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  • Nimish Maheshwari

Redefining Portfolio Management: A Critical Analysis of SEBI’s Consultation Paper

[Nimish is a student at National Law University Jodhpur.]


The Securities and Exchange Board of India (Board) issued a consultation paper on ease of doing business initiatives for portfolio managers (Managers) on 15 February 2024. The paper proposed three main initiatives and invited public comments.


The first proposal concerns the mandatory registration of portfolio management services (PMS) with the Association of Portfolio Managers in India (APMI). This proposal is similar to the Association of Mutual Funds (AMFI), which was formed to keep investors informed about the mutual fund market. It ensures transparency in each step of the industry’s transactions, thereby bringing accountability. Along similar lines, APMI will promote regulatory compliance and contribute to operational efficiency and risk management. The proposal aims to enhance transparency, accountability, and professionalism within the portfolio management industry, ultimately benefiting both distributors and managers while bolstering investor confidence and protection.


The second pertains to challenges in the digital customer onboarding process and managers’ responsibility to elucidate the fee structure to clients. This proposal will strengthen transparency in financial transactions through proper fee acknowledgement. This will also improve communication between portfolio managers and clients. Moreover, managers must resolve fee calculation discrepancies or client queries within 30 days. This will lead to timely dispute resolution and enhance trust and the client-manager relationship.


The third one is related to the critical aspects of the PMS-client agreement and disclosure document as given in the Securities and Exchange Board of India (Portfolio Management) Regulations 2020 (Regulations). To ensure understanding of clients, it is proposed that managers are required to provide their clients with a standard Most Important Terms and Conditions (MITC) document. The form, nature of communication, documentation, and detailed standards for the implementation of MITC will be prescribed by the APMI in consultation with the Board. This will have several positive effects, such as a better understanding for clients regarding the key terms like risks and obligations associated with the investment, thereby promoting transparency and informed decision-making. Clients’ acknowledgement will promote accountability on the managers’ part and ensure that they are fully aware of the terms and conditions governing their investment arrangements. 


This article will critically review the MITC proposal and suggest necessary additions and changes to address potential gaps. To address the same the article is further divided in parts. The next part presents a critical analysis of the MITC proposal. Thereafter, the author presents a potential shortcoming in the MITC proposal related to investment due diligence that the Board must address through the proposed amendment. The author then presents another shortcoming related to the lack of differentiation between institutional and retail investors. The article also discusses global insights about liquidity management and why it should be adopted in the Indian context. The author concludes by emphasizing the need to closely examine these suggestions and imbibe them into the amended regulation.


Critical Analysis of the MITC Proposal 


Regulation 22(1) mentions the agreement between a portfolio manager and client which includes provisions related to mutual rights, liabilities and obligations, fees payable, risks involved, investment objective, investment restrictions, tenure, and termination of the agreement. The contents of the agreement have been given in Schedule IV of the Regulations. Regulation 22(3) provides for disclosures related to portfolio risks specific to investment approach, related party transactions, conflicts of interests, performance of portfolio manager, and audited financial statements. The proposal is based on the premise that these documents grow in size, and investors may overlook crucial details, so to ensure that clients easily comprehend the information, managers furnish a standardized document MITC. The APMI and the Board will specify the format, mode of communication, documentation, and precise guidelines for implementing the MITC. This proposal is significant as it will gear toward better transparency, lessen the probability of future disputes, and ultimately promote ease of doing business. 


Understandably this proposal stands to benefit both clients and managers by promoting clarity, accountability and trust. However, the entire purpose of this consultation paper would be rendered ineffective if the manager’s disclosure of information or inclusion of information in the disclosure document is deficient and leaves out crucial details that actually benefit the clients. Like the information related to investment due diligence and liquidity management.


The author strongly recommends that the Board incorporates a few crucial topics that managers need to disclose information on. This will make the existing proposal more pertinent and significant, and ensure comprehensive disclosure of all necessary information.


Investment Due Diligence and Managing Risk


Current regulatory expectation regarding investment due diligence is given in, Regulation 21 read with Schedule III of the Regulations. On a close reading it can be found that it has been worded very wide and liberal as it only mentions that a manager must render a “high standard of service, exercise due diligence, and must ensure proper care and independent professional judgment.”


