CHAPTER - SIX

MUTUAL FUNDS REGULATIONS IN INDIA

The effectiveness of financial system depends on the mechanism of

regulations adopted for an orderly function of the system. Regulation aims at

safeguarding the interest of investors through imposing a number of restrictions on the

constituents of financial system – the financial institutions and/ or intermediaries,

financial markets and financial instruments. Different constituents of financial system

have different type and degree of regulations depending on their level of functioning.

The main purpose of regulations is to ensure the soundness, transparency and

efficiency of financial system. Mutual funds are important constituents of the

financial system in India. The need to regulate the mutual funds industry arises from

the very objective of setting up of these outfits. The main objectives of the mutual

funds industry have been twofold: to protect the investor’s interest by following sound

fund management policy and to act a via media to channelise investor’s resources to

the most productive areas of production through the capital market route. Further

since, mutual funds’ market operation involve buying / selling/ holding various listed

scrips or debt instruments, they have a significant impact on savings, investment,

liquidity and the overall status of the financial markets. The very market structure of

the industry also necessitates its own regulation. The entry of the private sector into

the industry has increased the chances of speculative activities. Stock prices may be

distorted by such activities unless regulated. All these meant that the growth of the

mutual funds industry should also be accompanied by the development of a suitable

regulatory framework for it. Mutual funds came under the control of Securities and

Exchange Board of India (SEBI) in 1993. Prior to 1993, there were no uniform

regulations for the industry and it was regulated by several parties with conflicting

aims and objectives. To look into the development of regulatory framework of mutual

funds in India, it would be pertinent to study it under two heads i.e. historical

perspective of mutual funds regulations and present system of regulations.

6.1 Historical Perspective of Mutual Funds Regulations

After the grand success of UTI, the Government of India gave permission to

public sector banks to commence mutual fund business since 1987. With this, in 1987,

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the State Bank of India and Canara Bank established their mutual funds by launching

variety of mutual fund schemes. Later, other public sector banks and insurance

organisations also established their mutual funds. But, to govern the activities of these

public sector mutual funds there were no separate rules and regulations in the

industry. The Unit Trust of India established with UTI Act, 1963 was liable to

regulate only the activities of UTI. The Banking Companies Act, 1947 guided only

the commercial banking activities of banks. The Indian Trust Act 1882 was too

general to look after the characteristics of mutual funds.1 So, mutual funds were

enjoying complete freedom in the market. The turnaround came when these public

sector mutual funds started offering assured return on their schemes. It led the

common investors to believe that mutual fund schemes are almost as same as bank

deposits in terms of safety. Sensing the problem, RBI issued guidelines in July, 1989

for proper functioning of mutual funds. But, these guidelines were applicable only to

the mutual funds Sponsored by public sector banks. The main aspects of guidelines

were (a) the constitution and management of mutual funds (b) investment objectives

and policies (c) prudential exposure ceiling limits (d) pricing policy and income

distribution (e) statement of accounts and disclosure norms.

The Abid Hussain Committee on Capital Market (1989), inter alia, emphasised

the need for strengthening regulatory framework for mutual funds. It also gave

recommendations for the setting up of joint sector mutual funds. Subsequently, the

Ministry of Finance issued some guidelines in June, 1990 most of which had already

been covered by RBI. These guidelines required the approval of mutual funds from

Controller of Capital Issues and their registration with SEBI. The guidelines were

related to (a) approval and registration of mutual funds (b) contribution limit and

other provisions for Sponsoring institutions (c) investment activities, ceiling, and

income distribution norms for mutual funds (d) separate accounts for scheme’s fund

allocation etc. Further, in February, 1992 the Department of Economic Affairs of

Ministry of Finance presented in detail the new set of guidelines. These guidelines

were applicable to all public, private and joint sector mutual funds (except UTI), the

1 Bansal, Lalit K. (1997). Mutual Funds: Management and Working. New Delhi: Deep & Deep

Publications Pvt. Ltd, p. 49.

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main objective of which was to instil the sense of competition, transparency and fair

play and spur the mutual funds to a great level of efficiency and friendliness. These

guidelines were related to (a) scope, formation and regulations of mutual funds (b)

norms for mutual fund schemes (c) norms for investment and distribution activities of

mutual funds (d) disclosure and reporting.

The existence of multiple guidelines and regulations led to a paradoxical

situation for mutual funds. So, the clash was natural to take place between the RBI

and Government. The RBI desired its guidelines to be followed by mutual funds

because majority of them were bank Sponsored and fall under the jurisdiction of RBI.

Government had a claim on monitoring of these mutual funds since public sector

banks were government companies. The Life Insurance Corporation of India (LIC)

and General Insurance Corporation of India (GIC) were regulated by the Ministry of

Finance as they were in the insurance business and thus, were not subject to the

jurisdiction of RBI. All this happened because under these guidelines, SEBI’s role

was rather minimal and confined only to prescribe the accounting and disclosure

requirements. The Government of India then handed over the rights of regulating

mutual funds activities to SEBI in March 1991, though it attained the statutory status

in 1992.

The need of having uniform set of regulations was still under way because the

existing regulations were inadequate in several respects. Mutual funds were having

limited scope, due to which they could serve only limited purpose. The disclosure

practices in mutual funds were also very limited and they lacked proper method of

computing Net Asset Values (NAVs). NAVs were declared on an annual basis, which

could hardly help investors in their investment decision making. The trusteeship

function was not separated from the fund management system which created clash

between the two. Also, the distribution features were common for various schemes.

Mutual funds were used to offer guaranteed returns and dividends to investors, which

created many problems for mutual funds later. There were a number of irregularities

in the transaction of government securities that caused the securities scam in 1992.

This affected the mutual funds and they were denied to launch any new schemes in

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the market till the time of their restructuring.

Thus, prior to 1993, mutual funds had three sets of guidelines viz., the

guidelines relating to UTI as per the UTI Act 1963, guidelines issued by RBI and the

guidelines of Ministry of Finance. There was overlapping and contradictions in these

guidelines. These guidelines were not comprehensive in nature and failed to cover all

areas of mutual funds.

In September 1991, the Government of India, appointed a Committee under

the chairmanship of S.A Dave to recommend a comprehensive set of guidelines for

Indian mutual funds industry. The committee gave recommendations for a sequential

operation of mutual funds. It also recommended the entry of private sector mutual

funds in India. Based on the recommendations of Dave Committee, SEBI issued SEBI

(Mutual Funds) Regulations, 1993 applicable for all mutual funds (including public

and private sector) except UTI. These guidelines (consisting of eight chapters and

seven schedules) came into effect from January 20, 1993. So, ultimately we had a

formal and comprehensive regulatory framework for mutual funds industry. However,

the separate rules for UTI and other public sector funds still had confusions in mutual

fund operations. The Narasimham Committee on Financial Sector Reforms (1991)

suggested that there should be equal treatment for all mutual funds including UTI.

Considering this, a committee headed by N. Vaghual (the then Chairman of Industrial

Credit and Investment Corporation of India (ICICI)) was constituted in October,

1993. The committee made recommendations regarding the constitution and function

of UTI and management of its schemes. With effect from July 1994, UTI came under

the control of SEBI. But, UTI had not made any changes in its statute and

organisational structure. The SEBI was given power only to look into the operations,

books and records of UTI.

Later, it came to light that mutual funds were not following the existing form

of regulations in letter and spirit. Also, the mutual funds industry had grown in size

and required certain modification, revision and relaxation in its regulations. At the

same time, SEBI wanted mutual funds to follow strict disclosure practices. It also

wanted to control the areas where mutual funds were lacking. Therefore, on

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December 9, 1996 SEBI issued the revised SEBI (Mutual Funds) Regulations, 1996

based on the recommendations of Mutual Funds 2000 Report. These new guidelines

were uniformly applicable to all the existing mutual funds in all the sectors including

UTI (except money market mutual funds).

6.2 Present System of Regulations

At present, guidelines of SEBI (Mutual Funds) Regulations, 1996 is governing

the structure and operation of mutual funds in India. The mutual funds defined in

these regulations are modelled after the UK’s Unit Trust. With these guidelines,

mutual funds are also governed by the provisions of Indian Trust Act 1882, Income

Tax Act 1961 and relevant provisions of the Companies Act, 1956. The agreement

reached between RBI and SEBI in January, 2000 has also authorised SEBI to regulate

the money market mutual funds. The Unit Trust of India has also come under the

aegis of SEBI (Mutual Funds) Regulations, 1996. So, SEBI is the sole agency for

regulating all the sectors of mutual funds in India.

