[RS Sanjanaa is a third-year BA LLB (Hons.) student at Symbiosis Law School, Pune]
A sponsor of a mutual fund refers to any bank, financial institution or a corporate who acts as the promoter of the mutual fund. The entity establishes the fund, obtains necessary approvals and funding, and incorporates an asset management company (“AMC”). On June 27, 2023, the Securities and Exchange Board of India (SEBI) introduced the Securities and Exchange Board of India (Mutual Funds) (Amendment) Regulations, 2023 (“Regulations”), which amended the SEBI (Mutual Funds) Regulations, 1996, addressing various aspects such as sponsor criteria, disassociation of sponsors, trustee responsibilities, AMC governance, and sponsor track record.
This post provides an overview of the pre-existing context and summarizes the key points of the Regulations. It also evaluates the potential positive impact of these Regulations on the mutual funds industry and discusses any potential issues they may present. It concludes that these Regulations offer much-needed clarity and aim to improve corporate governance in the mutual funds sector, but unresolved issues need prompt attention.
Understanding the Context
Prior to the introduction of the Regulations, the eligibility criteria for mutual fund sponsors were outlined in regulation 7 of the SEBI (Mutual Fund) Regulations, 1996. These criteria included the requirement for sponsors to have a minimum of five years’ experience in financial services, a positive net worth over the previous five years, and a contribution of at least 40% to the fund.
Proposing reforms to this framework, on January 13, 2023, SEBI released the “Consultation Paper on Review of Regulatory Framework for Sponsors of a Mutual Fund” based on the Draft Recommendations of a working group, which received endorsement from the Mutual Funds Advisory Committee. The paper highlights that over time it became apparent that once a mutual fund was well-established, the sponsor’s role diminished and became minimal, often reduced to merely signing the trust deed. This shift has been attributed to factors such as the reduction of guaranteed mutual funds, the emergence of in-house legal and financial experts within AMCs, the growth of AMCs themselves as sponsors, and the standardization of mutual fund trust deeds, reducing the need for individual contracts. Consequently, sponsors began to recede to the role of investors.
Hence, recognizing the need to facilitate new entrants in the sector to attract fresh capital, foster innovation, encourage competition, and provide exit options for existing sponsors, SEBI implemented the present Regulations. A similar attempt was made through an amendment in 2021, which allowed entities with a positive net worth of at least INR 100 crore to sponsor, even without a profitability track record.
Overview of the Regulations
The Regulations have been released by SEBI pursuant to its powers under section 30 read with section 11(2)(c) of the SEBI Act, 1992. The main aspects of this have been listed below.
Liquid Net Worth (Regulation 2)
Under regulation 2, the definition of liquid net worth has been added and defined as the net worth deployed in liquid assets which are unencumbered and includes cash, money market instruments, government securities, treasury bills, repo on government securities, and other instruments as specified by SEBI later on.
Original Criteria (Regulation 7(a))
Under the Regulations, the sponsor must meet three key conditions to be considered as having a “sound track record” under the amended clause. These conditions are as follows:
- The entity must have recorded a net profit in each of the immediately preceding five years, as opposed to the previous requirement of three out of five years.
- The average net profit over these five years, after deducting depreciation, interest, and tax, should be at least INR 10 crores.
- The liquid net worth mentioned earlier must exceed the proposed capital contribution by the sponsor.
Alternate Criteria (Proviso to Regulation 7(a))
In cases where an entity does not meet the previously mentioned eligibility criteria, it still has the opportunity to become a sponsor, subject to certain conditions. These conditions are as follows:
- The sponsor must adequately capitalize the AMC to ensure that the net worth of the AMC remains above INR 150 crores.
- The initial shareholding, amounting to at least INR 150 crores, must be locked in for a minimum of five years.
- The entity must appoint senior management personnel (as listed in the Regulations) to the AMC, with a combined experience of no less than thirty years.
- If an AMC is acquired, the entity must maintain liquid net worth equal to the incremental capitalization required to meet the first condition.
