Partitioning of advisory services from distribution activities

– Harshil Matalia (finserv@vinodkothari.com)

Updated as on July 04, 2020

The Securities and Exchange Board of India (SEBI) had notified SEBI (Investment Advisers) Regulations, 2013 (IA Regulations)[1] in 2013, to regulate activities of Investment Adviser (IA). IA is a person who provides investment advices with respect to financial and investment products to its clients for a consideration. Regulation 3 (1) of the IA Regulations mandates every person which acts as an IA or holds itself out as an IA to register itself unless the person is exempted from registration under regulation 4 of IA Regulations.

A series of consultation papers were issued in 2016, 2017 and 2018, which was followed by another consultation paper[2] proposing amendments in the IA regulations released by SEBI on January 15, 2020. Subsequently, SEBI in its meeting held on February 17, 2020[3] approved the proposals on regulatory changes based on comments received on consultation paper. On July 03, 2020, SEBI has amended IA regulations by introducing SEBI (IA)(Amendment) Regulations, 2020[4] (Amendment Regulations) which shall come into force on September 30, 2020. The main objective to bring such regulatory amendments is to protect the interest of investors and prioritize investors’ interest over the interest of IA.

This write-up provides a brief note on amendments brought by SEBI and its implications on the sector.

Segregation of Advisory & Distribution Activities

As per regulation 15(5) of the IA Regulations, there is an obligation on IA to disclose all conflicts of interest that arises while serving its clients. There is a possibility that IA would advise to invest in products which shall fetch maximum commission or products that may be risky and less sellable in the market. To overcome such a situation, IA must disclose potential conflict of interest to the client.

An IA may be engaged in activities other than investment advisory and hence it is necessary to ensure an arms-length relationship between its activities as an IA and other activities as prescribed under regulation 15(3). Individuals registered as IAs are not allowed to provide distribution or execution services under amended IA Regulations. However, corporate entities registered as IAs can offer execution or distribution services provided that the investment advisory services are offered through separate identifiable division or department.

Further as per recent amendments in Regulation 22 of IA Regulations, “family of IA” shall not provide distribution services to the same client advised by IA. SEBI has inserted a definition of ‘Family of IA’ which shall include individual IA, spouse, children and parents. SEBI has also prescribed the requirement for non-individual IAs to have client level segregation at a group level which means that client can either take advisory or distribution services from the IA and the same client cannot avail any other service, as the case may be, by the same IA or its group entities. Group for this purpose shall mean:

1. For Company- an entity which is a holding, subsidiary, fellow subsidiary, associate or an investing company or venturer of the company as per the provisions of Companies Act, 2013 or;
2. In any other case- an entity which has controlling interest or which is subject to controlling interest of a non-individual investment adviser.

Implementation of Advice (Execution)

IAs also offer implementation services to its clients i.e. execution of advice provided to the client by charging some reasonable consideration. Thus, the client finds ‘all in one shop’ by availing such services. It has been suggested that IA should clearly declare to the client that it will not seek any power of attorney or authorisations from its clients for auto implementation of investment advice. However, SEBI in Amendment Regulations emphasis that whether to avail implementation services would be sole choice of client and the IA cannot force its client to avail implementation services. Further, IA shall provide implementation services to its advisory clients only through direct schemes/products in the securities market. IA or group or family of IA shall not charge directly or indirectly any consideration including commission or referral fees for providing implementation services. SEBI has also mandated IAs to provide declaration that no consideration shall be received by IA for implementation of advice or execution services. The said declaration has been inserted under item 5 of the First schedule of IA Regulations.

Terms and Conditions of Investment Advisory Services

As per regulation 19, an IA shall maintain copy of agreement with the client, if any, along with other records specified under the said regulation. Since the requirement of advisory agreement is not mandatory under the erstwhile IA Regulations, most of the clients always remain unaware about the terms and conditions of the advisory services that they are going to obtain from IAs.

SEBI has been receiving numerous investor complaints against IAs that they charge exorbitant advisory fees, promising false returns, non-disclosure of detailed fees structure etc. In absence of written agreement between adviser and client, client may not be able to prove his claim.

Therefore, SEBI has mandated an execution of agreement between IA and client which shall specify key terms and conditions, as may be prescribed by SEBI, regarding investment advisory services and this would in turn facilitate transparency.

Advisory Fees

As per the Code of Conduct for IAs prescribed under third schedule of IA Regulations, IAs shall charge fair and reasonable fees to the clients in lieu of providing advisory services. There have been several complaints received by SEBI regarding unreasonable fees being charged by IAs. To restrain such instances and unfair practices, SEBI has inserted Regulation 15A regarding advisory fees that can be charged by IAs to its clients.