The creation of SEBI (Mutual Funds) Regulations, 1996 has removed the

rigidities and restrictions existing in 1993 regulations. Maintaining greater

transparency on the part of investors as well as the parties associated with working of

mutual funds has been the key objective of these comprehensive guidelines. These

guidelines have brought into account the new provisions regarding disclosure,

transparency, and obligations with respect to mutual funds, AMCs, trustee and the key

personnel associated with them. The SEBI (Mutual Funds) Regulations, 1996 consists

of ten chapters and twelve schedules.2 It covers the following aspects: (a) constitution

and management of mutual funds (b) constitution and management of AMCs and

Custodian (c) launching of mutual fund schemes (d) investment restrictions and

valuation policies (e) general obligations (f) inspection and audit (g) procedure for

action in case of default. The legal framework of mutual funds is built around the

concept of a Sponsor (promoter), a Mutual Fund (a trust), a Custodian (safe custody

of fund securities), a Board of Trustees (holding property of fund) and an Asset

2 Draft of Securities and Exchange Board of India (Mutual Funds) Regulations, 1996

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Management Company (AMC) (managing the investments of funds).

a) Constitution and Management of Mutual Fund

The present system of regulations requires the establishment of mutual fund as

a trust under the Indian Trust Act, 1882 and registration of the trust deed under the

Indian Registration Act, 1908. With this, the Sponsor of mutual funds executes the

trust deed in favour of the trustee and set up a mutual fund. Thus, the existing form of

regulations comprises four-tier structure of mutual funds for managing their

operation. Four constituents of mutual funds are Sponsor, Asset Management

Company (AMC), Custodian and Trustees. Thus, SEBI has incorporated the flair of

norms to constitute and manage the mutual funds.

(i) Setting up of Mutual Funds

The provisions of SEBI have to be satisfied for setting up mutual funds in

India. These provisions are the same as ‘fit and proper test’ followed in UK as SEBI

also confirms the soundness of Sponsor before giving it the permission to start mutual

fund business. It stipulates that for entering into the mutual fund business, Sponsor

has to give an application to SEBI in the prescribed format (form A) with application

fee of Rs. one lakh. If it is approved for soundness then, Sponsor has to pay an

amount of Rs. twenty lakh (as registration fees) to get registered with the SEBI. The

conditions of soundness means that the Sponsor must have a ‘sound track record in

carrying the business of financial services not less than five years including the

positive net worth of business in all the immediately preceding five years’. Sponsor

should also have a general reputation of fairness and integrity in all its business

transactions. Again, the net worth in the immediately preceding years should be more

than the capital contribution of the Sponsor in AMC. It is predetermined that Sponsor

should have profits after providing for depreciation, interest and tax in three out of the

immediately preceding five years, including the fifth year. Thus, a Sponsor, who

qualifies for the above conditions, is the ‘fit and proper’ person.

As per the regulations of SEBI, the Sponsor would set up a fund in the form

of a trust through the trust deed, which should be priory approved by the SEBI. With

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this, Sponsor is also required to hold at least 40 percent of the shareholding in AMC.

SEBI further stipulates that the Sponsor or any of its directors or the principal officer

to be employed by the mutual fund should not have been guilty of fraud or has not

been convicted of an offence involving moral turpitude or has not been found guilty

of any economic offence. After confirming the eligibility criteria, SEBI registers the

mutual funds and grant them a certificate in compliance with the regulations.

Thus, SEBI backs the entry of mutual funds by indispensable provisions of

financial integrity and fairness in operating business. The main purpose of these

stipulations is to ensure the strength and credibility of the promoters (Sponsors) so as

to prevent or minimise the fraudulent practices in mutual funds. In spite of these strict

stipulations, the promoters with fake and doubtful credentials have successfully

cheated the investors. A case in this regard is CRB mutual fund (1998).

(ii) Appointment of Trustees and Contents of the Trust Deed

SEBI provides regulations for the appointment, rights and obligations of

trustees. The SEBI regulations require that only a person of ability, integrity and

standing and who has not been guilty of moral turpitude, is eligible to be appointed as

trustee. Also, he should not have been convicted of any economic offence and

violation of securities laws. With these qualifications, the appointment of trustee

needs to be approved by SEBI. It is important to mention that no AMC and no

director (including independent director), officer or employee of an AMC shall be

eligible for appointment as a trustee of any mutual fund. A person who is appointed as

a trustee of a mutual fund shall not be eligible to be appointed as a trustee of any other

mutual fund. With an aim to promote fairness, SEBI requires that two-third of the

trustees should be independent persons and not be associated with the Sponsors in any

manner. To safeguard the interest of investors, SEBI regulations further, provide that

the trustees should be independent and they should not have business relationship

with Sponsor. Though, the trustees are often chosen and appointed by the Sponsor of

mutual funds which raises concern about the independence of trustees in discharging

their functions.

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The regulations also provide detailed guidelines pertaining to the contents of

trust deed which should also be approved by SEBI. The contents of trust deed must

contain the clauses which are necessary for safeguarding the interests of unit holders

since trustees hold the property of mutual fund in trust for the benefit of unit holders.

In doing so, trust deed should not contain any clause which has the effect of limiting

or extinguishing the obligations and liabilities of the trust in relation to any mutual

fund or the unit holders. Further, it should also not contain the provisions which have

the effect of indemnifying the trustees or the AMC for loss or damage caused to the

unit holders by their acts of negligence or acts of commission or omission.

b) Constitution and Management of AMC and Custodian

It is obligatory for the mutual fund to have an AMC for managing its assets.

For this, regulation empowers trustee to constitute a separate AMC for the mutual

fund. The AMC has to take prior approval from SEBI before commencing its business

activities. SEBI has laid down some conditions for the approval of AMC. One of

fundamental conditions requires that the AMC should have minimum net worth of Rs.

10 crore (revised from the limit of Rs. 5 crore in earlier regulations of 1993). It should

also pass the ‘fit and proper’ test criterion. Further, the key personnel of the AMC

must not be found engaged in work for any AMC or mutual fund or any intermediary

whose registration has been suspended or cancelled at any time by the SEBI. Also, the

directors of the AMC should be persons of having adequate professional experience in

finance and financial services related field. Any one of them (key personnel and

director of AMC) should not have been found guilty of moral turpitude or convicted

of economic offence or violation of any securities laws. In case of any offence, the

appointment of AMC can be terminated by the majority of trustees or 75 percent of

the unit holders of scheme.

Again with a view to grant the independence and professionalism in the

prudent management of AMCs, regulations require that at least, 50 percent of

directors in the AMC’s board should not be associates of, or be associated in any

manner with the Sponsor or any of its subsidiaries or the trustees. No change in the

controlling interest of the AMC shall be made unless the prior approval of the trustees

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and SEBI is obtained. The written communication about the proposed change should

be sent to each unit holder. The advertisement concerning the change should be given

in one English daily newspaper having nationwide circulation and in a newspaper

published in the language of the region where the Head Office of the mutual fund is

situated. SEBI has laid down certain restrictions on the AMCs for their proper

functioning.

(i) Limitations on the Business Activities of AMC

SEBI imposes certain restrictions on the business activities of AMC. It is

stated clearly that an AMC cannot act as a trustee of any mutual fund and cannot

undertake business activities except activities in the nature of management and

advisory services to offshore funds, insurance funds, pension funds, provident funds

as long as such activities are not in conflict with the activities of the mutual fund.

Further, it has been stipulated that AMC may itself or through its subsidiary can

undertake such activities only if it satisfies the conditions mentioned under clause (b)

of regulations 24. SEBI clears that AMC may itself or through its subsidiary will

undertake such services for other than broad based fund (fund having at least 20

investors and no single investors account more than 25 percent of the total corpus of

fund) only. But, AMC are restricted from carrying any part of activities relating to

trading desk, unit holder servicing and investment operations outside India.3

(ii) Obligations for AMC

An AMC is obliged to take all the important steps for ensuring that the

investment of funds pertaining to any scheme is not contrary to the provisions of these

regulations and the trust deed. It is an obligation for the AMC to exercise due

diligence and care in all its investment decisions in the manner as has been exercised

by other persons engaged in the same business. Further, AMC is required to obtain the

in-principal approval from any recognized stock exchange where the units of schemes

are proposed to be listed. This regulation was introduced in April, 2009. To make the

3 SEBI (Mutual Funds) (Amendment) Regulations, (2011) vide Notification dated 30 August,

2011.

