[Prankul Boobana is a fourth year student at NALSAR University of Law, Hyderabad]
With one of the bigger mutual fund houses winding up six of its debt schemes recently, the mutual fund (MF) industry, which was already facing liquidity issues, suffered a huge setback. In the past few months, the MF industry has witnessed various debt-laden companies defaulting and, resultantly, making delayed payments to the investors. Coupled with these events, the economic downturn triggered by the global pandemic is creating negative sentiments in the MF industry as well as the investors. In 2018, the Securities and Exchange Board of India (SEBI) released a circular permitting side-pockets in mutual fund schemes to deal with liquidity issues and risk management in the market. The current pessimism in the market poses a serious risk of redemption pressure, which can lead to more mutual fund schemes incorporating side-pockets.
Side-pocketing is a mechanism used to segregate distressed, illiquid and hard-to-value assets from the more liquid assets in a portfolio. This is done by creating a separate portfolio for the distressed and illiquid assets in the fund, resulting in two parts of the mutual fund scheme, with no new subscriptions or redemptions allowed (after the expiry of exit option) in the segregated fund. While side-pocketing is an accounting exercise, it has significant consequences in terms of the restrictions imposed on any subsequent activity by the investor with respect to the segregated fund. Notably, many fund houses have adopted this practice in light of defaults by companies, and thus have expressed acceptance towards the importance of such a measure. However, at the same time it is necessary to ensure that investor protection does not acquire a backseat in this process. This post analyses the legal framework adopted by SEBI for side-pockets through the lens of investor protection.
Side-pockets: The benefits and the harms
The principal reason for permitting side-pocketing is to avoid the risk of a run for redemptions. Investors, upon learning of defaults, tend to redeem the investments, which in turn leads to selling pressure on the fund. This rush of redemptions will force the funds to sell the good assets in the portfolio to meet the requirement, as there would be no takers of bad assets. This eventually leads to bad assets forming larger part of the corpus of fund portfolio. Thus, by stopping redemptions in the illiquid assets, the net asset value of the fund is stabilized. In the current market scenario of heightened volatility in the capital markets, redemptions threaten the security not only of the fund houses, but also of the entire MF industry.
The other major reason is to protect the existing, mostly unsophisticated, investors from suffering any unfair loss. This is done by segregating the illiquid assets and freezing the investors from selling them any further. Thus, the amount recovered from such assets, be it lesser or more than the expected amount, will go to the same class of investors. The idea is to protect the unsophisticated investors by preventing any new investors in the same assets from making an unfair windfall against the loss of previous investors.
While side-pocketing is important to maintain equitable exposure to risk, at the same time, it also has the potential to jeopardize the interest of investors. One major fear associated with side-pocketing is that it incentivises fund managers to invest in risky credit portfolios. Generally, fund managers are not inclined to invest in riskier securities, but the option of ring fencing the good assets, which side-pocketing provides, increases the risk appetite of fund managers that can translate into the interests of investors acquiring a lower pedestal. Side-pocketing serves as an easy tool to hide poor management decisions made by fund houses.
On the other hand, for the investor, prohibiting redemptions means that the investor’s capital is blocked, and the choice of an alternate investment decision is suspended for an uncertain period of time. Therefore, side-pocketing has the potential to harm the investors as much as it can do to protect them, owing to the manner it can be used by the fund managers.
It is clear that side-pocketing is a double-edged sword, but considering the importance it holds, it is necessary that there is an effective regulatory system which aims to protect the investors from any abuse. The SEBI circular has included some such safeguards for investor protection. The first, and most vital one of them, is that side-pocketing is permitted only when the investment is graded to “below investment grade” or on any such subsequent downgrade. Further, the total expense ratio, which is the amount charged by fund houses for management of the investment, cannot be charged while the fund is side-pocketed. It can be charged only when an amount on the side-pocketed fund is recovered, on a pro-rata basis (that is only to the extent of the recovered amount). Disclosure obligations in various forms including in Scheme Information Document and websites etc. have been imposed on the fund houses so that the existing and prospective investors are fully aware of information related to side-pocketed assets in the fund. However, there remain various concerns that are unaddressed in the circular.
First, the circular places heavy reliance on the fiduciary duty of trustees to ensure investor protection. The invocation of side-pocketing requires an approval from the trustees of the fund, and not from the market regulator, SEBI. Along with the approval, the duty of monitoring the recovery of side-pocketed assets is also placed upon the trustees.
It is pertinent to note that under the SEBI (Mutual Fund) Regulations 1996, trustees are placed with fiduciary obligations towards the investors. Trustees hold the property of mutual fund in trust for the benefit of unitholders. The trustees act as a custodian of the securities in which the funds invest and are required to ensure that the fund functions in the interest of the investors. Trustees perform the duty of loyalty and the duty of competence vis-à-vis the investors.
India follows a three-tiered structure for mutual funds, consisting of fund sponsor, asset management company (AMC) and the trustees. The sponsor, who sets us the fund, is required to hold at least 40% stake in the AMC. The trustees are appointed by the sponsors to oversee the management of fund. The AMC acts as a fund manager and is responsible for the day-to-activities of the fund. It is appointed either by the sponsor or the trustees. This structure depicts the existence of an interrelationship amongst the three of them. A case for clear independence of trustees from the sponsors or the AMC cannot be made here. This is despite that regulation 16 of the SEBI (Mutual Fund) Regulations require two third of the trustees to be independent and not associated with the sponsors in any manner. Such possibility of conflict of interest raises suspicion on the loyalty that the trustee has towards the investors. In such a case, relying on the fiduciary duty of trustees alone vitiates the fulfillment of objective of investor protection.
Secondly, it is optional for fund houses to side-pocket assets. Since the decision-making rests with the fund houses and trustees, the regulator cannot unilaterally force upon the practice of side-pocketing. However, considering that the practice is relatively new for the unsophisticated investors to understand and because of the increased risk in the market due to the debt funds crisis, the regulator is required to ensure that the fund houses are acting with the best interests of investors in mind. In order to avoid situations where the assets have been downgraded to the lowest level, and with the fund house choosing to not segregate the defaulting assets in its own interest (due to reputational factors or other reasons), the regulator may step in. SEBI can adopt a suggestive role here instead of imposing any sanctions. A possible solution is that SEBI may prescribe the conditions or thresholds, on reaching which the fund houses should ideally segregate the defaulting assets. In case of fund houses choosing to continue without segregating these assets, they can be required to explain the measures taken to make a recovery from the defaulting assets. An increased sense of accountability of fund houses will help in achieving more dedication towards investors protection.
Side-pocketing is crucial in a defaulting market to manage liquidity; however, safeguarding the interests of investors should remain the first of the concerns in such decision making. While the circular has incorporated some measures to prevent abuse of this mechanism, it fails to sufficiently deal with the harms that exist. Therefore, it is now necessary that the regulator determine who bears the responsibility to ensure investor protection, and to put in place the necessary safeguards.
– Prankul Boobana