The Karnataka High Court yesterday issued its 336-page ruling on the highly contested winding up of six schemes of the Franklin Templeton Mutual Fund (“FTMF”). FTMF’s decision was the subject matter of challenge before various High Courts, and the Supreme Court directed a transfer of all related petitions to the Karnataka High Court, which held a mammoth virtual hearing over several days before arriving at its decision. Crucially, the Court placed the ball in the unit-holders’ court by concluding that any decision to wind up the schemes is subject to their consent, to be obtained by way of a simple majority. But, it refused to interfere in the decision taken by the trustees of FTMF, as that is within the purview of industry experts. The Court also dealt with a number of other issues, including finding that it can pass directions to a private person in exercise of its writ jurisdiction, that the SEBI (Mutual Funds) Regulations, 1996 are constitutional, and that SEBI’s role in this significant case ought to have been more proactive. In this post, I briefly discuss two issues that are germane to the dispute and the decision.
Need for Unitholders’ Approval to Wind up a Scheme
The primary bone of contention was whether the decision to wind up schemes of a mutual fund can be taken by the Trustees of the fund, or whether the decision needs the consent of the unitholders as well. The relevant provision is regulation 39(2)(a) of the Mutual Funds Regulations, which provides that a scheme of a mutual fund may be wound up “on the happening of any event which, in the opinion of the Trustees, requires the Scheme to be wound up”. The provision does not explicitly stipulate unitholder consent when trustees decided to wind up a scheme. Regulation 41 provides for the procedure and manner of winding up, which requires the trustees to call a unitholder meeting to approve by simple majority the steps taken for winding up of the scheme. A closer observation would indicate that regulation 41 provides for unitholder intervention regarding the specific nature of the winding up and its contents rather than the question as to whether the scheme needs to be wound up at all in the first place; this was the focus of the Karnataka High Court as well.
Although regulations 39 to 41 comprise the provisions relating to winding up a scheme, the controversy emanated due to the presence of another provision in the form of regulation 18(15)(c) which provides that the trustees shall obtain the consent of the unitholders “when the majority of the Trustees decide to wind up or prematurely redeem the units”. Arguably a drafting inconsistency, this gave rise to a thorny interpretational question. Here, the Court engaged in a purposive interpretation of the Mutual Funds Regulations in light of its objectives, and found that the requirement of obtaining the consent of the unitholders under regulation 18(15)(c) to decide on whether to wind up a scheme cannot be circumvented by relying upon the absence of specific unitholder consent under regulation 39(2)(a). The Court noted:
“Thus, it is the duty of this Court to assign some significant meaning to the word ‘consent’ contemplated by sub-clause (c) of clause (15) of Regulation 18. Moreover, a provision of law must be construed in such a manner that it subserves the purpose of law. Even if contextual or textual interpretations are adopted, only one conclusion is possible that the consent contemplated by subclause (c) is to the majority decision of the Trustees for winding up of a Scheme or premature redemption of units in a Scheme. … On mere formation of opinion by the Trustees as provided in sub-clause (a) of clause (2) of Regulation 39, it cannot be said that the Scheme can be termed as ‘a Scheme to be wound up’ within the meaning of clause (3). When the majority of the Trustees form an opinion as contemplated by sub-clause (a) of clause (2) of Regulation 39, the Trustees are under a mandate to take consent of the unitholders as contemplated by sub-clause (c) of clause (15) of Regulation 18. Only after such consent is taken, it can be said that the Scheme is to be wound up as provided in clause (3) of Regulation 39. It is only after obtaining such consent that recourse to clause (3) of Regulation 39 can be taken.”
Apart from the interpretation of the regulations, the fact that FTMF had accepted the consent requirement in its statement of information issued along with the schemes weighed heavily in the mind of the Court. Hence, the threshold requirement of commencing a winding up was not satisfied in the absence of unitholder consent, which the Court found to be a sine qua non.
In examining the effect of this pronouncement, it is worth noting that the FTMF episode represents a first in the Indian mutual fund industry where regulation 39(2)(a) was invoked to wind up mutual fund schemes. Even though the Mutual Funds Regulations are nearly 25 years old, this question never arose in the past. The somewhat awkward interaction between regulations 18 and 39 that helped the Court achieve its result raises the question whether this was due to a drafting inconsistency. Would a clearer regulatory intention have mitigated the inefficiencies that have arisen in a timely resolution of disputes involving FTMF and its unitholders? Ultimately, the question relates to the allocation of powers regarding winding up of schemes: should the powers be vested solely with the trustees, or should they be exercised in conjunction with the will of a majority of unitholders? Presumptively, it is understandable that an existential decision to bring a scheme to a grinding halt must necessitate intervention by the unitholders whose interests could be adversely affected. But, whether it was necessary for the Court to engage in an interpretational exercise is a different question. Now that this issue has arisen, SEBI could consider whether the position requires clarification through amendments so as to avoid any doubt.