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AMC accountable, SEBI stipulates that it is also responsible for the acts of

commission or omission by its employees or the persons whose services have been

procured by the AMC.

To mitigate the conflict of interest between investors and fund managers,

SEBI has stipulated recently that the AMCs have to appoint a separate fund manager

for each fund managed by it unless the investment objectives and assets allocations

are the same and the portfolio is replicated across all the funds managed by the fund

manager. Further, the replication of minimum 70 percent of portfolio value shall be

considered adequate for the said stipulation. The AMCs have to entrust at all points of

time that fund manager shall not take directionally opposite position in the schemes

managed by him/her. This regulation is introduced to check the other fund

management activities by fund managers. In case, the fund manager is common across

mutual fund schemes under the permissible activities of AMCs, then AMCs have to

disclose on their website, the returns provided by said fund managers for all schemes

(mutual funds, pension funds and offshore funds etc.) on monthly basis. If difference

between the annual returns provided by the same fund manager for all schemes is

more than 10 percent, then AMCs have to report it to trustee and the explanation for

this to be disclosed on their website. 4

(iii) Brokerage Restrictions

To maintain the arm’s length relationship between Sponsor and AMC, SEBI

(Mutual funds) Regulations, 1996 specify the brokerage restrictions for AMCs. It

stipulates that the AMC is not permitted to purchase or sell securities through any

broker associated with the Sponsor, which is average of 5 percent or more of the

aggregate purchases and sale of securities made by the mutual fund in all its schemes.

The aforesaid limit of 5 percent will be applicable for the block of any three months.

Earlier, it was applied to the daily gross business of the mutual funds. It was amended

on the request of mutual funds because only at the end of the day, mutual funds came

to know the exact status of their buy or sale orders of schemes. Further, an AMC is

4 SEBI (Mutual Funds) Regulations 1996, Circular No. Cir/IMD/DF/7/2012 dated 28 February,

2012.

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also prohibited to purchase or sell securities through any broker (other than the broker

mentioned above) which is average of 5 percent or more of the aggregate purchases

and sale of securities made by the mutual fund in all its schemes unless the AMC has

recorded in writing the justification for exceeding the limit of 5 percent. The reports

of all such investments are to be submitted to the trustees on a quarterly basis. This

limit also applies for the block of three months.

The detrimental trade practices (unfair dealings) followed by brokers and

AMC compelled SEBI to execute tough guidelines. Regulations prohibit AMC to

utilise the services of Sponsor or any of its associates, employees or their relatives for

the purpose of any securities transaction and distribution, and sale of securities, unless

it discloses such information in the half yearly and yearly results to the unit holders.

Similarly, the AMC will have to take charge for filing the details of transactions in

securities with the trustees. It is to be done by the key personnel of the AMC in their

own name or on behalf of the AMC. The same will be reported to SEBI, as and when

required by it. Report of the details must also be sent to trustees. Other obligations are

to notify the trustees or mention in half-yearly or annual accounts of the scheme, as

also, in case when more than 5 percent of scheme’s NAV is invested by company. It

is mandatory for an AMC to submit the quarterly reports of each year to trustees so

that, the detection of aberration of its activities could become easy and clear. The

details of securities will also have to be filed by the director of AMC with the trustees

on a quarterly basis. But, the security transactions below Rs. 100,000 in value may be

ignored. The important provision is that the proper book of accounts, records and

documents for each scheme has to be maintained by AMC for a period of eight years.

Thus, SEBI put some restrictions on the activities of AMC to curb its possible

unfair trade practices. The intention behind such stipulations is that the AMC being

the subsidiary of Sponsor should maintain a wide distance from Sponsor and be

treated as a separate entity so that, the business interest of one does not clash with

another. Also, the full reporting of investment by AMC ensures that there is no scope

to misutilise the investment information it has.

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(iv) Appointment of Custodian

The mutual fund shall appoint a Custodian to carry out the custodial services

for the schemes of the fund and send notice to the SEBI within fifteen days about the

appointment of the Custodian. The Custodian undertakes the safekeeping of mutual

fund assets under its custody. For this, the mutual fund is required to enter into a

written Custodian agreement with the Custodian for the efficient and orderly conduct

of its affairs. The agreement, service contract, terms and appointment of the

Custodian should have the prior approval of the trustees. Further, no Custodian in

which the Sponsor or its associates hold 50 percent or more of the voting rights of the

share capital of the Custodian, is authorised to act as Custodian for a mutual fund.

Accordingly, in order to promote the interest of investors, SEBI requires

Custodian to be an independent entity in imparting its functions honestly. SEBI has

taken adequate and well-built measures to retain the accuracy of Custodian in

safekeeping the mutual fund assets. SEBI in maintaining the arm’s length relationship

has segregated the activities of AMC from Custodian, which leaves no chance for any

clashes between AMC and Custodian. Thus, the stringent provisions made by SEBI

leave no space for the misuse of mutual fund corpus.

c) Launching of Mutual Fund Schemes

The procedure for launching a mutual fund scheme by an AMC requires prior

approval from trustee and a copy of the offer document is to be filed with SEBI. It is

compulsory for every mutual fund to mention important disclosures in offer document

of mutual fund schemes, so that investors can take careful investment decisions on the

basis of information available. The offer document contains two parts i.e. Scheme

Information Document (SID) and Statement of Additional Information (SAI). SID

incorporates all the information pertaining to a particular mutual fund scheme,

whereas SAI incorporates all the statutory information regarding mutual fund. Mutual

funds are directed to prepare the SID and SAI in the prescribed formats mentioned by

SEBI. The board of the AMC and the Trustee(s) shall exercise necessary due

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diligence, ensuring that the SID/ SAI and the fees paid5 are in conformity with the

regulations.6 It is also mentioned by SEBI that every mutual fund scheme should have

at least 20 investors and the holding of single investor should not exceed 25 percent of

the total corpus of scheme. This regulation is not applicable to exchange traded funds.

Further, SEBI provides strict provisions for safeguarding the investors against

false disclosures made in offer documents. The offer document shall contain

disclosures which are adequate in order to enable the investors to make informed

investment decision including the disclosure on maximum investments proposed to be

made by the scheme in the listed securities of the group companies of the Sponsor. It

suggests the AMC to make modifications in offer document within 21 working days

from the date of filing as it deems fit. In case of no modifications made within the

specified period, AMC may issue the offer document containing the memorandum of

such information after being specified by SEBI. In order to standardise the launching

of schemes, SEBI made a necessary amendment in April, 2009 with respect to the

approval of scheme from stock exchange(s). This requires an AMC to take prior

approval from the concerned stock exchanges, where the units of a scheme are

proposed to be listed and the details of same should be disclosed in offer document.

SEBI also prescribes that the advertisement of every scheme should be in conformity

with the Advertisement Code as specified in the Sixth Schedule. Copy of mentioning

the same should be submitted to SEBI within 7 days from the date of issue. The

advertisement of each scheme is required to disclose the investment objective of each

scheme. Advertising code mentions that all advertisements must contain information

regarding investment objective, performance, periodicity and method of valuation,

basis and method of computing risk/ return factors in case of past performance claim,

advertising yield, return or any scheme detail or inviting subscription to the scheme

including the disclosures of all the risk factors. Also, no scheme would promise for

assured returns or give such name to scheme.

5 The filing fees was revised via gazette notification No. LADNRO/GN/2009-10/11/167759

on SEBI (Payment of Fees) (Amendment) Regulations, 2009 dated 29 June, 2009, The revised

filing fee was applicable to those scheme(s) whose scheme information document(s) had been

filed with SEBI on or after July 1, 2009.- SEBI Circular No - SEBI/ IMD/CIR No. 5/

169030/ 2009 dated July 8, 2009

6 SEBI Master Circular for Mutual Funds (2010), Mumbai, p. 6

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SEBI regulations also provide that an AMC should mention the minimum

amount of scheme it seeks to raise under the scheme and the extent of over

subscription to be retained in the prospectus/ offer document of the scheme. Other

stipulations regarding listing and conversion of close-ended schemes, repurchase,

allotment and refunding of funds along with transfer and sending of units certificates

are clearly mentioned under the regulatory provisions. There are also provisions for

disclosing the name of trustee of mutual funds and directors of AMC in the offer

document of scheme.

