Consensual restructuring of debt obligations, due to COVID disruption, not to be taken as default, clarifies SEBI

Vinod Kothari

finserv@vinodkothari.com

The global economy, as also that of India, is passing through a systemic disruption due to the COVID crisis. The Reserve Bank of India in its Seventh Bi-monthly Monetary Policy Statement 2019-20 dated March 27, 2020[1] has permitted banks and non-banking financial institutions to provide a moratorium to borrowers for a period of 3 months.

As a result, cashflows of banks and financial institutions from underlying loans will be disrupted, at least for the period of the moratorium. It is a different thing that the disruption may actually prolong, but 3 months as of now is what is explicitly regarded by the RBI has COVID-driven.

The financial sector is admittedly one the major issues of debt securities in India. Therefore, an issue that has arisen is, if the financial sector entities, or other issuers of debt obligations, are not able to repay the same on a due date, due to the pandemic crisis, will the same be a case of a default, and will the credit rating agencies (CRAs) report the same as a default?

In response, SEBI, vide Circular dated March 30, 2020[2], addressed to the CRAs, has clarified as follows:

  • If the delay in payment of interest/ principal has arisen solely due to the lockdown conditions creating temporary operational challenges in servicing debt, including due to procedural delays in approval of moratorium on loans by the lending institutions, CRAs may not consider the same as a default event and/or recognize default.
  • The above shall also be applicable on any rescheduling in payment of debt obligation done by the issuer, prior to the due date, with the approval of the investors/ lenders.
  • The above relaxation is extended till the period of moratorium by RBI.

The above circular is, though, addressed to the CRAs, the intent of the regulator is quite clear. If a restructuring of debt obligations happens due to the disruption caused by the pandemic, it is not a case of default.

“Default” is a credit event, mostly analogously referred to as “failure to pay”. A “failure to pay” is a credit event under ISDA Master Agreement, globally followed as the standard for derivatives documentation. Even under ISDA master agreement, there is an exception in case of a force majeure event. It is being contended, and with lot of force according to the author, that the widespread disruption in activity due to the COVID 19 constitutes a force majeure event[3]. If the same is taken as a “default’ leading to serious implications for the issuer, it will be exacerbating the problem of the present disruption. Therefore, a clarification from the regulators that any failure to pay under the present circumstances, solely connected with the disruption, is not itself a credit event.

On a reading of the definition of default under Guidelines for CRAs issued by SEBI[4] it can be derived that “Debt obligations” refers to an obligation to repay a debt on the scheduled repayment date, failing which, the same will be treated as default. If the payment is not required to be made as per contractual terms between the borrower and lender in the first place, then the same is not a debt obligation.

It may therefore be implied as follows:

  • Debentures/ Bonds – In case delay in payment of interest/ principal components of debentures by borrowers, is solely due to the lockdown conditions which create temporary operational challenges in servicing debt, the same may not be considered as a default event;
  • Commercial Paper – The above is implied even in case of commercial paper;
  • Pass through certificates – any rescheduling in payment obligation, if the waterfall clause is modified to reflect the reschedulement of the underlying cashflows, done by the issuer, prior to the due date, with the approval of investors/lenders shall not be treated as a default in PTCs, during the period of moratorium.

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49582

[2] https://www.sebi.gov.in/legal/circulars/mar-2020/-relaxation-from-compliance-with-certain-provisions-of-the-circulars-issued-under-sebi-credit-rating-agencies-regulations-1999-due-to-the-covid-19-pandemic-and-moratorium-permitted-by-rbi-_46449.html

[3] See an article by Richa Saraf on this issue here:  http://vinodkothari.com/2020/03/covid-19-and-the-shut-down-the-impact-of-force-majeure/

[4] https://www.sebi.gov.in/legal/circulars/nov-2016/enhanced-standards-for-credit-rating-agencies-cras-_33585.html

SEBI relaxes timelines at the time of disruption caused by COVID-19

Vinod Kothari & Company

corplaw@vinodkothari.com

Below is a short snippet of the relaxed timelines issued by the securities market regulator in the wake of the disruption caused by COVID-19.

Fintech Framework: Regulatory responses to financial innovation

Timothy Lopes, Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

The world of financial services is continually witnessing a growth spree evidenced by new and innovative ways of providing financial services with the use of enabling technology. Financial services coupled with technology, more commonly referred to as ‘Fintech’, is the modern day trend for provision of financial services as opposed to the traditional methods prevalent in the industry.

