Reset the norms
The Securities and Exchange Board of India (Sebi) has issued a stronglyworded 100-page final order on Monday, holding fund house Franklin Templeton India guilty of wrong-doing and mismanagement in six of its debt schemes. The schemes were closed in April last year, with Franklin Templeton citing severe market dislocation and illiquidity caused by the pandemic. The order, which is certain to be taken to the Securities Appellate Tribunal, debars the asset management company (AMC) from launching any new debt schemes for two years and imposes a fine of ~5 crore. Sebi has also ordered the AMC to return management charges levied on investors between June 2018 and April 2020. This award amounts to over ~500 crore.
Sebi has alleged wrongdoing on several counts. The fund house ran different schemes with similar investment strategies, which contravened the regulator’s 2018 instructions that there should be only one scheme per AMC in each of its 36 categories. The six schemes had similar portfolios, including roughly twothirds of AUM invested in securities rated AA or lower. According to the Sebi 2018 classification, only a credit-risk fund is allowed to make such allocations. Duration-based debt schemes are supposed to hold portfolios with a weighted average term to maturity conforming to the stated duration. This is known as the Macaulay Duration. Sebi alleged the six funds were breaching the Macaulay Duration by buying long-term securities. The funds also manipulated the Macaulay Duration by recognising long-term securities, which had an option to reset interest rates at specific periods as shorter-term securities, by accepting the period of the reset as the duration of the bond. In addition, Sebi said the funds refused to exit loss-making securities on many occasions when it could have exercised put options. It also said the schemes invested in illiquid securities without due diligence and some of the investments were akin to giving loans.
The funds also inflated their net asset values, “violating principles of fair valuation”. It did not “ensure fair treatment to all investors” and its terms meant unequal treatment favouring bond issuers over investors. This may also be a reference to insider trading charges filed against Vivek and Roopa Kudva for exiting the six schemes just ahead of the shutdown. The regulator needs to introspect about that aspect. It should in future be looking to monitor large unit sales by entities close to fund managers or related parties in situations where there are already signals of trouble. This order will anyhow force the industry to beef up compliance and that is a good thing. It is true that illiquidity caused by the pandemic resulted in unusual market conditions. But it is also evident that the fund house took grave risks to push up yields.
In a reclassification last week, the regulator tightened the debt mutual space by recategorising debt funds in a new way which allows less wiggle room for allocation outside the main category. Funds must now invest in better documentation of security selection processes, detailed credit analysis, monitoring of liquidity, etc. But many market watchers would consider the order to return ~500-odd crore harsh and not commensurate with the actions of the fund house, leading to speculation over the award being mitigated in size, or overturned, on appeal to the tribunal. But one way or the other, this order could reset the norms of the debt fund market.