With a view to maintain the reliability, SEBI mentions that no guaranteed

return shall be provided in a scheme unless such returns are fully guaranteed by the

Sponsor or the AMC or else a statement indicating the name of a person in the offer

document who will guarantee the return. Otherwise, the manner in which the

guarantee is to be met should be stated in the offer document. Further, all mutual fund

schemes except Equity Linked Savings Scheme (ELSS) will have the duration of 15

days for its opening, not more than that (Substituted for 45 days in Mutual Funds

(Amendment) Regulations, July, 2010 under Regulation 34). It is also mandatory for

an AMC to mention about the allotment of units, refunding of money and statement of

accounts to applicant within specified time. The prohibition to offer assured or

guaranteed returns schemes is the result of problems faced by mutual funds in

meeting their obligations to investors. Such practices were largely followed by public

sector mutual funds in 1990s. It was quite easy for them to sell the assured return

mutual fund units to investors. Many assured return schemes like the Ind Prakash, Ind

Jyoti Schemes (of Indian Bank Mutual Fund), Festival Bonanza Growth Scheme (BOI

Mutual Fund), Dhanvarsha 4 and 5 (of LIC Mutual Fund) and the assured return

schemes of Canara and PNB Mutual Funds suffered from this type of problem. These

schemes failed to pay the assured returns to their investors as specified in their

prospectus. In this case, the Sponsor of the said mutual funds was advised to meet the

short fall of the schemes.

Thus, SEBI has laid down strong provisions for launching the mutual fund

schemes. All mutual funds follow the adequate disclosure practices in the offer

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document of concerned schemes. This ensures that the prospective investor be aware

of the all important information regarding fund manager, director, setting up and

working of mutual funds. The adequate disclosures in offer document of scheme keep

the investor aware about the investment strategies followed by mutual fund. The

advertisements in offer documents are standardised in the manner that they have to

mention the important information regarding Sponsor, AMC, trustees and the schemes

in addition to natural risk factors related with the scheme. Such information is

necessary for the informed decision making of investors. The present regulations also

provide various procedures to control the functioning of mutual funds and any

deviation from the same calls for penalty from SEBI. Apart from this, the framework

of strict regulations regarding assured or guaranteed returns schemes protects the

investors against any possible tricky marketing practices pursued by mutual funds.

With these provisions, the safety of mutual fund investors is now ensured by SEBI.

d) Restrictions and Valuation Policies

To curb the unfair trade practices, SEBI put certain restrictions on the

investments made by mutual fund. For this, SEBI has prescribed a number of norms

for investment management in mutual funds. An important provision in this reference

is that the corpus of mutual fund scheme may be invested only in securities, money

market instruments, privately placed debentures, securitised debt instruments (asset

backed, mortgage backed securities), gold or gold related instruments and real estate

assets. SEBI mentions that the investment in mutual fund scheme must be in

accordance to its stated investment objective. For example, the corpus collected under

any money market scheme of a mutual fund must be invested only in money market

instruments and in case of gold exchange traded fund scheme, it must be invested

only in gold or gold related instruments. Same applies in the case of real estate mutual

funds which were launched in 2008 under the SEBI (Mutual Funds) (Amendment)

Regulations, 2008. In the sub-section Chapter VI A, SEBI has given detailed

regulations for real asset mutual fund schemes (an identifiable immovable property).

The provisions relating to restriction on investments (Specified in Seventh Schedule)

and borrowings are as follows:

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(i) Investment Restrictions

a. A mutual fund scheme cannot invest more than 15 percent of its net asset

value (NAV) in debt instruments issued by a single issuer which are rated not

below investment grade by a credit rating agency authorised to carry out such

activity under the Act. Such investment limit may be extended to 20 percent of

the NAV of the scheme with the prior approval of the Board of Trustees and

the Board of AMC. But, such limit is not applicable for investments in

Government securities.

b. A mutual fund scheme is not allowed to invest more than 10 percent of its

NAV in unrated debt instruments issued by a single issuer and the total

investment in such instruments cannot exceed 25 percent of the NAV of the

scheme. All such investments must be made with the prior approval of the

Board of Trustees and the Board of AMC.

c. No mutual fund scheme can invest more than 30 percent of its net assets in

money market instruments of an issuer.7 But, such limit is not applicable to

investments in Government securities, treasury bills and collateralized

borrowing and lending obligations.

d. No mutual fund under all its schemes can own more than 10 percent of any

company’s paid up capital carrying voting rights.

a. Transfers of investments from one scheme to another scheme in the same

mutual fund are allowed, provided such transfers are done at the prevailing

market price for quoted instruments on spot basis.

b. The securities so transferred are in conformity with the investment objective

of the scheme to which such transfer has been made

e. A mutual fund scheme is not permitted to invest more than 5 percent of its

NAV in the unlisted equity shares or equity related instruments in case of

open-ended scheme and 10 percent of its NAV in case of close-ended scheme.

7 SEBI (Mutual Funds) (Second Amendment) Regulations, 2009 with effect from 5-6-2009

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f. Some other restrictions on mutual fund scheme are that it is not allowed to

make investment in any unlisted security or security issued by way of private

placement by an associate or group company of the Sponsor or the listed

securities of group companies of the Sponsor which is in excess of 25 percent

of the net assets. Further, scheme of a mutual fund cannot make any

investment in any fund of fund scheme. It can also not invest more than 10

percent of its NAV in the equity shares or equity related instruments of any

company. The limit of 10 percent is not applicable to investments in case of

index fund or sector or industry specific scheme. However, all these

provisions are not applicable to the gold exchange traded fund schemes.

(ii) Borrowing Restrictions

a. The mutual fund is restricted to borrow except to meet temporary liquidity

needs of the mutual funds for the purpose of repurchase, redemption of units

or payment of interest or dividend to the unit holders. It is not allowed to

borrow beyond 20 percent of the net asset of the scheme and the duration of

such borrowing cannot exceed a period of six months.

b. The mutual fund cannot advance any loans for any purpose. It may lend and

borrow securities only in accordance with the framework relating to short

selling and securities lending and borrowing as specified by SEBI.

In earlier regulations, mutual funds had complete ban on borrowings. Fund

managers had to suffer from sudden fall of the funds especially in the case of open-

ended funds. The borrowing facility to mutual funds though offered in limited sense,

has helped the fund managers many times to come out of distress selling of funds.

(iii) Underwriting of Securities and Restrictions regarding Carry Forward,

Derivatives and Short Selling Transactions

Mutual fund may also enter into the underwriting agreement after obtaining a

certificate of registration in terms of the SEBI (Underwriters) Rules and SEBI

(Underwriters) Regulations, 1993 which can authorise it to carry on activities as

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underwriters. Mutual funds are strictly restricted to deal in carry forward transactions,

though they are free to make transactions in derivatives and short selling activities on

the recognised stock exchanges in accordance to the framework specified by SEBI.

(iv) Pricing of Units and Valuation of Investment

The NAV of scheme is statutorily required to be calculated on daily basis and

be published in two daily newspapers having circulation all over India.8 The price of

units shall be determined in line with the lastly determined NAV except if the scheme

announces NAV on daily basis. Whereas the sale price shall be determined with or

without a fixed premium added to the future net asset value which is declared in

advance. It is important that while determining the prices of units, mutual funds have

to ensure that the repurchase price is not lower than 93 percent of the NAV (95

percent in case of close-ended schemes) and higher than 107 percent of the NAV.

Also, the difference between repurchase and sale price of unit should not be more

than 7 percentage points calculated on sale price. Further, the NAV and sale/

repurchase price of all mutual fund schemes except for fund of fund (FOFs) schemes

(10 A.M) are required to be updated on AMFI’s website and the Mutual Funds’

websites by 9 P.M. of the same day.9 It is mandatory that the price at which the units

may be subscribed or sold and the price at which such units may at any time be

repurchased by the mutual fund should be noted to the investors.

With standard unit pricing norms, SEBI has also prescribed detailed valuation

norms for bringing uniformity in investments and computation of Net Asset Value

(NAV) by mutual funds. It provides that in computation of NAV, AMCs shall follow

the investment valuation norms specified in Eighth Schedule, and publish the same.