Rapid advances in technology coupled with financial innovation with respect to delivery of financial services and inclusion gives rise to all forms of fintech enabled services such as digital banking, digital app-based lending, crowd funding, e-money or other electronic payment services, robo advice and crypto assets.

In India too, we are witnessing rapid increase in digital app-based lending, prepaid payment instruments and digital payments. The trend shows that even a cash driven economy like India is moving to digitisation wherein cash is merely used as a way to store value as an economic asset rather than to make payments.

“Cash is King, but Digital is Divine.”

  • Reserve Bank of India[1]

The Financial Stability Institute (‘FSI’), one of the bodies of the Bank for International Settlement issued a report titled “Policy responses to fintech: a cross country overview”[2] wherein different regulatory responses and policy changes to fintech were analysed after conducting a survey of 31 jurisdictions, which however, did not include India.

In this write up we try to analyse the various approaches taken by regulators of several jurisdictions to respond to the innovative world of fintech along with analysing the corresponding steps taken in the Indian fintech space.

The Conceptual Framework

Let us first take a look at the conceptual framework revolving in the fintech environment. Various terminology or taxonomies used in the fintech space, are often used interchangeably across jurisdictions. The report by FSI gives a comprehensive overview of the conceptual framework through a fintech tree model, which characterises the fintech environment in three categories as shown in the figure.

Source: FSI report on Policy responses to fintech: a cross-country overview

Let us now discuss each of the fintech activities in detail along with the regulatory responses in India and across the globe.

Digital Banking –

This refers to normal banking activities delivered through electronic means which is the distinguishing factor from traditional banking activities. With the use of advanced technology, several new entities are being set up as digital banks that deliver deposit taking as well as lending activities through mobile based apps or other electronic modes, thereby eliminating the need for physically approaching a bank branch or even opening a bank branch at all. The idea is to deliver banking services ‘on the go’ with a user friendly interface.

Regulatory responses to digital banking –

The FSI survey reveals that most jurisdictions apply the existing banking laws and regulations to digital banking as well. Applicants with a fintech business model must go through the same licensing process as those applicants with a traditional banking business model.

Only a handful of jurisdictions, namely Hong Kong, SAR and Singapore, have put in place specific licensing regimes for digital banks. In the euro area, specific guidance is issued on how credit institution authorisation requirements would apply to applicants with new fintech business models.

Regulatory framework for digital banking in India –

In India, majority of the digital banking services are offered by traditional banks itself, mainly governed by the Payment and Settlement Systems Act, 2007[1], with RBI being the regulatory body overseeing its implementation. The services include, opening savings accounts online even through apps, facilitating instant transfer of funds through the use of innovative products such as the Unified Payments Interface (UPI), which is governed by the National Payments Corporation of India (NPCI), facilitating the use of virtual cards, prepaid payment instruments (PPI), etc. These services may be provided not only by traditional banks alone, but also by non-bank entities.

Fintech balance sheet lending

Typically refers to lending from the balance sheet and assuming the risk on to the balance sheet of the fintech entity. Investors’ money in the fintech entity is used to lend to customers which shows up as an asset on the balance sheet of the lending entity. This is the idea of balance sheet lending. This idea, when facilitated with technological innovation leads to fintech balance sheet lending.

Regulatory responses to fintech balance sheet lending –

As per the FSI survey, most jurisdictions do not have regulations that are specific to fintech balance sheet lending. In a few jurisdictions, the business of making loans requires a banking licence (eg Austria and Germany). In others, specific licensing regimes exist for non-banks that are in the business of granting loans without taking deposits. Only one of the surveyed jurisdictions has introduced a dedicated licensing regime for fintech balance sheet lending.

Regulatory regime in India –

The new age digital app based lending is rapidly advancing in India. With the regulatory framework for Non-Banking Financial Companies (NBFCs), the fintech balance sheet lending model is possible in India. However, this required a net owned fund of Rs. 2 crores and registration with RBI as an NBFC- Investment and Credit Company.

The digital app based lending model in India works as a partnership between a tech platform entity and an NBFC, wherein the tech platform entity (or fintech entity) manages the working of the app through the use of advanced technology to undertake credit appraisals, while the NBFC assumes the credit risk on its balance sheet by lending to the customers who use the app. We have covered this model in detail in a related write up[2].

