In the board meeting on December 28, 2017, SEBI has taken the following decisions:

Consultation Paper on amendments to Investment Advisers Regulations

SEBI had previously issued two consultation papers proposing to amend the SEBI (Investment Advisers) Regulations, 2013 to provide for a strict segregation of the investment advisory and distribution services of an entity. The SEBI Board has now decided to issue a third such consultation paper proposing regulations towards achieving: i) clear segregation between investment advice activity and distribution activity of an entity; and ii) allowing mutual fund distributors to explain the features of the products and ensure that the principle of ‘appropriateness’ is followed. ‘Appropriateness’ means selling the product that is best suited to the individual investor.

There has been a lot of discussion among stakeholders regarding this proposed move by SEBI as it affects a large number of distributors of financial products who at times also act as investment advisers to their clients. However, it seems that SEBI Board has now finally decided that there should be a clear segregation between persons providing investment advice, who act as fiduciaries to their clients, and distributors who sell financial products and earn commission from fund houses. In order to address the conflict of interest arising out of the distribution and advisory roles played by the same entity, SEBI proposes to restrict distributors from providing any investment advice to their clients. They can only do a ‘suitability’ or ‘appropriateness’ analysis of a particular mutual fund product with respect to a specific client.

The immediate impact, if the proposal is implemented, is that a large number of mutual fund distributors who act as the last mile contact for investors would be restricted from providing any kind of financial advice to their clients. Therefore, these investors would now have to seek specialist investment advice to determine the financial products in which they can invest and then purchase the same through a distributor of such products. The proposed move would create additional barriers for investors entering the market as there is no organized market or demand for pure advisory services. Hence, this proposal is pre-mature and may impact financial inclusion goals and penetration of mutual fund products.

Easing of Access Norms for Investment by FPIs

The SEBI Board has decided to rationalize the ‘fit and proper’ criteria for Foreign Portfolio Investors (“FPIs”). Currently, an FPI applicant has to fulfil various requirements such as being authorized by its Memorandum of Association/Articles of Association, having sufficient experience, being permitted to invest outside its home country, etc., in addition to being a ‘fit and proper’ person as defined under SEBI (Intermediaries) Regulations, 2008. Since Category I and II FPIs are essentially Government and Regulated entities, it has been decided that the documentation to satisfy the ‘fit and proper’ criteria will be sufficient for such FPIs and they need not satisfy the other requirements mentioned above.

As of now, a FPI applicant having a bank as an underlying investor is deemed to be a ‘broad based’ fund. It has now been decided to extend this criteria to FPIs having other institutional investors, such as sovereign wealth fund, insurance/reinsurance companies, pension funds, etc., as their underlying investors. While this is a good move, the reasoning behind classification of funds as ‘broad based’ and it being considered as a point of regulatory virtue is unclear. Narrower ownership of funds makes it easier to see the ultimate ownership, making KYC process easier. Further, it has also been decided to provide a time period of three months to regain the ‘broad based’ status if a fund loses the status due to the exit of some offshore investors and the total number of investors goes below the specified threshold.

Prior approval from SEBI in case of change in local custodian or designated depository participants (DDPs) will no longer be required and the new DDP will be permitted to rely on the registration granted by previous DDP at the time of transition.

Amendments to the SEBI (Credit Rating Agencies) Regulations, 1999

The Board has approved the increase of minimum networth requirement of Credit Rating Agencies (“CRAs”) from Rs. 5 crores to Rs. 25 crores. Such an increase is counter-productive as it may not result in the enhancement of quality of services, but would instead dissuade entities from seeking registration as a CRA adversely affecting the quality due to lower competition. Further, the cost of capital associated with this requirement will be passed on to the ultimate customer – the investor.

The Board has taken a decision to prohibit: (a) CRA’s; and (b) shareholders holding 10% or more shares or voting rights in a CRA, from holding 10% or more shares or voting rights in any other CRA. Shareholdings by pension funds, insurance schemes and mutual fund schemes are exempted from this restriction. The objective behind this move is ensure independence of each of the registered CRAs and prevent control of multiple CRAs by one set of persons.

Further, CRAs would now be allowed to withdraw the ratings, subject to the CRA having rated the instrument continuously for a stipulated period and in the manner specified by SEBI. We believe requiring the CRAs to mention reasons for such withdrawal is also essential to present the true financial position of the issuer.

The Board also decided to mandate segregation of the activities of a CRA other than that of rating of financial instruments and economic / financial research into a separate legal entity. Activities undertaken by CRAs like providing advisory services, rating of non-financial instruments etc., may create inherent conflicts of interest with the core activity. However, instead of requiring the establishment of a separate legal entity, mandating creation of “chinese walls” might be sufficient to address the concerns.

Listing of Security Receipts (SRs) issued by ARCs

SEBI Board has approved a framework for listing of security receipts (“SRs”) issued by Asset Reconstruction Companies (“ARCs”) under the SEBI (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 (“SDI Regulations”).

A separate chapter detailing the framework for listing of SRs will be added to the SDI Regulations. Under the SARFAESI Act, the ARCs can offer SRs to qualified institutional buyers and any other entity specified by the RBI. Currently, SRs are traded on an over-the-counter basis with a limited subscriber base making the market illiquid. Listing of SRs will enhance capital flows in the market and add liquidity.

Amendments to the REIT Regulations

The Board has decided to reduce the minimum threshold for investment by Real Estate Investment Trusts (“REITs”) in a Holding Company/Special Purpose Vehicles (“SPVs”) from 51% to 50%. This may potentially boost the registration of REITs as many real estate joint ventures have 50-50% partnerships with neither party willing to relinquish control. While the minimum level will be lowered, the REIT is still required to have an ultimate holding interest of 26% in the underlying SPV(s). Further, it has been decided to rationalize the definition of ‘Sponsor Group’ under the REIT Regulations.

Under the REIT Regulations, at least 80% of the value of REIT assets must be invested in complete and rent generating properties, while the remaining value of up to 20% can be invested in the specified assets. It has now been decided to allow investment in unlisted shares under the 20% category.

Cross-holding in AMCs or Trustee Companies

To reduce conflicting interests in Asset Management Companies (“AMCs”) and Trustee Companies (“TCs”) of competing mutual funds, SEBI Board has decided that:

  1. a) Sponsors, their associates, their group companies, and all connected AMCs of a mutual fund would have to restrict their shareholding in AMCs/TCs of other mutual funds to under 10%, and they would not be permitted to have representation on the boards of such AMCs/TCs of other mutual funds.
  2. b) Shareholder of an AMC/TC holding more than a 10% stake would also be subject to the same restrictions.

Although shareholding in competing AMCs/TCs may hypothetically result in conflicts of interest which may be inimical to the interests of the unit holders of the potentially less-favored fund, the actual harm sought to be avoided is unclear. Especially, in light of the highly regulated environment in which mutual funds operate. It is inefficient to restrict shareholding in competing AMCs/TCs using such a straight jacketed formula when there are other methods to prevent any harm to unit holders arising from such theoretically conflicting shareholder interests. This may be a remedy without an illness.