29 April 2020
Introduction
Things indeed have been less than perfect for the mutual funds industry as a result of economic slowdown as well as specific events, key among which is the value deterioration across a number of industries and asset classes. The onset of COVID-19 has served to exponentially compound these problems. The most recent victim of the current situation is Franklin Templeton India, which announced its decision to wind-up six debt schemes, citing this as the only viable option to preserve value for unitholders and enable an orderly and equitable exit for all investors.
AMFI, the mutual fund industry body, has tried to assure investors that majority of fixed income AUM is invested in superior credit quality securities and schemes have appropriate liquidity to ensure normal operations. Mutual funds are not one homogenous mass and separate schemes have different investment strategy and underlying assets, but the supervening effect of the ongoing pandemic has created such redemption pressures and corresponding lack of cash flows, that the mutual fund industry has been dealt a body blow by the ensuing demand-supply liquidity mismatch.
With this background, this blog attempts to look at the two sets of legal questions arising here: first in the context of winding-up of mutual fund schemes, and second, solutions and changes that can be made to the legal framework, generally or in the context of COVID-19.
Winding-Up: What does the law say?
The Mutual Fund Regulations contemplate three broad situations in which a scheme may be wound-up: (a) on the happening of an event which, in the opinion of the trustees, requires the scheme to be wound up; or (b) if 75% of the unit holders of a scheme pass a resolution that the scheme be wound up; or (c) if SEBI so directs in the interest of unitholders. A well-known example of (c) is SEBI’s order to Sahara to wind-up its mutual fund schemes after finding that it was no longer fit and proper to carry out the business. A long embittered legal battle did not bring relief to Sahara.
Like any legal and regulatory process, there are quite a few procedural aspects to consider. These will provide context to some of the more universal issues discussed later in this piece.
The immediate effect of a winding-up is that the trustee or the AMC ceases to carry on business activities in respect of the relevant scheme, as well as to create/issue or cancel/redeem units in the scheme. The law requires the trustees to give notice, disclosing the circumstances leading to the winding up of the scheme to SEBI and in two daily newspapers having circulation all over India, a vernacular newspaper circulating at the place where the mutual fund is formed.
A unitholder meeting is held to authorise the trustees or another person who disposes of the assets of the scheme in the best interest of the unitholders. After accounting for liabilities and expenses, the balance is paid to the unitholders in proportion to their respective interest in the assets of the scheme, as on the date when the decision for winding up was taken.
Once the winding up is complete, the trustee provides SEBI and the unitholders a report on the winding up, containing particulars of the entire process. On SEBI being satisfied that all measures for winding up of the scheme have been complied with, the scheme ceases to exist.
The process, when it is carried out now, will help identify the specific pain-points of a winding-up, emanating from the current situation and, provide lessons which may be applied in other cases and to build upon the existing set of laws.
Debt Servicing and Liquidity Concerns
Subsequent to the directions issued by the RBI on moratorium/ deferment of payment in light of the COVID-19 pandemic, SEBI, last Thursday (April 23), permitted valuation agencies appointed by AMFI to not consider as ‘default’, any delay in payment of interest/principal or extension of maturity of a security by the issuer if the same has arisen solely due to COVID-19 pandemic lockdown or the RBI moratorium.
This would help alleviate some of the immediate pressure in terms of devaluation of the instruments. However, a natural question that arises is if this will only be a quick-fix or simply postpone the default (or categorisation as default) to a later stage, without actually taking steps towards value preservation, not to speak of value enhancement.
Since before the lockdown, questions on liquidity presented themselves and eyes turned to the RBI. Issues surrounding liquidity and concerns over high risk credit are not new and have been simmering and boiling over in turn for the last few years.
