In February 2020, the Securities and Exchange Board of India (“SEBI”) approved proposals on some regulatory changes to the SEBI (Investment Advisers) Regulations, 2013 (the “Regulations”). These changes come in the backdrop of four consultation papers which were released in 2016, 2017, 2018 and 2020 respectively to strengthen the regulatory framework for investment advisers. In light of the various investor complaints against the conduct of investment advisers, SEBI felt the need to fine tune the extant regulations to make it more robust. SEBI has also come up with a possible solution to the much debated question of conflict of interest between advisory and distributor services that is marring this financial advisory industry. Through this post, the authors seek to dissect the possible ramifications of the far-reaching changes brought in the rules governing investment advisers.
According to the Regulations, investment advisers are those who provide investment advice for a consideration (regulation 2(m)). As the term has been broadly defined, in order to determine who falls within the ambit of the definition, it is pertinent to understand the meaning of “investment advice”. Investment advice has been defined in the Regulations as any advice relating to investing, purchasing, selling or dealing in securities or investment products and, advice on investment portfolio for the benefit of the client (regulation 2(l)). In simple terms, an investment adviser assesses the financial situation of a client and provides necessary advice required to meet the goals mentioned by the client. They take various factors such as tax effects and complexity of the product into account in order to devise a financial strategy best suited to the financial goals of their clients.
With this background, the post now examines the amendments brought in by SEBI and the way they can change the landscape of the advisory industry.
Segregation of Advisory and Distribution Services
According to the extant regulations, individuals and partnership firms were not allowed to provide advisory and distribution services simultaneously. Corporate entities, on the other hand, could do so provided the advisory services were carried out through a separate identifiable division or department. This provision could easily lead to circumstances where client interests were sacrificed to advance advisers’ self-interest – who might be motivated to advise on those products for which they receive maximum commission. This goes against the basic tenets of fiduciary relationship sought to be established by the Regulations.
To address this conflict, SEBI has prescribed that for corporate investment advisers there would be segregation of advisory and distribution activities at the client level. This essentially means that even though a corporate entity has an advisory as well as distribution arm, a single client cannot avail both the services from the concerned entity.
This move by SEBI was required to inhibit the advisers from acting in concert with distributors of a product to the detriment of the clients. Distributors might obtain highest commission for products which are most difficult to sell for reasons like higher risk or less liquidity and, in such circumstances, it is the investors who are exposed to higher costs and inferior performance. In order to avoid such complex conflicts, it was essential to bring in a measure which can ensure that the advice given is untainted. Delinking the product-sourcing from the advice will safeguard the interests and money of the investors. It will guard against the evil of mis-selling and ensure transparency in distribution of products, thereby boosting the credibility of the distributors and strengthening investor confidence. With fee-only advisers taking the field, the investors are highly likely to get quality advice suited to their needs, as the advisers would now lack the incentive to pitch for products which earn them the maximum commission. This would inevitably save consumers from those distributors who are masquerading as independent financial advisers.
Another measure that can be adopted by SEBI to improve the transparency of the advice is to mandate the corporate investment advisers to provide an objective analysis of the recommendations made by them. This can include a written documentation of why a particular product is suited to the needs of the client, how it will further their goals and how the adviser came to the conclusion that the specific recommendation will better serve the interests of the client as compared to other available means. This measure will not only boost investor morale in a significant way, but also ensure that the advisers stay true to their fiduciary obligations towards their clients.
According to the Regulations, there is no cap on the fees that an adviser can charge from its clients. The guideline only states that the fees charged should be fair and reasonable. Lately, SEBI has received multiple complaints about advisers demanding exorbitant advisory fees. In order to put a break on such acts, SEBI has come up with new proposals regarding fees that can be charged by the investment advisers.
SEBI has notified that advisers can charge their fees in one of two ways: first, they can adopt the assets-under-advice (AuA) model whereby they can charge a maximum of 2.5 per cent AuA per annum from a client across all schemes or, second, they can opt for a fixed fee model under which the maximum fee that can be charged per annum is INR 75,000.
Although the intent behind bringing the said change is laudable, placing a cap of INR 75,000 per annum might affect the viability of providing any services to certain clients. This is so because, for some clients, the advice might be sought for complex products or voluminous assets. In such a scenario, if the client requires customized advice, it is logical for the advisers to charge a fee which is proportionate to the efforts and skills put in by them. Another point of contention is that, though an upper limit exists in the fixed fee model, no such restriction is placed in the AuA model. So if, hypothetically, an adviser manages a portfolio worth INR 30 crores and follows the fixed fee model, the maximum fee which could be charged by it would be INR 75,000, which is not even 0.1 per cent of the total assets. On the other hand, if the AuA model is followed in the same scenario, the adviser can charge up to INR 75 lacs in accordance with 2.5 per cent limit. This disparity in the two models is something to be carefully reconsidered both, by the market players as well as the regulator.
