Balancing Flexibility and Investor Protection: A Critical Review of SEBI’s Proposed Reforms for Asset Management Companies

[Arihant and Keshav are students at Gujarat National Law University and Institute of Law, Nirma University, respectively.]

Mutual funds have been one of the most optimal and accessible investment instruments for retail investors for the last few decades in India, offering the benefit of professional fund management and diversification of risks. Under the current Securities and Exchange Board of India (SEBI) (Mutual Funds) Regulations 1996 (MF Regulations), asset management companies (AMCs) that operate mutual funds (broad-based funds) are restricted from providing any services to funds with less than 20 investors (non-broad-based funds) in order to ensure investor protection. To reconsider these restrictions on AMCs, SEBI released a consultation paper titled “Consultation Paper on Review of Regulatory Framework on Permissible Business Activities for Asset Management Companies (AMCs) Under Regulation 24 of The SEBI (Mutual Funds) Regulations, 1996” on 7 July 2025 (Consultation Paper). The primary objective of the Consultation Paper is to allow AMCs to widen their businesses by providing these services to non-broad-based funds as well, while trying to ensure the retail investor’s interest and ensure systemic integrity.

This piece aims to critically engage with the proposals of the consultation paper and constructively review the same. While authors appreciate SEBI’s approach of liberalizing financial institutions for promoting ease of doing business, it is equally important to ensure that such liberalization does not undermine investor protection or create market asymmetries. The Consultation Paper has mentioned a number of proposals, and in order to limit the scope of the discussion, the authors will deal with four key proposals: the role of the Unit Holder Protection Committee (UHPC), the 70% portfolio replication requirement, the prohibition on inter-business security transfers, and the proposed fee cap structure. In the opinion of the authors, each of these areas exposes potential lacunae that deserve a closer examination.

Background of the Problem

Regulation 24(b) of the MF Regulations restricts AMCs from “undertaking any business activity other than in the nature of management and advisory services provided to pooled assets”. These are funds with at least twenty investors and no single investor holding more than 25% corpus in the fund. The framework was initially introduced in 2011 with the objective of preventing any conflict of interest due to differential fee structures and protecting retail investors from bearing the costs of the non-broad-based funds, where the clients are High Net Worth Individuals (HNIs).

Over the years, AMCs and the Association of Mutual Funds in India have vouched to liberalize these restrictions on AMCs. They argue that the broad-based requirement makes it costly and tough for non-broad funds to leverage their fund from the management expertise of the AMCs providing services to the broad-based funds.

Overview of the Consultation Paper

In response to these concerns, SEBI’s consultation paper proposes overhauling Regulation 24(b) to allow AMCs to provide their services even to the non-broad-based funds directly, subject to several restrictions. The consultation paper aims to find a middle ground to protect investors and promote ease of doing business, especially with the super natural growth in the Indian Financial Market.

SEBI acknowledged the critical concerns that could arise regarding the safeguarding of retail investors in case AMCs are allowed to manage both mutual fund schemes and pooled non-broad-based funds. These include the resource diversion, where fund managers may be diverted from mutual funds to non-broad funds in the pursuit of getting higher fees, leading to suboptimal returns for retail investors.

SEBI also raised its concerns regarding market abuses, such as front-running, insider trading and contrary trade positions. In order to address these challenges, SEBI proposed several suggestions to create an optimal market for both retail investors as well as HNIs. Among the various suggestions, four proposals merit special attention due to their importance in the creation of a free and fair market while safeguarding investors’ interests.

First, a portfolio replication requirement is mandated by SEBI in the scenario where the same manager is proposed to provide services to both broad-based as well as non-broad-based funds. A common manager can only be allowed if at least 70% of the portfolio value is replicated across the funds with similar investment objectives.

Second, the paper places a cap on the fee differentials for such AMCs along with absolute restriction on performance-linked fees. SEBI provided two approaches: either a cap and floor on the absolute fees chargeable to pooled non-broad-based funds, or a cap on the difference in fees compared to similar mutual fund schemes.

Third, the paper suggests that the UHPC should have an enhanced role. The UHPC would be in charge of reviewing the fee differences between pooled non-broad-based funds and similar mutual fund schemes periodically. It will also review the decisions about the allocation of resources and ensure that all the changes are justified, documented and within SEBI’s limits. The AMC’s Board of Directors, trustees and SEBI shall get a report of UHPC’s filings.