The NAV of a scheme shall be calculated by dividing the net assets of the scheme by

the number of outstanding units on the valuation date. The calculation of NAV in case

of traded securities (on stock exchange) shall be done on the basis of their last quoted

closing price on stock exchanges. However, the non-traded securities on the basis of

certain valuation norms shall be valued “in-good faith” by the AMCs. SEBI also

8 SEBI (Mutual Funds) (Second Amendment) Regulations 1996, September 26, 2012

9 SEBI Circular No. SEBI/IMD/CIR No.5/63714/06 dated March 29, 2006.

177

mentions the basis of valuation for bonds, equity funds, debt funds, gold or related

funds, money market instruments and rights and warrants etc. In case, if valuation is

found inappropriate, AMC and Sponsor of the mutual fund shall be responsible to

compensate the affected investors.

e) General Obligations

(i) Maintaining Proper Book of Accounts and Records

To keep an eye on fund activities, SEBI requires every AMC to maintain

proper books of account, records and documents for each scheme so as to explain the

transactions and to disclose at any point of time the financial position of each scheme.

Also, the book of accounts, records and documents of each scheme should be

maintained and preserved by AMC for the period of eight years. Every AMC has to

follow the accounting policies and standards as mentioned in ninth schedule. So that it

may provide appropriate details of scheme wise disposition of the assets in fund at the

relevant accounting date and the performance during that period. AMC is also

responsible for executing the information regarding distribution or accumulation of

income accruing to the unit holder. Financial year for all mutual fund schemes shall

end on March 31. In respect of each financial year, every mutual fund or AMC is

required to prepare the annual report and statement of accounts of the schemes and the

fund as specified under eleventh schedule.

(ii) Limitation on Load, Fees and Expenses on Issue of Schemes

According to the guidelines of SEBI, an AMC may charge the mutual fund

investment and advisory fees within the permissible limits given as under.

i. 1.25 percent of the weekly average net assets outstanding in each accounting year

for the assets up to Rs.100 crore, and

ii. 1 percent of the amount in excess of Rs.100 crore in case of a scheme within net

assets exceeding Rs.100 crore.

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In case of the index funds, this limit should not exceed 0.75 percent of the

weekly average net assets. The overall expenses of the scheme excluding issue or

redemption expenses but including the investment management and advisory fee

permitted to be charged by a scheme are subject to the following limits:

(a) 2.5 percent on the first Rs.100 crore of the average weekly net assets.

(b) 2.25 percent on the next Rs.300 crore of the average weekly net assets.

(c) 2.0 percent on the next Rs.300 crore of the average weekly net assets.

(d) 1.75 percent on the balance of the assets.

(e) In exchange traded funds, the total expenses of the scheme including the

investment and advisory fees shall not exceed 1.5 percent of the weekly

average net assets.

(f) In case of bonds, the limit is 0.25 percent of the weekly average net assets.

(a) FOFs scheme has the limit of 0.75 percent of the daily or weekly average net

assets.

Some of the provisions of SEBI (Mutual Fund) Regulations, 1996 have been

amended in 1998. It provides that any expenditure in excess of the limits specified

above is to be borne by the AMC or by the trustee or the Sponsor.10

Regulations also

specify the nature of recurring expenses that can alone be charged by a mutual fund

scheme. Other expenses need prior approval of SEBI before charging from a scheme.

These recurring expenses include the marketing and selling expenses, agent’s

commission, brokerage and transaction costs, registrar services for transfer of units

sold or redeemed, fees and expenses of trustees, audit fees and Custodian fees, costs

related to investor communication, cost of fund transfer from location to location, cost

of providing account statements and dividend/ redemption cheques and warrants,

insurance premium paid by the fund, winding up costs for terminating a fund or

scheme and costs of statutory advertisements. The recurring expenses in case of gold

10 SEBI (Mutual Funds) (Amendment) Regulations. (1998), with effect from 12-1-1998.

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exchange traded fund include the cost of storing and handling of gold, whereas in case

of capital oriented scheme, the costs incurred on rating fees. Likewise, the recurring

expenses on real estate mutual fund schemes include the costs on insurance premium

and maintenance of the real estate assets. Schemes listed on a recognised stock

exchange include the expenses that incur on listing fees. But, there are some other

type of expenses which in any case cannot be charged from the mutual fund schemes

include (a) penalties and fines for infraction of laws (b) interest on delayed payment

to the unit holders (c) legal, marketing, publication and other general expenses not

attributable to any scheme(s) (d) fund accounting fees (e) expenses on investment

management/ general management (f) expenses on general administration, corporate

advertising and infrastructure costs (g) expenses related to depreciation on fixed

assets and software development.

It is essential to classify and limit the expenses of mutual funds by SEBI

because many times mutual funds have been found to devise perceptive methods in

charging fund expenses. With such restrictions, SEBI saves the investors from bearing

unjustified cost in mutual funds investment.

SEBI with a purpose to empower the investors regarding transparency in

payments and load structure of scheme took an important step two years back in 2009.

Under the stipulation, SEBI has removed the entry load on all mutual fund schemes.

Investors are stipulated to pay the upfront commission to distributors depending on

the level of service rendered by them. Also, in regard to direct application, the SEBI

mentioned that no entry load will be charged for the direct applications received by

AMC(s) through internet or submitted directly to the AMC or collection centre/

Investor Service Centre and not routed through any distributor/ agent/ broker.11

It has

been further clarified by SEBI that no AMC shall collect the additional management

fee on no-load schemes as referred to in Regulation 52 (3) of SEBI (Mutual Funds)

Regulations, 1996. All AMCs were previously (before 2009) allowed to charge the

additional management fee within the limit of 1 percent.

11 SEBI Mutual Fund Circular no. SEBI/IMD/CIR No.10/112153/07 dated December 31, 2007,

came into effect from January 4, 2009.

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(iii) Annual Reports and Summary

Mutual funds are statutorily required to mail scheme wise annual report or an

abridged summary to all unit holders within four months from the date of the closure

of relevant financial year. Earlier, this period was six months which was substituted

by SEBI Mutual Funds (Third Amendment) Regulations, 2008. Further, the scheme

wise abridged annual report should also be displayed on the website of mutual fund.

These websites must be linked to the Association of Mutual Funds in India (AMFI)

website so that investors and analysts can access the reports at one place easily. The

AMCs should also forward a copy of annual report and other information including

details of investments and deposits held by the mutual fund to SEBI, so that the entire

scheme wise portfolio of the mutual funds is clearly disclosed before the board. Full

annual reports should be available for inspection at the Head Office of the mutual

fund and a copy thereof shall be made available to unit holder on payment of such

nominal fee as may be specified by the mutual fund. Along with this, the AMCs are

required to display the link of the full scheme wise annual reports prominently on

their website.12

(iv) Periodic and Continual Disclosures

The mutual funds, AMC, trustee, Custodian and Sponsor of mutual fund are

statutorily required to make periodic and continual disclosures as may be called upon

to do so by SEBI. To meet this requirement, mutual fund has to submit to SEBI,

copies of the duly audited annual statements of accounts including the balance sheet

and the profit & loss account for the fund and in respect of each scheme, once a year.

Mutual funds also have to submit the copy of unaudited accounts of six months.

Further, a statement of movements in the net assets for each of the schemes of the

fund portfolio and a statement including changes from the previous period for each

scheme should be sent by mutual fund on a quarterly basis to SEBI. A mutual fund

and an AMC is also required to publish its unaudited financial results in one English

daily newspaper having circulation all over India and in a newspaper published in the

12 SEBI (Mutual Funds) (Amendment) Regulations (2011), with effect from 30-8-2011.

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language of the region where the Head Office of the mutual fund is situated. The

unaudited financial results should be published before the expiry of one month from

the close of each half-year that is 31st March and 30

th September. The half-yearly

results must be printed in at least 7 point Times New Roman font with proper spacing

for easy reading. SEBI made an amendment in March, 2000 with a view to improve

the disclosure standard of mutual funds. It stipulated that before the expiry of one

month from the close of each half-year (that is 31st March and 30

th September),

mutual fund will send to all unit holders a complete statement of its scheme portfolio.