The discussion paper has provided two modes of charging fees to clients. IAs can either charge fees by opting Assets under Advice (AUA) mechanism or they can charge fixed fees. SEBI inserted the definition of AUA in Regulation 2(aa) of IA Regulations which shall mean aggregate net asset value of securities and investment products for which IA has rendered investment advice irrespective of whether the implementation services are provided by investment adviser or concluded by the client directly or through other service providers. Under AUA mechanism, fees shall be charged on the basis of underlying assets under advice subject to maximum 2.5 percent of AUA per annum per family across all schemes/ products/ services provided. On other hand, as per fixed fees terms, IA can charge maximum Rs. 75,000 p.a. per family across all schemes/ products/ services provided. The option of choosing mode for charging fees is available with IA, however, change of mode can be effected only after 12 months of on boarding/last change of mode.

In practice, it would be difficult to implement maximum ceiling limit proposed by SEBI. There are certain portfolios that contain high risk products which requires effective skills and essential time to provide any investment advice. In such cases, maximum ceiling would be discouraging for IAs to charge a particular fees to compensate for their efforts. Therefore, in Board memorandum, SEBI has proposed to reconsider and enhance fixed fees from Rs. 75,000 to Rs. 1,25,000 p.a. per ‘family of client’ and fees under AUA mechanism shall be 2.5 percent of AUA per annum per ‘family of client’ across all schemes/ products/ services offered by IA. SEBI inserted a definition of ‘Family of client’ which constitutes individual, dependent spouse, dependent children and dependent parents. IAs would also be required to mention detailed fees structure along with adequate calculations under terms and conditions of advisory agreement. The above-mentioned proposed fees structure is not yet finalised; and is expected to be specified by the SEBI at the earliest. Also, SEBI is expected to bring more clarity that whether IA can charge fees using different fees structure to different categories of customers.

Eligibility Criteria for IAs

The eligibility criteria for IA includes qualification and net worth requirement. Under the erstwhile IA Regulations, regulation 7 and 8 deals with the qualification and net worth requirements respectively. IAs or a principal officer of non-individual IAs shall have minimum qualification as prescribed under the regulation 7.

SEBI has amended the qualification and net worth requirement. SEBI has introduced the definition of “persons associated with investment advice” and “principal officer” in Amendment Regulations. All client facing persons such as sale staff, service relationship managers, client relationship managers, etc. shall be deemed to be persons associated with investment advice, whereas principal officer shall mean managing director/managing partner, designated director etc. who is responsible for overall business operations of non-individual IAs. In terms of the erstwhile IA Regulations, IA shall have either professional qualification/post-graduation or graduation along with five year experience of advisory as mentioned in regulation 7(1). However, as per recent amendments, an individual IA and principal officer in case of non-individual IA shall be required to meet both the criteria that is to have professional qualification/post-graduation along with 5 years experience at all times. The requirement of certification on financial planning (NISM) remains unchanged.

In terms of the erstwhile IA Regulations, IAs which are body corporate shall have a net worth of not less than twenty-five lakh rupees and for IAs who are individuals or partnership firms shall have net tangible assets of value not less than rupees one lakh. However, SEBI has increased minimum net worth criteria to rupees fifty lakhs and rupees five lakhs for non-individual and individual IAs respectively. However, all persons associated with investment advice shall comply with the qualification requirements with minimum two years of experience. The existing IAs shall comply with new eligibility norms within 3 years from the date of commencement of Amendment Regulations. The summary of erstwhile eligibility criteria along with recent amendments is given below:

Use of Nomenclature

In order to obviate misunderstanding and confusion amongst investors regarding the roles and responsibilities of distributors including mutual fund distributors who refer to themselves as ‘independent financial adviser’ or ‘wealth adviser’, it is relevant that the nomenclature should not mislead the investors. Therefore, SEBI has inserted Regulation 3(3) which specifies that any person other than IA registered with SEBI, dealing in distribution of securities shall not use the nomenclature “Independent Financial Adviser (IFA) or Wealth Adviser or any other similar name.

Conversion of Individual IAs to Non-individual IAs

SEBI has inserted additional criteria under regulation 13 which directs individual IA to apply for registration as non-individual IA, in case number of clients of such individual IA exceeds 150 in total.

Conclusion

With these amendments, SEBI took efforts to make robust regulation for investment advisers. Some of the changes would definitely pick up the slacks, however, SEBI should reassess the proposal for ceiling limit on advisory fees and bring more clarity.

[1]https://www.sebi.gov.in/web/?file=https://www.sebi.gov.in/sebi_data/attachdocs/jun-2020/1591597643206.pdf#page=1&zoom=page-width,-15,842

[2]https://www.sebi.gov.in/reports-and-statistics/reports/jan-2020/consultation-paper-on-review-of-regulatory-framework-for-investment-advisers-ia-_45685.html

[3] https://www.sebi.gov.in/media/press-releases/feb-2020/sebi-board-meeting_46013.html

[4] http://egazette.nic.in/WriteReadData/2020/220363.pdf and https://www.sebi.gov.in/media/press-releases/jul-2020/sebi-notifies-amendments-to-sebi-investment-advisers-regulations-2013_47006.html