Loan & Equity Crowd funding

Crowd funding refers to a platform that connects investors and entrepreneurs (equity crowd funding) and borrowers and lenders (loan crowd funding) through an internet based platform. Under equity crowd funding, the platform connects investors with companies looking to raise capital for their venture, whereas under loan crowd funding, the platform connects a borrower with a lender to match their requirements. The borrower and lender have a direct contract among them, with the platform merely facilitating the transaction.

Regulatory responses to crowd funding –

According to the FSI survey, many surveyed jurisdictions introduced fintech-specific regulations that apply to both loan and equity crowd funding considering the similar risks involved, shown in the table below. Around a third of surveyed jurisdictions have fintech-specific regulations exclusively for equity crowd funding. Only a few jurisdictions have a dedicated licensing regime exclusively for loan crowd funding. Often, crowd funding platforms need to be licensed or registered before they can perform crowd funding activities, and satisfy certain conditions.

Table showing regulatory regimes in various jurisdictions

Fintech-specific regulations for crowd funding
Equity Crowd Funding Equity and Loan Crowd Funding Loan Crowd Funding
Argentina           Columbia

Australia             Italy

Austria                Japan

Brazil                   Turkey

China                   United States

Belgium                Peru

Canada                 Philippines

Chile                      Singapore

European Union  Spain

France                   Sweden

Mexico                  UAE

Netherlands         UK

Australia

Brazil

China

Italy

 

Source: FSI Survey

Regulatory regime in India

  1. In case of equity crowd funding –

In 2014, securities market regulator SEBI issued a consultation paper on crowd funding in India[3], which mainly focused on equity crowd funding. However, there was no regulatory framework subsequently issued by SEBI which would govern equity crowd funding in India. At present crowd funding platforms in India have registered themselves as Alternative Investment Funds (AIFs) with SEBI to carry out fund raising activities.

 

  1. In case of loan crowd funding –

The scenario for loan crowd funding, is however, already in place. The RBI has issued the Non-Banking Financial Company – Peer to Peer Lending Platform (Reserve Bank) Directions, 2017[4] which govern loan crowd funding platforms. Peer to Peer Lending and loan crowd funding are terms used interchangeably. These platforms are required to maintain a net owned fund of not less than 20 million and get themselves registered with RBI to carry out P2P lending activities.

 

As per the Directions, the Platform cannot raise deposits or lend on its own or even provide any guarantee or credit enhancement among other restrictions. The idea is that the platform only acts as a facilitator without taking up the risk on its own balance sheet.

Robo- Advice

An algorithm based system that uses technology to offer advice to investors based on certain inputs, with minimal to no human intervention needed is known as robo-advice, which is one of the most popular fintech services among the investment advisory space.

Regulatory responses to robo-advice –

According to the FSI survey, in principle, robo- and traditional advisers receive the same regulatory treatment. Consequently, the majority of surveyed jurisdictions do not have fintech-specific regulations for providers of robo-advice. Around a third of surveyed jurisdictions have published guidance and set supervisory expectations on issues that are unique to robo-advice as compared to traditional financial advice. In the absence of robo-specific regulations, several authorities provide somewhat more general information on existing regulatory requirements.

Regulatory regime in India –

In India, there is no specific regulatory framework for those providing robo-advice. All investment advisers are governed by SEBI under the Investment Advisers Regulations, 2013[5]. Under the regulations every investment adviser would have to get themselves registered with SEBI after fulfilling the eligibility conditions. The SEBI regulations would also apply to those offering robo-advice to investors, as there is no specific restriction on using automated tools by investment advisers.

Digital payment services & e-money

Digital payment services refer to technology enabled electronic payments through different modes. For instance, debit cards, credit cards, internet banking, UPI, mobile wallets, etc. E-money on the other hand would mostly refer to prepaid instruments that facilitate payments electronically or through prepaid cards.

Regulatory responses to digital payment services & e-money –

As per the FSI survey, most surveyed jurisdictions have fintech-specific regulations for digital payment services. Some jurisdictions aim at facilitating the access of non-banks to the payments market. Some jurisdictions have put in place regulatory initiatives to strengthen requirements for non-banks.

Further, most surveyed jurisdictions have a dedicated regulatory framework for e-money services. Non-bank e-money providers are typically restricted from engaging in financial intermediation or other banking activities.