Disassociation of Sponsor (Regulation 7C)
Existing sponsors can disassociate from the AMC provided the AMC has a diverse shareholding, with no single shareholder having more than 10% shareholding, and the board of directors has at least two-thirds independent directors.
Assessing the Potential Positive Impact on Industry
The primary positive impact of the Regulations is the enhancement of investor confidence through the requirement of a sound track record, leading to increased financial stability of sponsors. This mitigates the risks associated with sponsor-related issues and improves the functioning of mutual funds. A relevant example is Berkshire Hathaway, led by Warren Buffett, which has served as a sponsor for various funds and demonstrated consistent profitability, attracting a substantial number of investors and capital inflows.
Moreover, the provision on sponsor disassociation and the inclusion of independent directors promote effective corporate governance practices. This was evident in the case of Franklin Templeton Investments, where the presence of independent directors would have facilitated independent oversight and reduced the influence of sponsors, enabling better industry risk assessment and management.
Furthermore, the allowance of sponsor disassociation reduces compliance requirements when the sponsor’s shareholding falls below 10% in the AMC. This grants the AMC greater independence and flexibility in its operations, while still ensuring regulatory compliance.
Additionally, the implementation of a lock-in threshold of INR 150 crores, instead of the previous 40% shareholding threshold, offers improved exit options for sponsors, particularly in high net worth AMCs. This requirement ensures adequate capitalization of the AMC and adherence to regulatory standards.
Impediments Arising from the New Regulations
While the intended impact of the Regulations on the industry is commendable, certain issues arise that need attention. First, the heightened capital requirements create financial barriers for small sponsors. Consequently, market concentration would inadvertently favour larger sponsors, leading to reduced diversity. An analogous situation can be seen in the European Union’s Alternative Investment Fund Managers Directive, which proposed similarly stringent capital requirements for investment managers, such as a minimum initial capital criterion of €300,000. As a result, small investment managers could face challenges in launching their businesses, establishing new funds, and attracting investors. Moreover, this could potentially drive small entities to merge with or be acquired by larger ones, impacting competition.
Secondly, the previous provision allowing early-stage entities to sponsor a mutual fund, provided they had a net worth of at least INR 100 crores in the absence of meeting the ‘three out of five years’ profit requirement, has been removed. This means that they would now be subject to alternative criteria. SEBI’s aim in doing so is to prioritize financial viability and enhance risk management. However, this change will discourage loss-making early-stage entities from participating in sponsoring mutual funds. Ultimately, it will hinder innovation and competition in the sector, impeding access to capital for these entrepreneurial entities.
Thirdly, the Regulations present implementation challenges. For instance, there is a lack of clarity on the status of pending applications with SEBI. Furthermore, they impose an additional disclosure burden and compliance hurdles, such as evaluating the current liquid net worth of all sponsors. Furthermore, the Regulations could temporarily disrupt the market as all AMCs will need to restructure their operations, adjust business strategies, and ensure compliance, leading to a period of market volatility.
Fourthly, the liquid net worth requirement has a detrimental impact, extending to the individual sponsor level. Sponsors will need to reallocate a significant portion of their assets to liquid investments, which limits investment flexibility and reduces their risk-taking capacity. Moreover, this increases compliance costs for sponsors, as liquid assets tend to yield lower returns compared to other options like stocks or bonds. Ultimately, this affects the profitability of sponsors, which is, in fact, an eligibility criterion for sponsorship.
Fifthly, the increased representation of independent directors may strain the sponsor-AMC relationship. It could potentially lead to heightened conflicts and a reduction in the alignment of interests between the two parties, as sponsors would have less influence on strategic decisions.
Conclusion
Despite the notable challenges and issues associated with the Regulations, their importance cannot be undermined. While there is a need for SEBI to carefully evaluate and address the potential negative impacts, such as by introducing proportionate requirements based on sponsor characteristics instead of a generic capital cap, the overall objective of the Regulations remains crucial. They are designed to safeguard investor interests, foster market stability, enhance corporate governance practices, and uphold the reputation of the mutual funds industry. It is imperative for stakeholders to work collaboratively towards refining and implementing these regulations to ensure their effectiveness and long-term success.
– RS Sanjanaa