17 January 2018

Segregation of advice from distribution - simple, attractive but wrong

I have a piece in today's Economic Times where I argue that the complete segregation of advice from distribution of mutual funds and financial products is neither possible, nor desirable. Here is the link and below is the full piece:

Segregation of advice from distribution – simple, attractive and wrong

SEBI has come out with a third consultation paper on segregation of advice from selling of mutual funds. The fact that SEBI has not implemented the first two proposals is a good sign that the regulator is thoughtful and open to suggestions. It needs a bold step to altogether abandon the project of segregation of the two functions, which is simple, attractive and obvious. But wrong.

The context of the paper is SEBI’s current position where it allows distributors of mutual funds to provide incidental advice without a separate registration as an ‘investment advisor’. The current paper, which from its grammar seems to override the earlier more detailed proposal, proposes a clean segregation of advice from distribution of mutual funds. An advisor represents the investor and should not get a commission from the mutual fund. A distributor by contrast is an agent of the mutual fund and is entitled to a commission from the fund for ‘selling’ it.  The paper seeks to prohibit the advisor from selling and the seller from advising. This prohibition includes relatives for individuals and affiliates (including subsidiaries and parent companies) for corporate entities. The paper also suggests that the distributors continue with their current obligation to ensure sale of appropriate products to investors.

There are 5 birth defects with implementing the proposals. First, investment advice as a stand alone business is not viable in the Indian context. Of the few hundred who are registered as advisors, nearly every one of them, has a separate distributor license housed in a corporate entity or with a close relative. Mandating an absolute ban on advice would almost certainly mean that registered advisors will abandon their registration and retain their distribution license. This will be a disservice to investors who will be deprived of proper advice. Banks and other large institutions will probably abandon advice as the fee income is negligible compared to their commission income. This may change in another decade, but it is a very distant reality today.

Secondly, the prohibition on relatives, from undertaking advice when another is providing distribution will almost certainly be unconstitutional. It is difficult to imagine any court upholding a ban on a profession merely because a husband or a brother in law is carrying out another legitimate business which SEBI finds to be somehow in conflict even though both are completely independent. Indeed, many distributors today have husband-wife combinations for providing advice too, but prohibiting one when both are qualified, registered and regulated would be impermissible.

Thirdly, the very definition of suitability, which SEBI seeks to continue to impose on distributors, will mean advice. Thus prohibiting advice while mandating suitability is a contradiction in terms. A good advisor would always first find out the profile of the client, for instance the age, income, risk appetite, retirement plans, insurance needs, education of children goals, tax impact and many other things before advising the client. Once this is done a good adviser will advocate a diversified portfolio, diversification of assets being one of the only free lunches in the financial world. In other words, there is no such thing  as a mutual fund advisor. One can only be a good financial advisor if one allocates assets between equity (mutual fund, listed, unlisted securities), debt products, insurance, real assets, gold etc. If SEBI’s aim is to mandate advising only with respect to mutual funds, it is doing a great disservice to investors. All holistic advice must necessarily advice investment in different asset classes, different time horizons and different assets within each asset class for it to qualify as being suitable and in investor interest. This remains true whether such advice is provided by an advisor, a distributor or other persons who provide  incidental advice.

Fourth, connected to the previous point, it is impossible to sell any financial product without conducting a suitability check and provide some level of advice. A distributor today reaches out to remote towns, does the leg work of KYC and other documentation, provides risk profiling and basic advice before an investor is willing to invest in funds. A prohibition to provide advice to distributors would almost amount to regulatory mandated mis-selling and fraud in financial products. Not a goal SEBI is seeking to achieve.

Fifth, and very importantly, the concept of pure advice is a highly elite product. Even upper middle class investors rarely use such advice. Smaller investors almost by definition cannot afford a Rs. 5,000 per year or 20,000 per year advisory fee when they are starting a monthly systematic investment plan of Rs. 500 per month. The product is mainly suited for HNIs or Ultra HNIs. The only country in the world which has experimented with a segregation of such kind is UK, a developed and rich country. Even there, the regulator’s own study of the move after 3 years shows how millions have been left unattended and orphaned of advice  because of the segregation of advice.