According to the extant Regulations, an adviser was required to meet the following criteria to register with SEBI:
- A professional qualification or post-graduate degree or diploma in finance, accountancy, business management, commerce, economics, capital markets, banking, insurance or actuarial science; or
- A graduate in any discipline with an experience of at least five years in activities relating to advice in financial products/securities/fund/asset/portfolio management.
This is a big step in the right direction by SEBI. It is essential that advisers who are entrusted with the responsibility of providing advice on huge portfolios possess the required experience in dealing with such matters in the market. The new enhanced eligibility criterion is likely to provide assurance to the investors, which in turn will boost the advisory industry. It was important to raise the ceiling for the eligibility requirements as retail investors, who are most vulnerable to mis-selling, might completely and unquestionably adhere to the advice of their adviser without undertaking independent risk assessment. Thus, in order to protect the interest of such investors, it is essential to restrict the entry into the advisory market to only those who possess adequate knowledge and experience.
The existing regulations prescribe INR 25 lacs and INR 1 lac as the minimum net worth requirement for corporate entities and individuals/partnerships respectively. SEBI intends to raise these respective limits to INR 50 lacs for the corporate entities and to INR 10 lacs for non-corporate ones. Further, SEBI has also proposed that an individual adviser must mandatorily convert into a corporate entity if his or her AuA crosses INR 40 crores or the number of clients exceeds 150.
This enhanced net worth requirement might not only be too arduous for small scale advisers who have recently set foot in the industry, but it could also potentially drive many individual and small scale advisers out of the industry. Moreover, there exists no evident correlation between the quality of advice and the net worth of an intermediary. Such an entry barrier means that only those who have inherited a good fortune or own deep pockets will enjoy access to the market, but the gates will be shut for those who, albeit possessing the necessary qualification and experience, fall short on the pecuniary side.
Further, the requirement of mandatory conversion on crossing the set threshold also defies logic. It essentially means that an individual adviser who works efficiently and manages a big portfolio needs to necessarily comply with various corporate laws, make different filings and also attain a net worth of INR 50 lacs in order to continue with his services. This would further increase expenses for the individual adviser who will have to pay additional compliance costs associated with the corporate nature, thereby negatively impacting the viability of the advisory industry for them. The said change might also push some investors away from seeking advice, as the advisers might charge higher fees in order to re-register in a corporate format. In order to protect the investor’s interest and to ensure that the investment advisory industry flourishes, it is essential that SEBI reconsiders this proposal.
Clarity over Nomenclature
SEBI observed that many mutual fund distributors were using the terminology “independent financial adviser” or “wealth manager” to describe themselves. This was utterly deceptive as they were neither advisers nor independent, but rather the agents of and receiving commission from those whose products they were selling. It created confusion amongst investors as to the true nature of activities carried out by the entity concerned. In order to avoid this confusion, SEBI has now barred distributors from using any such nomenclature unless they have registered themselves as investment advisers.
This change will not only lucidly define the role of an intermediary but also enable the investors to identify and choose correctly. Since there are various intermediaries such as wealth manager, independent financial advisers, financial planners and wealth advisers, which make it difficult for the investors to discern the exact services that are on offer, this step of barring the use of the said designations by the distributors can go a long way in boosting investor confidence in the industry. However, one clarification that SEBI needs to provide is that whether those distributors who have used “wealth adviser” or related terms in their companies’ names will have to change the same in light of the proposal made.
Among other changes made by SEBI, one relates to mandating an agreement between the client and the investment adviser. It will ensure that the clients are aware of their rights and that there is necessary documentation describing the way in which the advisers will pursue their work. Overall, this move will inject the much needed transparency in an industry which was hitherto impaled by deceptive practices.
Presently, a robust regulatory framework governing the advisory industry is indispensable to assure the integrity of the advice given. By plugging the holes which led to huge conflict of interests, the market regulator has ensured that investors’ interest would be given paramount importance. Although these are welcome steps as far as regulatory landscape for the investment advisers are concerned, it is essential that SEBI takes a relook at some of the proposals which are likely to keep genuinely skilled advisers out of the market due to the stringent entry barrier.
– Aditya Bhayal & Prachi Tripathi