Regulatory regime in India –

The Payment and Settlement Systems Act, 2007 (PSS) of India governs the digital payments and e-money space in India. While several Master Directions are issued by the RBI governing prepaid payment instruments and other payment services, ultimately they draw power from the PSS Act alone. These directions govern both bank and non-bank players in the fintech space.

UPI being a fast mode of virtual payment is however governed by the NPCI which is a body of the RBI.

Other policy measures in India – The regulatory sandbox idea

Both RBI and SEBI have come out with a Regulatory Sandbox (RS) regime[6], wherein fintech companies can test their innovative products under a monitored and controlled environment while obtaining certain regulatory relaxations as the regulator may deem fit.  As per RBI, the objective of the RS is to foster responsible innovation in financial services, promote efficiency and bring benefit to consumers. The focus of the RS will be to encourage innovations intended for use in the Indian market in areas where:

  1. there is absence of governing regulations;
  2. there is a need to temporarily ease regulations for enabling the proposed innovation;
  3. the proposed innovation shows promise of easing/effecting delivery of financial services in a significant way.

RBI has already begun with the first cohort[7] of the RS, the theme of which is –

  • Mobile payments including feature phone based payment services;
  • Offline payment solutions; and
  • Contactless payments.

SEBI, however, has only recently issued the proposal of a regulatory sandbox on 17th February, 2020.

Conclusion

Technology has been advancing at a rapid pace, coupled with innovation in the financial services space. This rapid growth however should not be overlooked by regulators across the globe. Thus, there is a need for policy changes and regulatory intervention to simultaneously govern as well as promote fintech activities, as innovation will not wait for regulation.

While most of regulators around the globe have different approaches to governing the fintech space, the regulatory environment should be such that there is sufficient understanding of fintech business models to enable regulation to fit into such models, while also curbing any unethical activities or risks that may arise out of the fintech business.

[1] https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/86706.pdf

[2] http://vinodkothari.com/2019/09/sharing-of-credit-information-to-fintech-companies-implications-of-rbi-bar/

[3] https://www.sebi.gov.in/sebi_data/attachdocs/1403005615257.pdf

[4] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MDP2PB9A1F7F3BDAC463EAF1EEE48A43F2F6C.PDF

[5] https://www.sebi.gov.in/legal/regulations/jan-2013/sebi-investment-advisers-regulations-2013-last-amended-on-december-08-2016-_34619.html

[6] https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=938

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

[7] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=48550

[1] Assessment of the progress of digitisation from cash to electronic – https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=19417

[2] https://www.bis.org/fsi/publ/insights23.pdf

SEBI introduces enhanced disclosure and standardized reporting for AIFs

Timothy Lopes, Executive, Vinod Kothari Consultants Pvt. Ltd.

finserv@vinodkothari.com

SEBI has vide circular dated 5th February, 2020[1] introduced a standard Private Placement Memorandum (PPM) and mandatory performance bench-marking for Alternative Investment Funds (AIF). The move is part of SEBI’s initiative to streamline disclosure standards in the growing AIF space. The changes are made based on the recommendations of the SEBI Consultation Paper[2] on ‘Introduction of Performance Bench-marking’ and ‘Standardization of Private Placement Memorandum for AIFs’.

Template for Private Placement Memorandum (PPM)

The SEBI (AIF) Regulations, 2012 specified broad areas of disclosures required to be made in the PPM. This led to a significant variation in the manner in which various clauses, explanations and illustrations are incorporated in the PPMs. Hence, this led to concerns that the investors receive a PPM which provides information in a manner which is too complex to easily comprehend or with too little information on important aspects of the AIF, e.g. potential conflicts of interests, risk factors specific to AIF or its investment strategy, etc.

Thus, SEBI has mandated a template[3] for the PPM providing certain minimum level of information in a simple and comparable format. The template for PPM consists of two parts –

Part A – Section for minimum disclosures, which includes the following –

  • Executive Summary –

This lays down the summary of the parties and terms of the transaction. In effect, it is a summary term sheet of the PPM, laying down essential features of the transaction.

  • Market opportunity / Indian Economy / Industry Outlook;

The theme of this section includes a general economic background followed by investment outlook and sector/ industry outlook. This section may include any additional information as well which may be relevant. An illustrative list of additional items which may be included has been specified in the template.