But, if the statement of scheme portfolio is published by way of advertisement in one

English daily newspaper of all India circulation, then there is no need to send this to

unit holders. Now, the Scheme Portfolio(s) are also required to be disclosed on the

Mutual Funds’ websites before the expiry of one month from the closure of each Half

Year (i.e. March 31 and September 30) and a copy of the same shall be filed with the

SEBI along with the Half Yearly Results in prescribed format. The trustee of a mutual

fund is bound to make such disclosures to the unit holders. It is essential to keep the

investors informed about any information which may have an adverse bearing on their

investments. Such disclosures are also necessary to publish particularly for providing

the true and fair picture of the operations of the mutual fund.

The aforesaid provisions have been stipulated by SEBI in order to keep an eye

on the operation of mutual funds. It is important because now, mutual fund has

become one of the emerging players of Indian financial market thus needs the

adequate monitoring by regulator. The disclosures in mutual funds as standardised by

SEBI also keeps it informed about the financial performance of mutual funds. The

requirement of displaying financial results on websites provides the needed

information to investors that may be helpful for them in taking prudent investment

decisions. The disclosure of such information also encourages in-depth research work

of mutual funds.

(f) Inspection and Audit

SEBI is authorised to appoint one or more persons as inspecting officer who

can undertake the inspection of the books of account, records, documents and

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infrastructure, systems and procedures or can investigate the affairs of a mutual fund,

the trustees and AMC. Simultaneously, to inspect or investigate the books of account

or the affairs of the mutual fund, trustee or AMC, SEBI appoints an auditor who has

the same powers and obligations as an inspecting officer. For the comprehensive

auditing of mutual funds, SEBI uses the “Systems Audit” which must be conducted at

least once in two years by an independent Certified Information System Auditor

(CISA)/ Certified Information Security Manager (CISM) qualified or equivalent

auditor.13

Thus, SEBI has been granted immense powers to see it to that the affairs of

mutual funds are orderly. In order to promote interest of investors, SEBI is also

empowered to penalise the party found at fault in mutual funds.

(g) Procedure for Action in Case of Default

SEBI is liable to take action against mutual funds in a case when (1) it breaks

any of the provisions of the Act and the regulations; (2) it fails to furnish any

information or furnishes wrong information relating to its activity as a mutual fund as

required under the regulations; (3) it fails to submit periodical returns as required

under the regulations (4) does not cooperate in any inquiry or inspection conducted by

the SEBI; (5) it fails to comply with any directions of the SEBI issued under the

provisions of the Act or the regulations; (6) it fails to resolve the complaints of the

investors or fails to give a satisfactory reply to SEBI in the context; (7) it is guilty of

misconduct or improper or unbusinesslike or unprofessional conduct which is not in

accordance with the Code of Conduct specified in the Fifth Schedule; (8) it indulges

in unfair trade practices in securities. The purpose of this clause ‘unfair trade

practices’ is same as prescribed in the Securities and Exchange Board of India

(Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market)

Regulations, 1995; (9) AMC fails to maintain the net worth in accordance with the

provisions of regulation 21; (10) it fails to pay any fees (11) it violates the conditions

of registration; (12) mutual fund, AMC or trustees of that mutual fund do not carry

out their obligations as specified in these regulations. Accordingly, the erring mutual

fund will be treated in the manner as provided under the Securities and Exchange

13 SEBI Mutual Fund Circular No. SEBI/IMD/CIR No. 9/176988/2009 dated September 16, 2009.

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Board of India (Procedure for Holding Enquiry by Enquiry Officer and Imposing

Penalty) Regulations, 2002. SEBI can suspend or cancel the registration of an

intermediary holding a certificate of registration under section 12 of the SEBI Act

who fails to exercise due diligence or to comply with the obligations under these

regulations. Without prejudice to regulations as mentioned above, a mutual fund

and/or AMC shall be liable for action14

in two cases; 1) when the advertisement

issued is in contravention with the Advertisement Code specified in Sixth Schedule 2)

when the valuation of securities is in contravention of the Principles of Fair Valuation

specified in Eighth Schedule. Thus, SEBI provides rigorous framework of provisions

against mutual funds so that they could afraid from committing any type of offence in

business.

6.3 Recent Regulatory Developments

The regulatory developments which took place recently in the mutual funds industry

are as follows:

1. It becomes mandatory for every mutual fund to disclose the complaints of

investors on their website, on the AMFI website as well as in their annual

reports.15

2. The mutual funds must have a valid Unique Client Code (UCC) to furnish its

operations in the securities market. UCC can be obtained by mutual fund from

the Bombay Stock Exchange Ltd. (BSE) or National Stock Exchange Ltd.

(NSE) whenever its new scheme or plan is launched.

3. The investor who desires to hold units in dematerialised form and makes

investments more than Rs. 50,000 is applicable to be filed under Know Your

Customer (KYC) norm by the AMC. Consequent to this market development,

NSE and BSE have launched Mutual Fund Service System (MFSS) and Star

Mutual Fund in 2009. The AMFI has issued strong guidelines to avoid the

mutual fund subscriptions from Third Party Payment mode.

14 SEBI (Mutual Funds) (Amendment) Regulations, 2012

15 SEBI Mutual Funds Circular No. Cir/ IMD/ DF/ 2/ 2010 dated May 13, 2010.

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4. To Know Your Distributor (KYD) requirements have been introduced by the

AMFI on SEBI's instruction. It is mandatory to comply with the KYD procedure

(with effect from September 1, 2010) before applying for fresh

ARN Registration/ ARN (AMFI Registration Number) Renewal.

5. Mutual fund distributors are now permitted to collect transaction charges of Rs.

100 from existing investors and Rs. 150 from new investors for per Rs. 10,000

and above. The transaction charges will be deducted by the AMC from

subscription amount and paid to the distributor. Distributors can also choose to

‘opt out’ from charging the transaction charges from investors. Further, if the

distributors are found to practice splitting investment to increase their

transaction charges by mutual funds instituted system, then stringent action

including recommendations to Association of Mutual Funds in India (AMFI)

will be taken against them.16

6. SEBI has announced framework for setting up infrastructure debt funds (IDF) in

mutual funds industry (Chapter VI-B under regulations 49L-49T).17

Mutual

funds are also allowed to invest in repos in corporate debt securities subject to

certain conditions and the guidelines issued by RBI.18

7. SEBI has mandated the AMCs to appoint a separate fund manager for each fund

managed by it unless the investment objectives and assets allocations are the

same and the portfolio is replicated across all the funds managed by the fund

manager. Further, the replication of minimum 70 percent of portfolio value shall

be considered adequate for the said stipulation. It also directed AMC to entrust

that fund manager shall not take directionally opposite position in the schemes

managed by him/ her at all points of time.19

This regulation is introduced to

check the other fund management activities of managers. Wherein the fund

manager is common across mutual fund schemes under the permissible activities

16 SEBI Mutual Funds Circular No. Cir/IMD/DF/13/2011 dated 22 August, 2011

17 SEBI (Mutual Funds) (Amendment) Regulations, 2011 vide notification dated 30 August 2011

18 SEBI Mutual Funds Circular No. CIR/IMD/DF/19/2011 dated November 11, 2011

19 SEBI (Mutual Funds) Regulations 1996, Circular No. Cir/IMD/DF/7/2012 dated 28 February

2012

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of AMCs, then AMCs have to disclose on their website, the returns provided by

said fund managers for all schemes (mutual funds, pension funds and offshore

funds etc.) on monthly basis. If difference between the annual returns provided

by the same fund manager for all schemes is more than 10 percent, then AMCs

have to report it to trustee and the explanation for this is to be disclosed on their

website.

8. Earlier, only foreign institutional investors (FIIs) and sub-accounts registered

with SEBI and non-resident Indians (NRIs) were allowed to invest in mutual

fund schemes. No direct investment by foreign investors was permitted. The

RBI and SEBI issued circulars in this regard and recommended to facilitate

direct investment by foreign qualified investors (QFIs) in mutual fund

schemes.20

With this, the Government announced in Union Budget of 2011-12

that QFIs be allowed to invest in Indian mutual funds. It would enable the Indian

mutual funds to have direct access to foreign investors and widened the class of

foreign investors in equity market. It would also raise the efficiency of mutual

fund market participants.

