[Aman Jha is a third-year student at National Law University, Delhi and Anurag Shah is a fourth-year student at School of Law, Christ University Bangalore]
The Securities and Exchange Board of India (“SEBI”), through a circular dated April 28, 2021, has directed Asset Management Companies (“AMCs”) to compensate its key employees partly in the form of units of the mutual fund schemes managed by the AMC with effect from July 1, 2021. While the rationale of SEBI is to align the interest of unit-holders with those of the key employees of the AMC, the same has not been well received by the industry.
This post analyses the circular and addresses whether such an alignment would affect the interest of employees of AMC as a result of over-reach on SEBI’s part.
Skin in the game directive
The circular requires the AMCs to pay one-fifth (twenty percent) of the gross annual CTC to an employee in the form of units of the mutual fund schemes in which the employee is involved or has oversight upon. The circular restricts itself to employees in the top tranche or directly related to the management of the schemes, which it refers to as ‘Key Employees.’ The term ‘Key Employees’ is defined as including Chief Executive Officers (CEO), Chief Investment Officers (CIO), Chief Risk Officer (CRO), chief of sales, and the heads of department that report directly to the CEO. However, the definition would not include secretarial staff or personal assistants reporting to the CEO. The fund management team and the research team are also a part of the definition. Further, the AMC would be free to include any additional employees in the definition.
The compensation to be paid to such employees shall be in proportion to the Assets Under Management (“AUM”) of the scheme in which the employee is involved in. However, certain types of funds such as Exchange Traded Funds (“ETFs”), Index Funds, Overnight Funds and existing close-ended schemes are excluded from the ambit of the circular. The circular allows a Key Employee to diversify its holdings in-case she is involved in handling only one scheme. The diversification can be done by allotting 50 percent of the aforementioned compensation in the fund being managed and the rest 50 percent in funds with a similar risk profile or higher risk profile.
The compensation under the circular would be locked-in for a minimum period of 3 (three) years or for the scheme’s tenure, whichever is less. The units cannot be redeemed during the lock-in period; however, the employee would be allowed to borrow against such units in cases such as medical emergencies or on humanitarian grounds subject to the policy of the AMC. The units cannot be redeemed during the lock-in period even in cases of resignation or retirement before the employee attains the age of superannuation as per the policy of the AMC. In case of resignation after achieving superannuation, the units shall be redeemable except in case of units of close-ended schemes.
The efficiency of skin in the game
Skin in the game as a concept has been academically and philosophically debated since a long time. It basically means that if a player of the game has his skin involved in the game, it would work as a positive incentive for them to give their best performance. The concept of skin in the game has been aptly explained by the renowned author Nassim Nicholas Taleb in his book ‘Skin in the Game: Hidden Asymmetries in Daily Life’. Skin in the game can be used in multiple industries to ensure the responsibility of people in the playing field. Some examples in the book by Taleb include actors bearing a cost in case a film fails to perform in the theatres, or a fund manager investing his money in the funds they manage. According to Taleb, skin in the game works as negative and positive incentive at the same time, it disincentives the players from being careless by removing moral hazards and incentivizes better performance.
A moral hazard is a problem that arises when the risk is not directly borne by the person undertaking the act. For example, if a fund manager is getting a bonus if the fund performs well, but there would be no negative impact if the fund underperforms, the fund manager would not be bearing the risk directly and the problem of moral hazard would arise. Taleb, in his book, also provides multiple examples of moral hazards being solved by skin in the game. One such example is that of war hawks who support wars, do not actually participate in it, and are therefore subject to moral hazard. However, if they are required to have their skin in the game by participating in the war directly, their stance might be different.
