The Quest for Liquidity – Recent Measures to Curb Discretionary Restrictions on Redemptions of Mutual Fund Units

[The following guest post is contributed by Arka Saha, who is a 4th Year B.A.LL.B. (Hons) & Executive Student in CS (ICSI) at National Law University Odisha (NLU-O)]
One of the key objectives of mutual fund investments, along with returns and security, is liquidity – the ability to liquidate holdings and withdraw investments in units as per the needs of the holder. Even closed-ended schemes, which refer to schemes having a fixed maturity period as opposed to open ended schemes, are mandated to provide liquidity in investments either through mandatory listing on a stock exchange, or through a repurchase facility as per Regulation 32 of the SEBI (Mutual Funds) Regulations 1996. However, the regulations permit for certain conditions pertaining to redemption via repurchase, without specifying any guidelines as to how these restrictions are to operate and the circumstances under which they can be placed. Through its circular dated May 23, 2008, SEBI posited that such restrictions on redemption were to be placed only with due consent of the board of directors of the Asset Management Company (AMC) and the Trustees of the fund. Recent developments, especially the fiasco pertaining to the JP Morgan Asset Management Company which denuded investor confidence in the mutual fund industry due to liquidity issues, has forced the regulator’s hand in doing away with widespread discretion available to the AMCs as to restrictions on redemptions.
The Trigger
In August last year, two debt funds of the J.P. Morgan AMC, namely the JP Morgan India Short Term Income Fund (JSTI) and JP Morgan India Treasury Fund (JTF), which had combined exposure to debt papers of Amtek Auto to the tune of around Rs. 200 crores representing 10.78% and 5.87% of the funds’ respective total corpus, imposed restrictions on redemptions of units in light of increased redemption pressure due to a sharp fall in the Net Asset Values, via gating of redemptions at 1% of  total outstanding units on any given day. Unit holders were thus stopped from redeeming their investments, and had to wait to liquidate, while the Net Asset Value of the schemes fell further due to continued sell pressure in the debentures and stocks of the company in light of a credit downgrade by Care Ratings, default in interest payments, and weak fundamentals. The restriction imposed was in light of the increasing lack of liquidity in the debt papers, which made it difficult for the schemes to reduce exposure in proportion to redemption pressure. Gating of redemptions had the effect of nurturing a market wide distrust in the mutual fund industry, as it distorted the fundamental feature of liquidity.
Subsequently, the AMC had to resort to ‘side-pocketing’ , a practice previously unheard of in India and thus unregulated, which refers to the segregation of illiquid or toxic assets from the total body of assets and cash holdings of the scheme into separate units, before allowing redemption of those units in the two schemes that had no exposure to debentures of Amtek Auto. The newly created, segregated units that contained exposure to debentures of Amtek Auto exclusively were closed for subscription and redemption until they were disposed of at a loss of around 15% to PE Investors in December 2015, thus finally according some liquidity to unit holders with regard to the monies caught up in these units. This episode brought upon the scrutiny of the regulator, which on 31 May 2016 came out with a circular laying down guidelines pertaining to the placement of restrictions on redemptions.
Recent Measures
The Circular stipulates certain circumstances under which restrictions can be placed on redemptions in extant schemes from 1 July 2016 and in all schemes coming into existence after 31 May 2016. The general tone of the circular establishes that restrictions can now be placed upon systemic risks to the markets resulting in high redemption pressure and not due to bad investment decisions by AMCs resulting in a drop in the Net Asset Value of schemes of funds. The circular states that restrictions can be placed only in case of markets becoming illiquid in general, unexpected occurrences which inter alia are related to political, economic, military, monetary or other emergencies resulting in the closure of stock exchanges, or irregular functioning of the same, and in operational issues arising due to unpredictable circumstances such as force majeure and technical failures – given that they occur in spite of reasonable appropriate diligence of third parties and adequate disaster recovery systems.
Therefore, restrictions cannot be placed on redemptions due to illiquidity or other defaults in specific securities held by a fund. Further, such restrictions can be placed for a maximum of ten working days in a three-month period, with the same having to be sanctioned by the board of directors of the AMCs and the trustees of the fund in question. The circular further imposes a duty to disclose any restriction thus sanctioned to the regulator. In addition, in a move that will most benefit retail investors, no restrictions can be imposed, notwithstanding any reason, for redemption requests amounting to Rs. two lakhs. For redemption requests above the two-lakh rupee mark, only that part exceeding the Rs. 2 lakh threshold is to be subjected to the imposed restrictions.
The conditions mandated by the circular, in the opinion of the author, which are extended towards benefiting small investors by protecting them from draconian restrictions that can at present be placed by AMCs due to failure on their part in picking out fundamentally strong investments, are in tune with  international best practices.[1]  In effect, the guidelines on restrictions will ensure that AMCs do not take unnecessary risks without conducting proper due diligence, instead relying on credit rating agencies which will soon be subject to more stringent regulations themselves to increase transparency and accountability in light of them not providing adequate reasons while suspending ratings. However, these guidelines will only prove to be conducive to the needs of the small retail investors if they are further educated about risks associated to their investments, (the practice of gating or placing absolute restrictions on redemptions is done to prevent large falls in NAVs due to redemption pressure, ensuring that all existing unit holders face the brunt of investments gone bad equally by not allowing anyone to pull out), as more often than not they lack the sophistication to know when to pull out, thus giving rise to risks of falling NAVs due to quicker redemptions in large scale by more educated and experienced investors such as other funds.
– Arka Saha

[1]    The Securities and Exchange Commission, the securities regulator in the United States of America which has a more vibrant mutual fund industry, allows restrictions on redemptions only under exceptional circumstances as the one permitted by SEBI under the current circular.