9. SEBI has recently directed AMCs to regulate the distributors by carrying out

due diligence process. According to which, distributors have to meet one of the

following criteria to distribute mutual fund products to investors.21

a. Multiple point presence (more than 20 locations)

b. AUM raised over Rs. 1,000 million across industry in non-institutional

category but including high net worth individuals

c. Commission received of over Rs. 10 million per annum across industry

d. Commission received of over Rs. 5 million from a single mutual fund

20 AP (DIR series) circular no 08 dated 9 August, 2011; circular no CIR/IMD/DF/14/2011 dated 9

August , 2011 and circular no CIR/IMD/FII&C/13/2012 dated 7 June, 2012.

21 SEBI (Mutual Funds) Circular No. Cir/IMD/DF/13/2011 dated August 22, 2011 and Circular

No. Cir/IMD/DF/7/2012 dated February 28, 2012

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SEBI has mentioned that at the time of empanelling distributors, mutual funds

and AMCs shall undertake due diligence to satisfy ‘fit and proper’ criteria. It has

further clarified that the due diligence of distributors is solely the responsibility of

mutual funds and AMCs. This responsibility shall not be delegated to any other

agency. However, mutual funds and AMCs may take assistance of a reputed agency

while carrying out due diligence process of distributors.

6.4 Role of the Association of Mutual Funds in India (AMFI)

The AMFI represents the interests of all mutual funds operating in the country.

It was established on August 22, 1995 as a non-profit organisation. It is dedicated to

develop the Indian mutual funds industry on professional as well as on ethical front.

AMFI functions under the committee system. It is an apex body of all registered

AMCs. The following objectives are the working spirit behind AMFI as defined in its

own language;

i. To define and maintain high professional and ethical standards in all areas of

operation of mutual funds industry.

ii. To recommend and promote best business practices and code of conduct to be

followed by members and others engaged in the activities of mutual fund and

asset management including agencies connected or involved in the field of

capital markets and financial services.

iii. To interact with the SEBI and to represent to SEBI on all matters concerning

the mutual funds industry.

iv. To represent to the Government, Reserve Bank of India and other bodies on all

matters relating to the mutual funds industry.

v. To develop a cadre of well trained agent distributors and to implement a

programme of training and certification for all intermediaries and other

engaged in the industry.

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vi. To undertake nationwide investor awareness programme so as to promote

proper understanding of the concept and working of mutual funds.

v i i . To disseminate information on mutual funds industry and to undertake studies

and research directly and/ or in association with other bodies.

AMFI is committed to assist the investors, distributors and company

members through compilation and dissemination of information pertaining to mutual

funds. It is also actively associated with SEBI in the matter concerning regulations

and compliance and, many others. The vision of AMFI echoes the ‘mission’ of the

Investment Company Institute (1998), which is ‘to advance the interest of investment

companies and their shareholders, to promote public understanding of investment

company business, and to serve the public interest by encouraging adherence to high

ethical standards by all elements of the business. The initiatives taken by AMFI in

framing a code of ethics acknowledged as AMFI Code of Ethics (ACE), and a set of

AMFI Guidelines and Norms for Intermediaries (AGNI) are the noteworthy initiatives

towards improving the standards of working of mutual fund service providers. The

ACE sets out the standards of good practices to be followed by the Asset Management

Companies in their operations and in their dealings with investors, intermediaries and

the public. The set of AMFI Guidelines and Norms for Intermediaries (AGNI) is

brought out for intermediate parties in order to promote best practices in sales and

marketing of mutual fund schemes and are applicable to all ARMFA (AMFI

Registered Mutual Fund Advisors). Apart from this, AMFI has formed various

committees to promote the high professional standards in industry. These committees

are the committee on valuation, committee on best practices, committee on operations

and compliance, committee on registration of AMFI certified distributors, committee

on investor awareness programme education, and committee on customer

engagement.

In a short span of time, AMFI has contributed significantly to improve the

business practices among mutual funds. It has very well promoted the interest of its

members. Thus, AMFI, being an association of mutual funds, has been playing a key

role in developing the standards of mutual funds industry.

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6.5 ULIP Controversy

ULIPs are the Unit Linked Insurance Plans that combines the advantages of life

insurance with investment in stock market. It offers an opportunity to investors having

financial security as well as wealth accretion under single roof. In India, SEBI

(Security and Exchange Board of India) regulates the stock market related activities

with the power to manage mutual funds and other investment schemes that invest in

stock market. To regulate the insurance market related activities, IRDA (Insurance

Regulatory Development Authority) is the sole regulator in India. The insurance

companies launched Unit Linked Insurance Plans (ULIPs) which are similar to mutual

fund schemes with some part of insurance added to it. These plans invest in stock

market and therefore should fall under the control of SEBI as was contended by SEBI.

The ULIPs products generated by various insurance companies do not prefer to abide

this rule. Therefore, the problem of not taking SEBI’s permission over the issuance of

ULIP products became the major issue between SEBI and IRDA that led ULIP

controversy between the two. As a result, SEBI banned 14 insurance companies from

selling ULIPs products on April 9, 2010. The Bajaj Allianz, Bharti, AXA, Birla Sun

Life, HDFC Standard Life, ICICI Prudential, ING Vyasa, Kotak Mahindra Old

Mutual, Max New York Life, Reliance Life and SBI Life etc. were the main insurance

companies that were banned overnight.

The SEBI claimed that ULIP is a type of mutual fund product that falls within

the jurisdiction of capital market watchdog i.e., SEBI and not IRDA. SEBI said that

insurers should take approval for ULIPs products to sell them in market. However,

IRDA has responded by denying the jurisdiction of SEBI over ULIPs and ordered to

continue their selling. Both regulators approached to the Ministry of Finance for

solution, which suggested for seeking a joint legal mandate. But, both denied the

suggestion and reached the court for protecting their rights. Several actions and

reactions took place but no conclusion was arrived. At last, the two months long battle

between IRDA and SEBI is ended by the promulgation of the Securities and

Insurance Laws (Validation and Amendment) Ordinance, 2010 in which, government

has clearly supported the claim of IRDA to regulate unit-linked insurance plans. It

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asserted that ULIPs will be construed as the insurance products which will serve the

IRDA norms in future. The new guidelines of IRDA pertaining to ULIPs came into

effect from July 1, 2010. The Ordinance further stated for the constitution of a joint

committee that can resolve the future conflicts among four regulators – RBI, SEBI,

IRDA and PFRDA (Pension Funds Regulatory Development Authority). The

Ordinance has also amended the provisions of RBI Act, 1934; Insurance Act, 1938;

the Securities Contract (Regulation) Act, 1956 and the Securities and Exchange Board

of India (SEBI) Act, 1992. Hence, passing of Ordinance Bill has proposed the ideal

principle for financial regulation – ‘a single regulator for a single business’.

6.6 Critical Assessment and Suggestions

The working of mutual fund is governed by UTI Act 1963, Indian Trust Act

1882, relevant provisions of the Companies Act 1956, Securities Contract Act 1956

and various tax laws. The overall regulation, overseeing and supervision of mutual

funds industry is done by Ministry of Finance of Government of India, the RBI and

the SEBI. Initially, the RBI has issued guidelines for bank-Sponsored mutual funds in

1987. Then mutual funds followed the guidelines from the Ministry of Finance in

1991. Thereafter, the SEBI issued guidelines in 1991 and comprehensive set of

regulations in 1993. With the growth of mutual funds industry, it became necessary

that all mutual funds follow uniform norms for valuation and investment accounting

practices so that anyone could judge their performance on a comparable basis.

Therefore, SEBI issued new mutual fund regulations in December, 1996. The new

regulations are uniformly applicable to all mutual funds in all the sectors, including

UTI and Money Market Mutual Funds (MMMFs) governed by RBI. So, SEBI

governs the operation of mutual funds and exercises an immense control over them

through highly structured regulatory regime that indicates the SEBI as a powerful

regulator. The existing regulations lay down various measures to protect the mutual

fund investors by making the investment practices of mutual funds more transparent.

The level of competition in the industry has continuously been going up, so it needs to

perform a more dynamic and competitive role to meet the tests of time. We have

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observed some areas in mutual fund regulations which are to be addressed soon so as

to make it more competitive and transparent.

1. The first level regulation of mutual funds in the country rest with the trustee. The

actions taken by the trustee are deemed to be the actions of the mutual funds. The

trustee is supposed to perform many duties like – approve the appointment of the

director of asset management company, obtain periodic reports from the asset

management company about the fund operations, monitoring security dealings of

key personnel of the asset management company, review of contracts, file

periodic reports to the regulator, discipline the asset management company etc.