The unintended consequence of this ‘removal of conflict’ will in fact be a removal of all advice in India, a steep increase in actual and opportunity costs, mandatory misselling products to clients. The approach proposed should be replaced instead by a robust enforcement against mis-selling by SEBI, which is in fact not prevalent. Almost the entire misselling occurs in insurance based investments and in selling of stock derivatives, both of which have attained epidemic proportions. SEBI should follow the advice of its own International Advisory Board as also the Sumit Bose Committee which have recommended against implementing this move in the near future. In fact, it should work towards expanding the scope of incidental financial advice, as there is no such thing as mutual fund advice. In this case, SEBI should avoid the Occum’s razor that the simplest explanation is the best suited.

04 January 2018

Time for SEBI to double-check its well intentioned reforms

I have a piece in today's Economic Times on the SEBI Board meeting decisions - on commodity market integration, requirement of networth for credit rating agencies, cross holding restrictions in mutual fund AMCs and CRAs, routes of complying with minimum public shareholding and FPI investment regulations. The full piece is copied below, and linked here:

SEBI board has come out with several interesting decisions this month end. There are many areas where it has chosen the prudent path of the Aristotelian mean. However, in many areas it needs to relook at the reforms carried out. This piece focuses on the latter.

The regulator has announced the integration of trading in commodity derivatives market with other segments of securities market at exchange level. While in Phase-I, integration has been achieved at the intermediary level, in Phase-II, necessary steps would be taken to enable a single exchange to operate various segments such as equity, equity derivatives, commodity derivatives, currency derivatives, interest rate futures & debt etc. This would happen by October 2018 from a regulatory perspective. However, it is possible that the exchanges are ready much in advance of that date. The integration is a logical conclusion and a good move.  An even closer integration would be possible if clearing corporations, those invisible but critical bodies which manage money, securities and risk, become inter-operable bringing efficiencies in risk management and more efficient deployment of capital.

SEBI’s dealing with credit rating agencies is well calibrated where it speaks of improved standards. But, it needs to review two decisions. First, increasing networth of CRAs to Rs. 25 crores in an area depleted of competition should be reviewed. If lawyers don’t need a networth to operate, why should credit rating agencies? We need smarter and better intermediaries, not richer ones. The policy leanings towards richer is more honest than poorer is misguided and in fact counter-productive. A liquor baron may be eligible to set up a CRA, but an IIMA graduate would not. Additionally, the cost of capital lost with this requirement would be passed on to the ultimate customer – the investor. The policy of networth in areas which do not require capital should be reviewed across the board not just for CRAs. Second, restriction on one CRA holding shares or directorship of another CRA would limit the free flow of capital and controls without reducing any conflict and is thus over-regulation. If at all any conflict mitigation is require from the perspective of rating shopping, that can be addressed by appropriate substantive restrictions.

On sponsors of AMCs of mutual funds, SEBI seeks to address potential conflict of interest by mandating that a sponsor cannot own shares of more than two mutual funds over 10%. It is unclear which conflict of interest SEBI is seeking to reduce. It would limit the market for capital and controls without reducing conflict. Does, say a private equity investor owning 15% of two mutual fund AMCs put the investors in any conflict situation. It is unclear how an investor is short changed if a credible person controls substantial stakes in multiple asset managers. If Warren Buffet can take multiple insurance companies or AMCs and merge them later, why outlaw that market in India. Taken to its logical conclusion, AMCs, almost ten in number, with public sector banks or other government sponsors would be in conflict of this provision, as the government is the ultimate sponsor of these AMCs.

