to be submitted to the client every six month, but now a performance report to the client needs to be submitted every three months along with disclosure of default in payment of coupons or debt security or downgrading of rating by the credit rating agency. The frequency of reporting to the clients is a step in the right direction. But, one recommendation of the working group with regard to reporting, which the new regulations failed to incorporate, is the standard format of the report to the client. Currently, there are no rules governing the content of the report, i.e., what the manager is required to mention. Thus, there exists wide divergence regarding the manner in which performances are reported. A non-standard reporting format makes it difficult for the clients to compare the performances of various portfolio managers and take informed decisions with regard to a service provider. The working group recommended a reporting format but SEBI did not accept it. Uniform disclosure was the need of the hour considering the increasing popularity of the service. The standard reporting format would have reduced the information asymmetry between manager and the client, thereby helping clients make an informed choice.
Hits and Misses
The new regulations introduce for the first time the concept of “investment approach” in the agreement between the portfolio manager and the client. An investment approach is a broad outlay of the type of securities and permissible instruments to be invested in by the portfolio manager for the customer, taking into account factors specific to clients and securities. Thus, offering customized services to client considering their need and requirement is another move for investor- friendly regulations.
The current regulations are silent regarding distributors. There are no guidelines, code of conduct or disclosure requirement with distributors. Since there are no minimum qualification criteria for distributors, any person or entity can refer a client to invest with portfolio manager for a commission with chances of misinformation or mis-selling by intermediary, thereby resulting in wrong guidance to clients. The working group proposed common minimum qualification criteria and a code of conduct to be followed; and to curb mis-selling and misinformation, it was mandated that the fee or commission paid to distributor shall be disclosed to the client.
Unfortunately, SEBI did not include any of the provision governing distributors. This might be detrimental as there could exist conflicts of interest for distributors. Hence, to ensure that clients are not at a disadvantage, the distributors must disclose to the client the fee or commission received by them.
The magnitude of changes introduced by SEBI are aimed at building the investor confidence and promises a positive outlook for the industry. The changes such increased investment by clients and increased net worth for portfolio managers are preferred goals, but SEBI should have considered the implementation aspects of these goals if the ultimate objective is to increase the participation in PMS. For example, minimum investment by client will hurt the broader objective of enhancing the investor base and in turn will reduce the market and also impinge upon the freedom to contract and the right to choose from the investment options available. Also, the enhanced eligibility criteria for a principal officer will lead to increased compliance cost for the portfolio manager. It is hoped that SEBI will reassess the important recommendations missed out and incorporate them in the existing regulations.
– Anukrati Mishra
 Regulation 23(2) of the SEBI (Portfolio Managers) Regulations, 2020.
 Regulation 9 of the SEBI (Portfolio Managers) Regulations, 2020.
 Regulation 9 of the SEBI (Portfolio Managers) Regulations, 2020.
 Regulation 8 of the SEBI (Investment Advisors) Regulations, 2013.
 Regulation 22(11) of the SEBI (Portfolio Managers) Regulations, 2020.
 Explanation to Regulation 22 (2) (c) of the SEBI (Portfolio Managers) Regulations, 2020.