Academically, a lot of quantitative study has been done on the efficiency of the skin in the game concept. One such study was undertaken by the faculty of Yale School of Management, which analyzed a database of incentives by mutual funds to its employees to understand if director’s ownership plays any role in the fund’s performance. The study found that effective governance does play a significant role in the performance of funds. After analysing the database, they concluded that mutual funds with lesser ownership of directors in the fund constantly underperformed. The underperformance could be traced to two hypotheses: firstly, lack of skin in the game led to the directors being less active in monitoring the performance of the funds, or secondly, the directors having insider information of the performance of funds. The latter would make it easy for the directors to invest their money in funds they knew would perform better, thereby non-ownership funds would seem to have underperformed.
The study negated the hypothesis related to private information as the statistics did not support the same. Therefore, they concluded that the underperformance of the funds was owing to the lack of incentive to the directors. This study suggests that skin in the game can be a significant form of incentive for the directors and would be beneficial for the unit holders as well. However, the question that arises here is whether ‘mandatory’ skin the game would be as effective an incentive for employees of mutual funds.
SEBI’s directive and employees’ interest
Even though skin in the game is a beneficial concept when it comes to investor protection, it becomes complicated if it is mandated by a force of law. SEBI’s circular makes it mandatory for the defined set of employees to undertake skin in the game. As already mentioned, the output that SEBI is trying to achieve is to align the interest of unit holders with that of the employees; however, the same might be detrimental to the employees’ interest. The circular in a way mandates the employees to save a part of their savings in the funds that they are involved with. While doing this, SEBI has not taken into consideration the fact that each employee would have their own risk profile. Especially for the not-so-high remuneration posts, investing one-fifth of their remuneration into schemes that do not match their risk profiles might not be a good decision. This decision might have repercussions in case the fund managers are not involved in funds that match their risk appetite. For example, a fund manager with a higher risk appetite involved in a low-risk fund might start taking more risks if his remuneration is involved in the fund. The same might be harmful for the investors as it does not match with their risk appetite.
The definition of ‘Key Employees’ in the circular is a non-exhaustive definition, with the AMCs having the option to include any other class of employees as it deems fit. Such a non-exhaustive definition creates ambiguity on the scope of the workforce to which this circular applies. Further, it has also ignored the personal requirement that would arise for each employee based upon their liabilities such as loans or high cost of living in certain cities. The circular also provides for a lock-in of the investment, which would not be redeemable in cases of resignation before superannuation. This lock-in restricts the choice of the employees to liquidate their holdings in case they want to resign from the AMC. Therefore, this circular has, in essence, made it difficult for AMCs to retain or bring in new talent. One way out of this would be to increase the employee’s pay to meet the requirement; however, the same would be an additional cost of the AMCs, which will be passed on through higher management fees to the investors.
Another pertinent observation with respect to the circular is that using remuneration to put the fund manager’s skin in the game might be construed as being overboard. Taking into consideration the rigorous competition between fund managers in mutual fund industry, the reputation of the fund managers already seems to play the role of skin in the game. SEBI has already made a lot of disclosures mandatory in the mutual fund industry, thereby giving the investors an opportunity to compare the relative performance of different fund managers.
Therefore, the circular compromises the employees’ interest in the garb of aligning it to the unit-holders interest. Therefore, SEBI should re-consider if mandating such a requirement would be a good idea. Skin in the game can also be done in the same was as ESOP plans work – by providing an option to the employees to choose it out of their own volition. The circular, by restricting the way the employees can utilize one-fifth of their remuneration, has gone against the essence of including ‘salary’ within the ambit of the constitutional right to property. Moreover, SEBI brought in such a major directive through a circular, therefore bypassing the tradition of public consultation on important issues by SEBI. The Supreme Court has time and again reiterated the importance of public consultations in issues where the public interest is involved. For instance, in the case of Cellular Operators Association vs. Telecom Regulatory Authority of India, it suggested that the parliament should pass a law to ensure that authorities that have power to make laws on behalf of parliament undertake public consultation. Therefore, before mandating such a requirement, SEBI should undertake public consultation in order to find a middle ground to this issue.
– Aman Jha & Anurag Shah