  • Investment Objective, Strategy and Process;

A tabular representation of the investment areas and strategy to be employed is laid down in under this head. Further, a flow chart depicting the investment decision making process and detailed description of the same is required to be specified. This will give investors a comprehensive idea of the ultimate investment objective and strategy.

  • Fund/Scheme Structure;

A diagrammatic structure of the Fund/ Scheme which discloses all the key constituents and a brief description of the activities of the Fund/ Scheme.

The diagrammatic representation shall specify, for instance, the sponsor, trustee, manager, custodian, investment advisor, offshore feeder, etc. 

  • Governance Structure; 

To enhance the governance disclosures to investors and ensure transparency this section mandates disclosures of all details of each person involved in the Fund/ Scheme structure, including details about the investment team, advisory committees, operating partners, etc.

  • Track Record of the Manager;

The track record of the Fund Manager is of great significance since investors would like to know the skill, experience and competence of the Manager before making an investment.

The template mandates disclosures about the manager including explicit disclosure of whether he is a first time manager or experienced manager.

  • Principal terms of the Fund/ Scheme;

Explicit disclosures about the principal terms such as minimum investment commitment, size of the scheme, target investors, expenses, fees and other charges, etc. are required to be disclosed as per the template.

Major terms and disclosures are covered under this section. 

  • Principles of Portfolio Valuation;

This section would broadly lay down the principles that will be used by the Manager for valuation of the portfolio company.

The investors would get a fair idea of the manner in which valuation of the portfolio would be undertaken, in this section.

  • Conflicts of interest;

All present and potential conflicts of interests that the manager would envisage during the operation of the Fund/ Scheme at various levels are to be disclosed under this section.

This would enable investors to factor in the conflicts of interests existing or which may arise in the future of the fund and make an informed decision.

  • Risk Factors;

All risk factors that investors should take into account such as specific risks of the portfolio investment or the fund structure are required to be disclosed in the PPM.

These risks would include operational risks, tax risks, regulatory risks, etc. among other risk factors. 

  • Legal, Regulatory, and Tax Consideration;

This section shall include standard language for legal, regulatory and tax considerations as applicable to the Fund/Scheme, including the SEBI (AIF) Regulations, 2012, Takeover Regulations, Insider Trading Regulations, Anti-Money Laundering, Companies Act, 2013. Taxation aspects of the fund are also to be disclosed.

  • Illustration of fees, expenses and other charges;

A tabular representation of the fees and other charges along with the expenses of the Fund are required to be disclosed for transparency of investors and no hidden charges. 

  • Distribution Waterfall;

The payment waterfall to different classes of investors is required to be disclosed in detail.

  • Disciplinary History.

Any prior disciplinary action taken against the sponsor, manager, etc. will be required to be disclosed for better informed decision making of investors.

Part B – Supplementary section to allow full flexibility to the Fund in order to provide any additional information, which it deems fit.

The template requires enhanced disclosures mandatorily required to be made by the AIF, such as risk factors, investment strategy, conflicts of interest and several other areas that may affect the interest of the investors of AIFs.

This will standardize disclosures across the AIF space and increase simplicity of information to investors in a standard reporting format. Enhancing disclosure requirements will increase investor understanding about AIF schemes.

Further there is a mandatory requirement to carry out an annual audit of the compliance of the PPM by either an internal or external auditor/ legal professional. The findings arising out of the audit are required to be communicated to the Trustee or Board or Designated Partners of the AI, Board of the Manager and SEBI.

Exemption has been provided from the above PPM and audit requirements to the following classes of funds:

  1. Angel Funds as defined in SEBI (Alternative Investment Funds), Regulations 2012.
  2. AIFs/Schemes in which each investor commits to a minimum capital contribution of Rs. 70 crores (USD 10 million or equivalent, in case of capital commitment in non-INR currency) and also provides a waiver to the fund from the requirement of PPM in the SEBI prescribed template and annual audit of terms of PPM, in the manner provided at Annexure 3 of the SEBI Circular.

These requirements are however applicable from 01st March, 2020.

Bench-marking for disclosure of performance

Considering that investments by AIFs have grown at a rate of 75% year on year in the past two years, a need was felt to introduce disclosures by AIFs indicating returns on their investments. Prior to the SEBI circular there was no disclosure requirement for AIFs on their investment performance.