As this goes into press, the RBI has announced a liquidity facility for mutual funds and opened a special INR 50,000 crore window for high-risk debt mutual funds. This scheme is available from April 27 to May 11, unless the allocated amount is utilised earlier. The preferred mechanism to infuse liquidity here is the repo window, operating under the Liquidity Adjustment Framework, according to which, the RBI will lend to banks for specific on-lending to mutual funds. Such exposure to mutual funds will be exempt from capital market exposure limitations, under current prudential regulations applicable to banks. This is a timely move by the RBI and reminiscent of similar efforts in the past, where mutual funds were assisted with tiding over a liquidity crisis both in 2008 and 2013.
Reserves and Fail-safes
In a recent industry event, SEBI alluded to a debate on whether mutual funds need to be at par with banks, having a statutory liquidity ratio and cash reserve ratio. In fact, late last year, SEBI had introduced measures to introduce liquidity buffer in overnight and liquid funds, amongst certain corporate governance and investment norms.
While more of these measures may be helpful on a rainy day, managers and investors focusing on higher returns are unlikely to be thrilled. The monies that will go into these reserves would necessarily come from the assets and income of the schemes. In the banking industry as well, balance sheets saw a dip after RBI conducted the AQR exercise. The NBFC sector has been accused of, arguably fairly, indulging in practices such as ever-greening of loans to escape provisioning requirements. The protectionist norms may also face resistance since NAV and returns are already in trouble and introduction of such measures at this stage may upset the cart more than bettering the market.
Since mutual funds are principally investment vehicles, SEBI may also be more circumspect in dictating what would essentially be the terms of portfolio management. However, the systemic impact that a prospective failure of a fund house may have is undeniable.
Other Considerations
Apart from the substantive issues, developments of these nature also highlight the procedural difficulties inherent in the system. In a country currently under lockdown, the need to move to a digital platform in the context of providing public notices and client outreach is staring us in the face. It is clear to experts as well as the common man that the post-COVID world is bound to be different. Courts and regulators are grappling with the reality of importance of virtual connections. Investment in technology, in digital access has brought results as the world was unexpectedly plunged into a work from home situation.
A question that also arises is whether there is a better way to ensure that ongoing financial literacy is a reality as opposed to an ideal. In 2014-15, Standard & Poor conducted a Global FinLit Survey and found that India had the worst financial literacy rates among major emerging economies. However, the problem is not limited to India. A recent survey revealed that nine out of ten consumers in the UK feel that they are undereducated in terms of personal finance.
While SEBI and AMFI have certainly led from the front in this matter, this should remain a priority. Mutual fund investments are generally considered “safe”, so when they are impacted by market realities, there are more chances of cognitive dissonance in retail clients who cannot be expected to be as discerning as institutions and not be driven (and driven away from the markets) by anxiety. The Indian retail market base is inherently risk-averse and while efforts of penetration and greater participation are made, it is important to ensure that some fundamental risks are not glossed over.
Fintech platforms can be more helpful in this space and there are some players who are working towards this. Perhaps it would be useful to have the regulator sponsor or patron some of these platforms to ensure better outreach.
Conclusion
COVID-19 is here to stay and its impact across asset classes and industries is constantly evolving. The Indian government as well as the regulators have taken the threat seriously and introduced multiple measures to preserve the health and economic situation of the country. While slowdown in economic activity and growth is inevitable in these times, it is necessary that loss of investor value and confidence is mitigated to the extent possible. Maybe a programme similar to the Troubled Assets Relief Program, which was established in 2008 by the US Treasury, to stabilise the financial system at large through a multi-pronged approach, including capital infusion, will be considered. This tool, which salvaged a systemically important financial institution like AIG and brought some key industry lines back on their feet, is touted to have resuscitated the US economy and a similar comprehensive programme in India to tide over these times, deserves serious attention. Undoubtedly, both the Government and our regulatory institutions have before them the unenviable task of dual hatting as regulators as well as wartime consiglieres.
For further information, please contact:
Shruti Rajan, Partner, Cyril Amarchand Mangaldas
shruti.rajan@cyrilshroff.com