It has been found that if practices around investment due diligence are inconsistent, it may at times results in loss for the clients as many a times, investments are being made in illiquid or complex securities without due diligence by overlooking the material risk due to which customers suffer losses. Henceforth there is a need to specifically make clearer expectations for managers concerning investment due diligence (over and above the existing conduct rules).


To understand what these guidelines will look like, we can take guidance from the OECD Guidelines for Multinational Enterprises on due diligence.


OECD Guidelines for Multinational Enterprises are the most comprehensive international instrument on business conduct. They stand out as a pioneer in the global capital market in defining due diligence. Due diligence is a process of identifying actual and potential adverse impact, preventing or mitigating adverse impact by tracking performance and communicating results


Prior to investing, it is crucial to perform thorough quantitative and qualitative risk evaluations. This entails actively examining investment portfolios to pinpoint potential high-risk zones, such as specific industries, regions, or product categories. It is essential to take into account various factors, such as the hazards associated with the investee companies’ operations, the unique attributes of the investee companies’ home countries, including the socio-economic climate in which they operate, and the governance structure within which they conduct their activities.


Difference between Institutional and Retail Investors


Portfolios managed for retail investors are different from institutional investors with respect to the access to information, access to large assets, risk tolerance, size of information, regulatory oversight to the financial sophistication and because of this retail Client-PMS agreement may be based on a standard service which hardly require any modification. This may have limited customization, and in result there is limited scope for the client to negotiate terms and conditions. Whereas the portfolio management of companies is more professional-focused which may be subjected to much more modification in terms and conditions. There must be different rules pertaining to MITC for retail and institutional investors as they are different from one another. Hence there must be a separate set of rules governing the disclosure document requirement of retail and institutional investors.


Exploring Beyond Borders: Insights for India’s Future?


To ensure proper market functioning, it is crucial to have a clear regulatory framework for liquidity management by managers in India. While the investment approach is discussed in the Master Circular Clause 4.6 (Circular), it lacks guidance on liquidity management. The management of liquidity in funds has become increasingly important due to the growth of the fund industry. The International Organization of Securities Commissions (IOSCO), which is recognised as the global standard setter for the securities sector, has released recommendations for Liquidity Risk Management for Collective Investment Schemes. These recommendations are based on insights from the 2007-2010 financial crisis. Effective liquidity risk management is essential to protect investors’ interests, maintain investment and market orderliness, reduce systemic risk, and support financial stability. IOSCO has partnered with the FSB to analyse possible systemic risks arising from liquidity risk management in investment schemes. Many member jurisdictions, including the UK, France, Hong Kong, and the US, have made significant progress in updating their regulatory framework or guidance on liquidity risk management in investment schemes based on these recommendations.


IOSCO expects that securities regulators in countries will actively promote the implementation of the recommendations by responsible entities. However, the recommendations must be adapted to suit the specific legal structures prevailing in each jurisdiction. Therefore, many countries across the world have updated and introduced liquidity management regulations that are tailored to their own legal structures. For instance, the Securities and Futures Commission in Hong Kong emphasizes the need for regular assessments and periodic disclosure of liquidity risks by portfolio managers in its Fund Manager Code of Conduct guidelines. The Securities and Exchange Commission in the US released a Liquidity Final Rule in June 2018, which requires open-ended funds to categorize their holdings into liquidity categories - highly liquid, moderately liquid, less liquid and illiquid - based on the time it takes to liquidate assets.


Conclusion 


The consultation paper is a step in the right direction as to the establishment of APMI and digital onboarding of clients. The proposal related to MITC has also been made with the long-term benefit of the change kept in mind. This move is anticipated to enhance India’s international reputation as an attractive investment destination. Nevertheless, implementing these changes is not a daily affair; therefore, the board must remain mindful of the ongoing developments in the contemporary world. In this article, the author has proposed some of the areas of potential gaps that might occur in the future. The author has presented some of the pioneer investment practices which are in practice around the world. It has been proposed that the board must integrate different insights related to due diligence, liquidity management, etc., from diverse global trendsetters into the amendments so that the goal of ease of doing business along with a robust system of checks can be achieved in India.


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