There was no bench-marking of returns disclosed by AIFs to their prospective or existing investors. However, returns generated on investment is one of the most important factors taken into consideration by potential investors and is also important for existing investors in order to be informed about the performance of their investment in comparison to a benchmark.

Therefore, it is felt that there is a need to provide a framework to bench-marking the performance of AIFs to be available for the investors and to minimize potential misselling.

In this regard SEBI has introduced the following –

  1. Mandatory bench-marking of the performance of AIFs (including Venture Capital Funds) and the AIF industry.
  2. A framework for facilitating the use of data collected by Bench-marking Agencies to provide customized performance reports.

The new bench-marking framework prescribes that each AIF must enter into an agreement with a Bench-marking Agency (notified by an AIF association representing at least 51% of the number of AIFs) for carrying out the bench-marking process.

The agreement between the Bench-marking Agencies and AIFs shall cover the mode and manner of data reporting, specific data that needs to be reported, terms including confidentiality in the manner in which the data received by the Bench-marking Agencies may be used, etc.

Reporting to the Bench marking Agency –

AIFs are required to report all the necessary information including scheme-wise valuation and cash flow data to the Bench-marking Agencies in a timely manner for all schemes which have completed at least one year from the date of ‘First Close’. The form and format of reporting shall be mutually decided by the Association and the Benchmarking Agencies.

If an applicant claims a track-record on the basis of India performance of funds incorporated overseas, it shall also provide the data of the investments of the said funds in Indian companies to the Benchmarking Agencies, when they seek registration as AIF.

PPM and Marketing material –

In case past performance of the AIF is mentioned in the PPM or any marketing material the performance versus benchmark report provided by the benchmarking agencies for such AIF/Scheme is also required to be provided.

Operational Guidelines for the benchmarking criteria is placed in Annexure 4 to the SEBI Circular.

Further there is an exemption from the above requirements to Angel Funds registered under sub-category of Venture Capital Fund under Category-1 AIF.

Conclusion

These changes are likely to bring about higher disclosure and transparency in the AIF space, especially for existing as well as potential investors of AIFs. Standardization of PPM will eliminate any variance from the manner of disclosures made by various AIFs.

Links to related write ups –

http://vinodkothari.com/2018/03/can-aif-grant-loans/

http://vinodkothari.com/wp-content/uploads/2018/03/PPT-on-financial-and-capital-markets_27-02-18_final.pdf

http://vinodkothari.com/aifart/

[1] https://www.sebi.gov.in/legal/circulars/feb-2020/disclosure-standards-for-alternative-investment-funds-aifs-_45919.html

[2] https://www.sebi.gov.in/reports-and-statistics/reports/dec-2019/consultation-paper-on-introduction-of-performance-benchmarking-and-standardization-of-private-placement-memorandum-for-alternative-investment-funds_45215.html

[3] https://www.sebi.gov.in/sebi_data/commondocs/feb-2020/an_1_p.pdf

SEBI brings in revised norms for Portfolio Managers

Timothy Lopes, Executive, Vinod Kothari Consultants Pvt. Ltd.

finserv@vinodkothari.com

The securities market regulator has recently introduced the new SEBI (Portfolio Managers) Regulations, 2020 (PMS Regulations), bringing in several changes to the Portfolio Management industry, including doubling the ticket size for investments and increasing the net-worth requirement of Portfolio Managers.

The Portfolio Management Services (PMS) industry has witnessed substantial growth in its Assets Under Management (AUM) in the last 5 years as shown in the data below. There has also been a substantial increase in the number of clients, indicating that the PMS industry plays a significant role in managing funds of High Net-worth Individuals.

Source: SEBI PMS Data[1]

This growth called for a need to review the existing PMS Regulations and provide for enhanced regulations to protect investor interest and increase transparency and disclosure norms for the benefit of investors.

SEBI constituted a Working Group to identify the areas that required change in the PMS Regulations. Based on the Report of the Working Group[2], SEBI introduced the new PMS Regulations on 16th January, 2020 which is primarily aimed at reducing risk for investors by imposing certain investment caps and increasing transparency in the PMS industry. We discuss some of the major changes made and their impact on the industry.

Increase in ticket size of investment

The new regulations prescribe an increase in the minimum investment limit from earlier Rs. 25 Lakh to Rs. 50 Lakh in the new regulations. The rationale behind the increase is that Portfolio Management Services unlike mutual funds are more complicated and riskier products, meant for investors with higher risk taking capacity. So to avoid retail investors with limited understanding of volatility and risk entering this product, it is thought prudent to increase the minimum investment limit.