These duties are considerable in magnitude and call for significant expertise and

devotion of time. But, the regulations in India do not mandate that the trustee

company (and its directors) be provided with adequate administrative support for

discharging their responsibilities. Further, SEBI requires at least four trustees in a

mutual fund and 2/3 of them must be independent from AMC. However, their

functions in fund management are not demarcated in the regulations. Trustees are

usually drawn from diverse background. They are generally experienced bankers,

eminent lawyers, ex-judges and renowned charted accountants. So, it would be

unrealistic to expect them to possess a high level of mutual fund expertise. This

situation is not conducive to the exercise of competence. The directors of the

trustee company receive sitting fees when they attend the board meetings. This

amount is moderate and perhaps not commensurate with the level of

responsibilities expected to be discharged by them. Inadequate compensation may

result in a superficial trusteeship function. A possible method of improving

mutual fund governance in India would be to consider entrusting the trusteeship

to corporations whose business is to provide trustee services.22

There are three

specific advantages of doing so. First, the trustee company could be large and

independent. Second, the specialist trustee company would be able to discharge

the trusteeship duty more professionally. Third, the regulator would be able to

specify the preconditions for an entity to be registered with it as a specialist

22

Asian Development Bank Report TA 4010-IN (2004) – Reforms of Mutual Funds, p.5

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company. Among other conditions, it would be possible for assessing the risk of

the trusteeship business and prescribing adequate risk mitigating mechanisms

through a possible capital adequacy norm for the trustee company.

2. SEBI has comprehensive provisions to deal with violation of mutual fund

regulations. The defiance of norms for registration, information, application,

submission, cooperation, code of conduct, trade practices, investor complaints

and obligation for mutual fund, AMC and trustees are subject to penal provisions

of SEBI as given in chapter IX in SEBI (Mutual Fund) Regulations, 1996. The

accused party is dealt in the manner as specified under SEBI Prohibition of

Fraudulent and Unfair Trade Practices Relating to Securities Market Regulations,

1995 and SEBI Procedure for Holding Enquiry by Enquiry Officer and Imposing

Penalty Regulations, 2002. These regulations state the minor and major penalties

for mutual funds which among others include the debarring of a branch as well as

of whole time director for six months and the suspension/ cancellation of

registration for three months etc. But, there is no mention of any penal provision

against the officers, employees, key personnel, fund managers of an AMC and

fund Custodian who are found guilty of violating regulations. The absence of

adequate regulations against such erring persons cannot be said to secure the

rights of investors properly. Further, SEBI provides the penalty of Rs. 1 lakh to

Rs. 1 crore whichever is higher, if mutual funds fail to comply with the SEBI

(Mutual Fund) Regulations, 1996. Whereas in US, if any person who wilfully

violates the rules and regulations of Investment Company Act 1940, is liable to

pay a fine of $10,000 (maximum) or may get imprisonment of up to five years or

both. In China, if a fund manager or fund Custodian violates any provisions of

Law of the People’s Republic of China on Funds for Investment in Securities,

then in addition to charging the fine of not less than 30,000 Yuan and not more

than 300,000 Yuan, these parties are given disciplinary warning or suspended/

disqualified from dealing in fund management business or fund custody. Same

procedure is adopted for an employee of fund management or special fund

Custodian department. Looking at the provisions in other countries, we find that

the punishment imposed by SEBI on mutual funds violating its regulations is very

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small. In fact, it encourages them to go for bigger scams. It is therefore suggested

that the amount of penalty should be suitably enhanced and prison term should

also be added to it. The fund managers, fund Custodian, employees and staff

should also be brought under the penal provisions as in US and China.

3. The mutual fund regulations do not prescribe any qualification for the fund

manager. So anybody can become fund manager irrespective of his/ her

qualifications. Contrary to that, a mutual funds distributor/ advisor is required to

pass the ‘National Institute of Securities Market’s (NISM) Mutual Fund

Distributors Certification Examination’ so as to become eligible to do his/her

work. The fund manager performs a very responsible and risky task. So, we feel

that there ought to be some qualification for them also. In China, fund managers

are stipulated to have a professional qualification for dealing in fund business.

They should also have at least three years’ working experience as Manager or

Senior Managers in a firm dealing with fund management. UK Financial Service

Authority (FSA) has laid down the qualification for all entities dealing in

investment business. Fund/ Investment managers in UK are required to obtain the

Certificate in Investment Management/ Certified International Wealth Managers

Diploma (CIWM)/ MSc in Investment Analysis/ Masters of Wealth Management/

Investment Advice Certificate for engaging in investment management activities.

On the same pattern, some guidelines relating to fund manager’s qualifications

may be prescribed by SEBI. This will lead to better utilisation of investors’

money and enhance their confidence that their money is in good hands. SEBI is

also silent about the qualification of trustee in mutual funds. Whereas in UK, the

trustee/ depository is required to have a Certificate in Collective Investment

Scheme Administration/ Investment Management Certificate/ Certificate in

Corporate Finance/ Client Service Management Certificate to be a trustee of

mutual fund. Trustee is the main entity for keeping track of the mutual fund

activities and its development. So, SEBI should outline the educational

qualification of trustees in mutual funds and make it a necessary stipulation.

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4. The mutual fund distributors are out of the regulatory purview of SEBI. There are

no separate regulations framed by SEBI for them. In US, distributors are

registered under the Securities Exchange Act of 1934 as broker-dealers. They are

regulated by Securities Industries and Financial Markets Associations and are

required to pass broker-dealer exam for selling mutual fund units. Similarly,

Financial Service Authority (FSA) in UK spells out the responsibilities for

distributors in ‘The Responsibilities of Providers and Distributors for the Fair

Treatment of Customers’ (RPPD). Such regulatory norms for distributors are yet

to be framed in India. Recently, SEBI has taken some steps in this regard. It has

directed AMCs to regulate the distributors by carrying out due diligence process.

We feel that giving responsibility to AMCs to regulate distributors is not enough

to secure the interest of investors. SEBI should frame separate and more

comprehensive regulations for distributors so as to regulate their activities

properly. Besides, SEBI should set up a separate governing body to look into the

activities of mutual fund distributors as in UK.

5. Fund managers are bound to invest funds according to the investment objectives

of schemes stated in the offer documents. They do not have choice to invest in

other good performing securities. This mandate sometimes, restricts the mutual

funds to perform effectively in the market.

6. SEBI regulations regarding transparency in mutual fund product names and

definitions are not comprehensive in nature. Mutual fund products are used to

have hazy names like T.I.G.E.R (The Infrastructure Growth and Economic

Reforms), S.M.I.L.E (Small and Medium Indian Leading Equities) and C.U.B.

(Competitive Upcoming Businesses) etc. The equity funds are vaguely defined

such as ‘opportunities funds’ and ‘multi-cap’ funds. Because of this, investors do

not understand how diversified funds are different from ‘opportunities funds’ and

‘multi-cap’ funds. Owing to this, investors do not get the real picture about where

the fund will be invested and what kind of risk it will take. To tackle this

problem, SEBI is trying to evolve a fund labelling system which can help

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investors to some extent. It is a good step and it will certainly boost up the

investors’ confidence in the market.

7. The ban on entry load in 2009 reduced the ability of distributors to sell mutual

funds in the market. Earlier, distributors were paid Rs. 2.25 (per hundred rupees)

as compensation by AMCs, which was deducted as the entry load from scheme’s

amount. The average commission paid to distributors was 1.78 percent in 2008,

which came down to 0.98 percent in 2010. The entry load ban not only lowered

the distributors’ commission but also compelled large number of distributors to

go out of the mutual funds business. As a result, the participation of households

in mutual funds has declined. Also, from June 30, 2009 onwards, SEBI has

enabled investors to pay commissions directly to the distributors depending on

his/ her assessment of various factors, such as the quality of service rendered by

distributors. But, we think that no investor will be interested to pay money

separately for any kind of service received from distributors. It will raise a

concern from distributors regarding the non-receipt of payment from investors,

and may thereby lead to the conflict of interest between distributors and

investors. These regulatory steps do not seem to be practical and may go against

the distributors who are considered key to the success of the mutual funds

industry.