Discretionary Portfolio Management and Insider Trading

The concept of discretionary portfolio management (“DPM”) is one whereby a portfolio manager makes investments on behalf of a client. The decisions regarding which investments must be made, and on what terms, are left to the portfolio manager. The client neither influences the decision-making of the portfolio manager nor does the client get involved in day-to-day investment decisions.
Request and Guidance
In the context of DPM, a question arose as to whether the possession of insider information by a client would vitiate a trade by the portfolio manager in terms of the regulations governing insider trading. This came up in a requestfor informal guidance made by HDFC Bank to the Securities and Exchange Board of India (“SEBI”). HDFC Bank set out the broad circumstances where such an issue arose. Several employees of the Bank could be in possession of unpublished price sensitive information (“UPSI”) pertaining to the Bank or other listed companies with which it deals. Hence, they would be prohibited by the SEBI (Prohibition of Insider Trading) Regulations, 2015 (the “Insider Trading Regulations”) from dealing in those securities. They would also be subject to closures of trading windows by the Bank or other listed companies. In this context, it may be necessary for such employees to make investments through other means such as mutual funds or DPM. The core issue was whether they could make investments through DPM while in possession of UPSI.
HDFC Bank’s request letter sets out details regarding the functioning of DPM, and how the client has no control or influence whatsoever on the investment decisions made by the portfolio managers. Hence, even though the clients (in this case employees) are in possession of UPSI, that ought not to matter as, decisions are taken by portfolio managers who are not privy to that information. In essence, the Bank’s case is that the information available with the clients should not be attributed to the portfolio managers, thereby rendering a wider (and arguably lenient) interpretation to the provisions of the Insider Trading Regulations.
However, in its informal guidance, SEBI refused to accept the request made by HDFC Bank, and opined that investments made by employees of the Bank who are in possession of UPSI will be in violation of the Insider Trading Regulations if portfolio managers carry out trades for them under the DPM scheme. SEBI’s reasoning is as follows:
i. Regulation 4(1) of the [Insider Trading] Regulations unambiguously states that no insider shall trade in securities that are listed or proposed to be listed on a stock exchange when in possession of unpublished price sensitive information.
ii. Further, in the explanatory notes to Regulation 4 of PIT Regulations it is mentioned that when a person who has traded in securities has been in possession of UPSI, his trades would be presumed to have been motivated by the knowledge and awareness of such information in his possession.
iii. It is therefore inferred from the above that dealing in securities, whether it is direct or indirect, is not relevant, but that any insider when in possession of UPSI should not deal in securities of the company to which the UPSI pertains. Even while dealing in such securities through a discretionary portfolio management scheme, the trades of insider shall be presumed to be motivated by the knowledge and awareness of UPSI.
On similar grounds, SEBI concluded that employees would be prohibited from undertaking any trading through DPM when the trading window is closed.
At a broad level, SEBI’s approach in the guidance is consistent with a rather strict approach adopted by the Regulations towards insider trading. As I had discussed in a recent paper(pages 5 to 8), SEBI as well as other jurisdictions such as the United Kingdom and Singapore adopt the “parity of information” approach towards insider trading whereby the focus is on whether the person trading had UPSI, and not whether that information influenced the dealing in shares or whether the person had a blameworthy state of mind. This effectively broadens the scope of the insider trading regime. Consequently, in its guidance, SEBI simply looked at whether the employees had UPSI and, if so, their actions were presumed to have motivated the trades in shares. Such a presumptive approach was put to full use by SEBI in this guidance.

This much is understandable. But, it is somewhat intriguing that SEBI used such a strict “parity of information” approach even in the scenario of trading through DPM rather than when employees (or possessors of UPSI) trade by themselves. SEBI did not place the requisite emphasis on the fact that the decisions are made by the portfolio managers independent of any UPSI that their clients in the form of employees may possess. SEBI effectively treated the UPSI in the hands of the clients as if the portfolio managers held it. If it is indeed the case that there is an opaque wall between the portfolio managers and clients in a DPM, then that conclusion is somewhat perplexing. It has the effect of expanding the scope of the insider trading prohibition when employees invest through indirect means. If investments through DPM are covered within the scope of insider trading, will it then also extend to investments through mutual funds? Although SEBI has not specifically considered mutual funds in this guidance, it is not clear whether its expansive interpretation may rein in other forms of investment management.