On additional methods for listed entities to achieve minimum public shareholding (MPS) requirements of 25%, SEBI is directionally correct in liberalising two additional methods-Qualified Institutions Placement (QIP) and Sale of shares up to 2% to comply with the MPS requirement. But is it unclear, why the restrictions were in place in the first place and why sale in secondary markets is limited. Is the highly efficient secondary market deserving of this suspicious treatment? Why not allow promoters to sell in the market in a transparent and anonymous market when SEBI itself says that “open market will facilitate quicker and cheaper compliance”. As the US appeal court held in the famous Business Roundtable ruling striking down an SEC rule: “Indeed the Commission has a unique obligation to consider the effect of a new rule upon efficiency, competition, and capital formation”.

The Foreign Portfolio Investor norms too have met with reforms in terms of regulations. The regulator seems to have seen the difficulty of privatising the registration of FPIs and the private players being even more stringent in implementing the norms relying more on grammar than the intent of the law.  It has therefore rationalised fit and proper criteria for FPIs, simplified requirements of broad based nature of FPIs etc. These are good moves. The essence of foreign portfolio money should be on clean money and not on other factors which have fascinated the regulator for two decades. It is unclear why it should get into whether or not funds are ‘broad based’ or not. When SEBI has allowed even individuals to invest through the erstwhile FII regulations and continues to allow it under the current regulations, why being ‘broad based’ is a point of regulatory virtue is unclear, as narrower ownership of funds makes it easier to see ultimate ownership and thus make KYC easier.

SEBI has wisely decided to defer both the deep segregation of investment advisors from distributors, which would have hurt investors rather than help them and also the implementation of the Kotak Committee report which require substantial rethinking, and divvying up regulations from best practices.

19 December 2017

CII's 8th Financial Markets Summit

The flagship financial/capital market seminar of Confederation of Indian Industry (CII) will take place on 20th December 2017.  The summit promises to be interesting one. I will be speaking on "Commodities Markets regulations" Please do register for the same, details are as below:

28 November 2017

Control Alt Delete for Promoters

I have a piece in today's FE - why the insolvency ordinance was a necessary moral imperative and unnecessary economic analysis will take us off track - linked here. The full piece is reproduced below:

The ordinance, by cutting the rot, will allow early but small failures, while penalising promoters who wait too long in the hope of being bailed out.