This increase is likely to deny the benefits of PMS to retail investors in the Rs. 25 – 50 Lakh investment bracket. Further the growth of PMS industry is likely to decline as there will be fewer new investors entering this product due to the increased limit. However with the sharp and rather rapid growth in the economy and stock markets, the increased investment limits seems justified considering that the last increase in the minimum limit was done 8 years ago in February, 2012.

Net-worth requirement increased to Rs. 5 crores

The new regulations prescribe an increase in the capital adequacy requirement of Portfolio Managers from the present Rs. 2 crores to Rs. 5 crores with a view to act as a deterrent to non-serious players in the PMS industry and also put pressure on fringe players co-existing with serious managers.

The limit was also increased considering several other factors such as inflation, rising income levels, increased compliance costs, IT costs, etc.

New Investment norms

Earlier the investment made by PMS was liberal as opposed to mutual funds where there existed several restrictions on investment and exposure norms. The new regulations have brought in investment restrictions for both discretionary and non-discretionary PMS.

Discretionary PMSs are those wherein the Portfolio Managers have some degree of discretion with respect to managing the funds of their clients. While non-discretionary PMS have no degree of discretion and require prior client consent each time a transaction is undertaken.

The PMS Regulations, 2020 introduce restrictions on investment in unlisted securities by mandating discretionary PMS to invest only in listed securities, while non-discretionary PMS can invest in unlisted securities up to 25% of their AUM.

This move is likely to reduce the risk for clients of PMS and disallow high exposure to investment in unlisted securities. It is important to note that similar restrictions on investment are also imposed on Mutual Funds in 2019. Investment in listed securities only brings in higher levels of disclosures and transparency to the clients investment portfolio.

Further investment in mutual funds may be done by Portfolio Managers only through ‘Direct Plans’. This is with a view to avoid charging any distributor’s fee from the clients.

Other investment norms are largely the same as 1993 PMS Regulations.

Nomenclature “Investment Approach”

The Working Group recommended the adoption of a standard nomenclature called the Investment Approach of Portfolio Managers, permitted to be used in reporting and disclosure documents of PMS as the same does not compromise the bi-laterality of the Portfolio Management Contract.

Adopting the nomenclature for reporting and disclosures by Portfolio Managers will allow them to easily compare performance of multiple investment approaches under the umbrella of one Portfolio Manager. There are concerns as to whether investors would then get confused between a Mutual Fund Scheme and the Investment Approach of a Portfolio Manager. This is unlikely as the Working Group addressed this issue by stating that the investors in PMS are highly sophisticated with higher understanding of the differences between Mutual fund schemes and Portfolio Managers.

Standardized Reporting

Performance reporting standards were revisited in light of the need for standardized & accurate reporting for all Portfolio Managers. Proposals were made by the Working Group for reporting at the client level, reporting to SEBI and reporting for marketing materials as well. Since, there was no standardized reporting in the earlier framework, several issues were pointed out by the Working Group such as –

  • Cherry picking certain portfolios by Portfolio Managers;
  • Performance calculation differed among several Portfolio Managers;
  • Portfolio managers showing model returns;
  • Portfolio managers inflating returns by annualizing partial periods;
  • Comparing the strategy’s returns with incorrect benchmark returns;
  • Not taking into account the cash component in computing returns
  • Ignoring withdrawn portfolios;
  • Not disclosing qualitative parameters such as a change in the identity of the fund manager, change in the investment strategy.

The PMS Regulations, 2020 address these issues by bringing in standard performance reporting for all Portfolio Managers. The Regulations prescribe calculation of performance of a Portfolio Manager using a standard ‘Time Weighted Rate of Return’ (TWRR) and has also increased the frequency of reporting to clients from the earlier half yearly reporting to quarterly reporting to clients.

Qualifying criteria for employees of a Portfolio Manager

Considering the importance of educational qualification as well as work experience in the PMS industry, the working group recommended a change in the qualifying criteria of the Principal Officer (PO) as well as employees of the PO. The new qualifying criteria is depicted hereunder –

Particulars PMS Regulations, 1993 Working Group Recommendation PMS Regulations, 2020
Definition of PO Reg 2(d) – “principal officer” means an employee of the portfolio manager who has been designated as such by the portfolio manager; Reg 2(l) – “Principal Officer” means an employee of the portfolio manager who is responsible for:-

(A) The decisions made by the portfolio manager for the management or administration of a portfolio of securities or the funds of the client, as the case may be.

