Alignment of interest of Key Employees of Asset Management Companies (AMCs) with the Unitholders of the Mutual Fund Schemes

The Securities and Exchange Board of India (SEBI), the regulator of securities market vide it’s circular SEBI/HO/IMD/IMD-I/DOF5/P/CIR/2021/553 dated 28th April, 2021 naming Alignment of interest of Key Employees of Asset Management Companies (AMCs) with the Unitholders of the Mutual Fund Schemes, had mandated for AMCs to pay 20% of CTC of Key Employees of AMCs in the form of units managed by them. Before, moving to the circular and understanding the same let’s understand the background and why such circular was required to be issued.

Background and need of the circular

India is one of the developing countries, and the securities market in India is still in the developing stage as compared to other developed countries. We have seen in the recent Web Series Scam 1992, how Harshad Mehta had misused the unorganized system and looted the money of the retail investors for his benefits. The SEBI, after its foundation in 1992 had made numerous changes and the securities market had been more regulated and transparent, but the saying is as time changes, people become smarter and scams change their colors.

With the past experience and awareness spread by the regulator, many investors have realized they should avoid investing in penny stocks/bonds, as they may become the victim of a pump and dump schemes any day. Although, many investors still become the victims of the same because of the underlying greed and lack of knowledge. Retail investors realized it is better to invest through mutual funds instead of having direct exposure in equity/bonds because Mutual funds have a large AUM size giving the investors the benefit of diversification, liquidity, and expertise of experts who can evaluate the risk better than retail investors.

It all started in 2018 with the well-known crisis of IL & FS, resulting from the failure of debt securities of IL&FS which were downgraded to D, default rating by various rating agencies, leading to huge losses to retail investors.

This was not the sole incidence, DHFL and Yes Bank along with others were yet to follow the path of IL&FS and they also defaulted in repayment of their dues to the investors due to the frauds by management. As per the reports published in 2019 and 2020 it was reported both AMCs Yes Mutual Funds (AMC of Yes Bank) and DHFL Pramerica (AMC of DHFL) had huge exposures in the securities of it’s parent companies, as per the disclosures made by them at the time of bursting of the crisis, it was noted that few schemes of AMCs were having exposures in single company securities upto 30% of the AUM size of the scheme.

In toto, this was against the principle of diversification which led to huge losses to investors in the scheme raising the question mark on credibility/independence of fund managers who were managing such schemes, all in vain. Defaults made by such big companies having almost most secured ratings issued by the rating agencies led to a shortage of liquidity for subprime debt instruments resulting Franklin India Templeton closed it’s 6 schemes naming Franklin India Low Duration Fund, Franklin India Dynamic Accrual Fund, Franklin India Credit Risk Fund, Franklin India Short Term Income Plan, Franklin India Ultra Short Bond Fund, and Franklin India Income Opportunities Fund in April, 2020 for further subscription and redemption, stating that the low liquidity prevailing in the bond market had forced them to close these schemes to safeguard the interest of retail investors.

Learning the lesson from these incidences, SEBI stringent the guidelines for fund managers and Asset management companies imposing investment limit in a single company, single sector exposures etc for the schemes along with revising the risk profile (risk o meter guidelines) of the schemes.

Simultaneously, the demand from various experts/industries started to implement, a new guideline mandating that the top officials of the AMC invest in the schemes of the AMCs which they are selling to the retail investors. This principle is called putting your skin in the game you play, this principle is very common in the developed countries, wherein the fund managers/portfolio managers also invest in the same instruments which they advise to subscribe/invest to their clients, it gives confidence to clients that they are taking utmost care while investing.

Circular and it’s Implications

SEBI circular no. SEBI/HO/IMD/IMD-I/DOF5/P/CIR/2021/553, had mandated for AMCs to pay it’s key employees at least 20% in the form of units of the schemes wherein they have the roles/oversight, which will put the skin of key employees in the game they play.

Key Features of Circular

1. A minimum of 20% of the salary/ perks/ bonus/ non-cash compensation (gross annual CTC) net of income tax and any statutory contributions (i.e. PF and NPS) of the Key Employees of the AMCs shall be paid in the form of units of Mutual Fund schemes in which they have a role/ oversight.