Business Judgment of the Trustees
Under the Mutual Fund Regulations, the initial decision to wind up schemes in circumstances such as that involving FTMF are to be taken by the trustees. The question is whether the trustees’ decision and its merits are subject to review by a court. In order to analyse this aspect, it would help to summarise the mutual fund structure envisioned under the regulations. Mutual funds are organized in the form of trusts at the instance of the sponsors. The assets of the mutual fund are held by the trustees (usually a trustee company acting through its board of directors) for the benefit of the unitholders, who are the beneficiaries of the trust. The management of the fund is handed over to an asset management company (“AMC”). The structural outline is relevant, given that one of the challenges to the FTMF case was that the trustees had effectively outsourced their decision-making to the AMC, thereby abdicating their responsibilities.
While looking at the merits of the trustees’ decision, the Court paid adequate deference to the fact that the circumstances giving rise to the winding up of the scheme were attributable to the Covid-19 pandemic and the subsequent lockdown and volatility it triggered in the stock markets. The Court rightly refused to intervene on the grounds that these are business decisions best left to experts in the field (such as the trustees in this case). It noted:
“262. … Whether a situation was created requiring winding up of the said Schemes is a very complex and complicated issue to decide. A very large number of factors are required to be considered by the Trustees who have in their fold, experts in the field. The question whether the decision of winding up of the said Schemes will be ultimately beneficial to the investors/unit-holders or whether it will be detrimental to the interest of the investors/unit-holders can be dealt with only by the experts in the field. It is not possible for a Writ Court to decide whether the impugned decision is beneficial to the unit-holders or it is detrimental to their interest. We do not possess expertise to decide whether the decision of winding up was in the best interest of the unit-holders/investors, inasmuch as, basically, the decision of winding up of the said Schemes is a commercial decision. … The commercial viability of the decision to wind up cannot be decided by a Writ Court. … The Court cannot enter into an arena of the merits of the decision which is essentially a commercial decision. It should be best left to the experts in the field. The Board of Trustee company is not a quasi judicial authority. It is not expected to record detailed reasons. Moreover, some latitude has to be given to such decision making process based on commercial considerations and the prevailing condition of economy. Therefore, in exercise of writ jurisdiction under Article 226 of the Constitution of India, this Court cannot go into the merits of the decision of the Trustee Company to wind up the said Schemes. Therefore, we are unable to interfere with the ultimate decision taken by the Trustee Company to wind up the said Schemes.”
This is akin to the “business judgment rule” that exists in several jurisdictions, recognised either statutorily or judicially to protect decision-making by directors of companies. Through these observations, the Court has effectively embraced the same principles in the context of trustees of a mutual fund. Although the Court has confined its pronouncement to the exercise of writ jurisdiction under Article 226 of the Constitution of India, similar principles ought to apply under other civil legislation as well when directors’ (or trustees’) decisions are called into question.
On the question of the trustees’ reliance on information from the AMC and its management, the Court found that the presence of the President and other officers of the AMC at the board meetings of the trustee when they made the decision to wind up the schemes would not vitiate such a decision. The trustees could not have made such a significant decision without consulting with the AMC and its management, and securing relevant information from them. Ultimately, it was found that the decision was that of the directors. This aspect of the ruling places emphasis on the tripartite structure envisaged by the Mutual Fund Regulations consisting of three parties, viz., sponsor, trustees and the asset management company.
Given the magnitude of the funds involved in the scheme, the number of affected unitholders, the unprecedented nature of the situation and the array of litigation initiated around the country (that were then consolidated in the present petition), this decision is likely to be watched very closely. The Karnataka High Court itself has recognised the importance of the legal issues, and stayed the operation of its order by six weeks. The fact that FTMF will move the Supreme Court on appeal is not at all surprising. The nature and intensity of the issues involved leads one to hazard a guess that this will not only be admitted by the Supreme Court, but that it will also be heavily contested.