(B) The overall supervision of the operations of the portfolio manager.

Reg 2(p) – “principal officer” means an employee of the portfolio manager who has been designated as such by the portfolio manager and is responsible for: –

(i) the decisions made by the portfolio manager for the management or administration of portfolio of securities or the funds of the client, as the case may be; and

(ii) all other operations of the portfolio manager.

Qualifying criteria for PO The principal officer of the applicant has either–

(i) a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university; or

(ii) an experience of at least ten years in related activities in the securities market including in a portfolio manager, stock broker or as a fund manager;

(iii) a CFA charter from the CFA Institute.

Principal Officer of a Portfolio Manager shall have minimum qualification as given below:

1. a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university and relevant NISM certification

AND

2. an experience of at least Five years in related activities in the securities market including as a portfolio manager, stock broker, Investment Advisor or a fund manager.

 

the principal officer of the applicant has–

(i) a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university or a CFA charter from the CFA institute;

(ii) experience of at least five years in related activities in the securities market including in a portfolio manager, stock broker, investment advisor, research analyst or as a fund manager; and

(iii) the relevant NISM certification as specified by the Board from time to time.

Provided that at least 2 years of relevant experience is in portfolio management or investment advisory services or in the areas related to fund management.

Qualifying criteria for employees of the PM The applicant has in its employment minimum of two persons who, between them, have at least five years’ experience in related activities in portfolio management or stock broking or investment management or in the areas related to fund management; Minimum two employees with –

(i) a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university and relevant NISM certification

AND

(ii) an experience of at least two years in related activities in the securities market including as a portfolio manager, stock broker, Investment Advisor or a fund manager.

In addition, any employee of the Portfolio Manager who has decision making authority related to fund management shall have the same minimum qualifications as the Principal Officer.

In addition to the Principal Officer and Compliance Officer, the applicant has in its employment at least one person with the following qualifications :-

(i) graduation from a university or an institution recognized by the Central

Government or any State Government or a foreign university; and

(ii) an experience of at least two years in related activities in the securities market including in a portfolio manager, stock broker, investment advisor or as a fund manager:

Provided that any employee of the Portfolio Manager who has decision making authority related to fund management shall have the same minimum qualifications and experience as specified for the Principal Officer in clause (d) of sub-regulation (2) of regulation 7:

There are several legal and regulatory compliances required on part of a Portfolio Manager under the PMS Regulations. This called for the need to mandate appointment of a Compliance Officer, in addition to the Principal Officer, who shall be responsible for all legal and regulatory compliances.

Under Regulation 34 of the PMS Regulations, it is specifically stated that the role of the compliance officer shall not be assigned to the principal officer or employees of the Portfolio Manager. This was not stated under the PMS Regulations, 1993. This means that a person having the necessary legal background and qualifications will be required to be additionally appointed by each Portfolio Manager and it must be ensured that the role is not assigned to the principal officer or employees of the Portfolio Manager.

Conclusion

The changes in the PMS Regulations bring in enhanced disclosure and standardization for the PMS industry. Clients of PMS will be able to better understand and compare the terms of services offered by various Portfolio Managers.

Although the changes in the regulations are most welcome, the growth of the PMS industry will likely see a slowdown due to the increased investment minimum limit for clients of PMS of Rs. 50 Lakh.

[1] https://www.sebi.gov.in/statistics/assets-managed/assets-managed.html

[2] https://www.sebi.gov.in/sebi_data/commondocs/aug-2019/Report%20of%20Working%20Group%20on%20PMS_p.pdf

Recent Developments in Corporate Laws

In its stride to achieve transparency, good governance, and ease of doing business, the Government has time and again introduced amendments, proposed new ideas in the corporate laws. The very recent example of such changes are (a) Changes in RPTs proposed in LODR; (b) Minority Squeeze outs under Companies Act; and (c) introduction of Winding-up Rules, 2020.

In light of the these amendments/ proposed amendments, it becomes important to understand its impact on the already existing set-up. A brief analysis of the aforementioned topics has been discussed here