2. The compensation in units shall be paid proportionate to the AUM of the schemes in which the Key Employee has a role/oversight. For this purpose, Exchange Traded Funds (ETFs), Index Funds, Overnight Funds, and existing close-ended schemes shall be excluded.

Example: Mr. X is managing the following schemes

S.No. Scheme AUM Size % of Salary
1 A Large Cap Equity 5,000 10%
2 B Mid Cap Equity 3,000 6%
3 C Index Funds 700 Nil
4 D Open Ended Debt Scheme 2,000 4%
5 E Existing Closed Ended Debt Scheme before the applicability of circular 1,000 Nil

3. It should be paid proportionately over 12 months of salary.

4. Lock-in Period: Units shall be locked in for at least 3 years or tenor of the scheme, however, the persons retiring on superannuation age can redeem the units before completion of the lock-in period. This exemption is not granted to those employees who are either resigning or retiring before the attainment of superannuation age.

Example :

a. X who had been allotted units in scheme as on 1.10.2020 retires at the superannuation age of 60 years from AMC, as on 1.10.2021, he can sell /redeem entire units.

b. X had been allotted units in scheme as on 1.10.2020 resigns from the AMC, as on 1.10.2021, he can not sell/redeem his units till 30.09.2023.

c. X had been allotted units in close ended debt scheme as on 1.10.2020 having maturity as on 30.09.2025 retires at the superannuation age of 60 years from AMC, as on 1.10.2021, he can redeem his units only on 30.09.2025, however, he can sell the units in open market if the same is tradable on or after 1.10.2021 as the same has been released from lock in.

5. Key Persons are having the option to subscribe to at least 50% of the units in the schemes managed by them and 50% in other schemes having the same risk o meter.

6. Employees of the AMCs may borrow against the lock-in units from AMCs, in case of emergency i.e medical emergency or any other emergency having humanitarian grounds following the company policy.

7. This Circular shall be applicable from 1st July, 2021.

8. Definition of Key Employees:

a. Chief Executive Officer (CEO)

b. Chief Investment Officer (CIO)

c. Chief Risk Officer (CRO)

d. Chief Information Security Officer (CISO)

e. Chief Operation Officer (COO)

f. Fund Manager(s)

g. Compliance Officer

h. Sales Head

i. Investor Relation Officer(s) (IRO)

j. Heads of other departments, Dealer(s) of the AMC;

k. Direct reportees to the CEO (excluding Personal Assistant/Secretary)

l. Fund Management Team and Research team

m. Other employees as identified & included by AMCs and Trustees

Clawback

Units allotted to the Key Employees shall be subject to clawback in the event of violation of Code of Conduct, fraud, gross negligence by them, as determined by SEBI. Upon clawback, the units shall be redeemed and amount shall be credited to the scheme.

Disclosure and monitoring:

1. The compliance of the provisions of this circular shall be ensured by the AMCs and monitored by the Trustees. Any non-compliance in this regard, shall be reported in the quarterly CTR and half yearly trustee report.

2. Every scheme shall disclose the ‘compensation, in aggregate, paid in the form of units to the Key Employees’, under the provisions of this Circular, on the website of the AMC.

Concluding Remarks: This circular issued by the SEBI was in need of the hour, it will bring more transparency in the acts of the key employees of the  AMCs, as they have their own skin in the game they are playing. Along with that, this will boost the morale of upcoming new investors in the market. However, this circular is binding on AMCs only and not on the agents, banks, insurance companies, etc.  In the event of failure of AT-1 Bonds of Yes Bank, it was noted by the SEBI, the employees of the banks sold AT-1 Bonds to the customers of the bank stating they are superior FDRs offering a higher rate of interest while the case was different in toto.

Hence, appropriate measures should be taken by SEBI, IRDA, AMFI and RBI collectively wherein they should issue collective binding guidelines for agents, bankers, the assets management team of insurance companies, NPSs, PPF, etc. in the interest of retail investors.

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