Lastly, in order to avoid any conflicting interest, SEBI mentioned that any transfer of assets between mutual fund schemes and non-broad-based funds must be restricted to eliminate the risk of fraud, low liquidity or offloading illiquid assets from one business segment to another, especially at the cost of retail mutual fund investors.

Analysis

In the view of the authors, some of the SEBI’s suggestions suffer from significant practical limitations and structural flaws. Addressing the same is required to protect the retail investors and overall market functioning from the material risks. The authors have mentioned these practical limitations and provided recommendations for the same below. These recommendations will help policymakers to create a fairer market for retail investors.

70% replication rule

As mentioned earlier, in order to avoid duplication of staff and additional cost associated with segregation of the fund managers, the SEBI proposes that the same fund managers may be allowed to manage both the funds, provided that both funds are having same investment objective and 70% of the portfolio is replicated across the funds. However, the term “same investment objective” is prone to broad interpretation. For example, if the investment objective of the fund is to generate “long-term capital appreciation from a diversified equity instrument”, then this potentially could encompass both a low-risk Nifty 50 fund and a high tactical fund targeting special situations but falling under the broad objective. Despite similar stated objectives, the actual portfolio strategy may vary for both funds.

Further, the levy of 30% allows the fund managers to reserve their best ideas or early access opportunities to the non-broad-based fund clients, including high-risk, pre-IPO, exclusive opportunities or time-sensitive trades. Thus, creating a potential for preferential treatment of selective investors, which goes against the spirit of SEBI’s objective of equitable treatment.

Additionally, the protective cover extended to retail investors in the form of no directionally opposite trades also appears to be insufficient as it does not prevent the situation where indirect benefits, such as early trade timing, selective exits where bad positions in exited in one fund first and exclusive access of the QIP or IPO allocation for non-broad-based clients.

To effectively address this concern, it is suggested that SEBI may increase the replication threshold to 85% or 90% to reduce the performance disparity. Further, SEBI may adopt a standardized definition of investment objective for shared managers along with a mandatory external audit of trade allocation to prevent any vague equivalence, which will, in turn, enhance greater trust and accountability.

Differential fee justification and inadequate monitoring mechanism

SEBI proposes a cap and floor price on the fee structure and requires justification for any difference in fee based on complexity, customization, mandate, etc. However, these terms remain undefined and broadly worded, thereby allowing fee differences to be easily justified using internal documentation, which ultimately weakens the intended transparency.

Further, as a safety measure, SEBI has suggested the requirement of a periodical review of fee differentials or resource allocation by the UHPC. However, the UHPC is composed of members appointed by the AMC Board itself, thus unlikely to act independently and take an adversarial stance.

Further, the UHPC only has the power to observe, suggest and recommend anything regarding the issues. It has no authority to block any investment or halt a fee schedule. Even if a conflict is flagged, the AMC Board retains the power to override its recommendations, reducing the UHPC to a mere reporting body without real enforcement capability.

In order to prevent this, it is suggested that SEBI may consider mandating external validation of fee justification. Additionally, mandatory disclosures by AMCs regarding resource allocation ratios and cost attribution across schemes can further enhance the transparency and avoid the risk of arbitrary fee differentials.

Asset transfer prohibition

SEBI has inter alia proposed that the transfer of securities between pooled non-broad-based funds and mutual fund schemes may not be allowed. Here, the intention of SEBI is to prevent any unfavourable transfer of bad or low-quality assets to mutual fund schemes. However, the SEBI here only bans the direct transfer of assets between schemes, leaving the way open for any indirect transfer via market-based mechanisms. For example, the AMC could sell the risky or illiquid bonds held in a pooled fund to a third-party broker and then, a few days later, repurchase the same by the mutual fund scheme of the same AMC, thereby resulting in a round-tripping of assets through market-based intermediaries.

To address this concern, the SEBI could implement cross-scheme issuer-level tracking with a mandate of reporting any repurchase made by the mutual fund of the same AMC within a period of 15 days, with an adequate justification for such a repurchase. This will add a layer of transparency and accountability on AMCs regarding any transaction they execute.

Conclusion

While the Consultation Paper is a progressive step towards enhancing operational flexibility for AMCs, the proposed framework requires stronger safeguards to prevent regulatory arbitrage and protect retail investors. There is a need to clarify key definitions and empower oversight mechanisms like UPHC, the current framework risks and creating structural balances. As the complexity of the mutual fund industry grows, it is crucial that transparency, accountability, and investor confidence remain at the forefront of any regulatory changes. The success of this well-intentioned program will depend on anticipatory adjustments.