The greatest philosopher, who almost no one has read, Immanuel Kant, spoke about the categorical or moral imperative. He discussed the imperative as a principle of reason, which was an unconditional obligation to do the right thing regardless of our will or desires. The insolvency ordinance should also be seen from this perspective, ignoring a strictly economic explanation of the best financial outcome. In summary, the government brought out an ordinance which would debar promoters or rather former promoters from becoming buyers of their erstwhile company. In its own words, the government’s objective is “to keep-out such persons who have wilfully defaulted, are associated with non-performing assets, or are habitually non-compliant and, therefore, are likely to be a risk to successful resolution of insolvency of a company” and “to impose restrictions for such persons to participate in the resolution or liquidation process.”
In brief, the ordinance bars wilful defaulters, undischarged insolvents, persons convicted of an offence with over two-year imprisonment, individuals disqualified as directors under the Companies Act, persons banned by SEBI from securities market and persons banned under insolvency law for fraudulent activities. It also bars a person who executed enforceable guarantee in favour of a creditor in respect of an insolvent entity and promoters or sister concerns of companies with non-performing assets of more than one year. While few can quarrel with the first list even though the concept of wilful defaulter is not well-articulated by the central bank, it is the second list that has caused controversy. Should failed promoters be ineligible to purchase shares of the company they sank, however innocently? Should guarantors who guaranteed loan repayment be debarred from bidding for bad assets?
To give the context, we have lived in a decade where outrageous loans were made. While at it, both lenders and borrowers enjoyed the Omerta Code of keeping defaults very private. At help was a section of the RBI Act that seemed to support the dark web where the public was kept in the dark about the stratospheric debt of companies most of us had not even heard of. Clearly, RBI has not heard of the Right to Information Act. How many of us know that Bhushan Steel had a debt of `50,000 crore? Many loans were clearly crony capitalism at play. Many were just poor investment decisions in industries which bled because of macroeconomic conditions or global pricing pressures or even domestic competitiveness issues. With a decade since many were made, it is difficult to figure which ones were the crony offerings and which ones were genuine business failures.
In a court of law, this would be a near-impossible hypothesis to prove, whether or not, in a given case, bribes or other benefits were the cause of the loans. Even in the event of business failures, there is very little cause for letting the rot set so deep that hardly anything is salvageable in many of these companies. Imagine you or me getting a car loan which, after three years, is ten times the value of the car. It wouldn’t happen, so why did it happen when there were many more zeros involved and the degree of scrutiny ought to have been higher? Genuine business failure is no justification for being asleep on the wheel so long that the value of the loan exceeds the value of the asset by many times. It was almost as if the lenders thought that, by efflux of time, the rust will vanish.
This experience is so different from your and my experiences as borrowers. Not only would we not get more than the value of the car or house, but in the case of a depreciating asset, the cover would always comfortably exceed the due as on that date. Add to this, no one’s experience on a debt forgiveness of even a single rupee by a single month for our personal loans, and add to that the potent cocktail of justifiable outrage that it wasn’t bankers’ money that has been used to bail out such companies through haircuts. It was taxpayers’ money directly and depositors’ money indirectly, in terms of lower deposit rates on savings accounts. Contrary to what economists have convinced us, we live in a society rather than in an economy. And individual and societal outrage at this loss is both necessary and justified.
Yes, commentators have seen this from an economic lens and have argued against the introduction of a restriction on grounds of economic efficiency. Yes, the ordinance is a blunt tool. Yes, it will have the unintended effect of reduced salvage value. Yes, it will be challenged, like all laws which have a big financial impact. Yes, it will be unfair to some promoters who have failed, but want a second chance, while at the same time offering the most money to bankers and lenders. But seen from a moral or political lens, the ordinance makes a lot of sense. People’s sense of unfairness at fat cats buying houses abroad while their companies default in India needed to be resolved.
Similarly, going forward, the moral hazard of taxpayers paying the bills of failed or corrupt businessmen will reduce. And companies which needed to be laid to rest will finally be laid into the crematorium and the endless wait for the rust to vanish on its own, monsoon after monsoon, will also go away. Failing companies will be resolved within a year of the downslide, minimising the damage to lenders and equity shareholders alike. As a good entrepreneur would tell us, failing often is not the key to success, but failing small and early might be. The ordinance, by cutting the rot early, will allow early but small failures, while penalising promoters who wait too long either in the hope of being bailed out or based on unreal hope. India will see a new age of businesses from the ashes of the dead and this creative destruction will make India more competitive.
Ultimately, we should not underestimate the power of creative destruction. As I read at a reserve forest which saw several forest fires each year, “the forces of creation are at least as powerful as those of destruction.” I am also hopeful that an unintended benefit of this whole process will be a wider-held shareholding taking root in India rather than the promoter-driven model. That can have significant upsides in terms of better and more professional governance of Indian companies which are larger and more competitive. Yes, your and my outrage has helped bring this ordinance and our continuing outrage should ensure that public loot and imprudent lending does not continue. At this stage, our moral thirst is more than our economic thirst. That is for the present. With the ordinance, expect behavioural changes so that both the moral and economic thirsts are quenched simultaneously in the future. What is good for a car loan should be good for industry loan as well.

23 November 2017

Finsec Law Advisor recognised as the highest ranked law fim in financial services regulatory practice

We are pleased to announce that our firm, Finsec Law Advisors, has been recognised as the highest ranked law firm in India for Financial Services Regulatory practice by Asialaw Profiles 2018*. We have also been recommended in the Investment Funds practice and several other areas, details of which can be accessed at Asialaw.com

Getting this recognition from a Euromoney publication in our 7th year of existence - ahead of peers many times our size, truly humbles us. We are grateful to all our clients and well-wishers for their kind support to a relatively young specialist firm.

We take this opportunity to thank everyone who was part of this journey.

*Asialaw Profiles is published annually by the Euromoney publications and serves as the guide to Asia-Pacific's leading domestic and regional law firms. The annual rankings are primarily based on independent market survey and feedback received from other legal practitioners and clients.