03 November 2016

Did Sebi just score a self-goal on stock advice and free speech?

I have a piece in today’s ET “Did Sebi just score a self-goal on stock advice and free speech?” where I argue that the consultation paper of SEBI lacks internal logic, and would hurt investors rather than protect them. The restrictions on free speech would make Warren Buffet (if he chose to come to India, or commented on Indian stocks) a criminal. Please find below the full piece:

SEBI has come out with a consultation paper to modify the existing regulations of investment advisors, distributors and research analysts. The proposed amendments should be abandoned, commas and full stops included. As proposed, they would hurt investors, mandate un-suitable products to investors, fight the law of economics (unsuccessfully), outlaw honest conduct as fraud and place unconstitutional restrictions on your and my freedom of speech.

The current regulatory landscape is as follows. We have 80,000 odd distributors of mutual funds. These are agents of mutual funds and receive a commission from the funds. This is a conflicted model as it incentivises distributors to sell the products juiciest for themselves, not the most appropriate for the investor. This has been tackled by SEBI in a three-pronged approach. Limit commissions aggressively, strict disclosure norms of what is shared with the distributor and imposition of fiduciary standards on the distributors. Then there are advisors who advise clients for a fee and are not permitted a commission, though their distribution arm may charge such commission on a disclosed basis. Distributors of mutual funds are today exempt from registering as an investment advisor so long as they give incidental advice, which in fact they are obligated to give based on a 2011 circular of SEBI. Specifically, they are obliged to study the financial situation, investment experience, and investment objectives of the investor before recommending a product.

Now SEBI seeks to take away the advisory exemption to distributors. This seemingly innocuous move will have catastrophic consequences. While we have over 500 registered advisors, by my estimate, those who are advisors without any affiliated distribution function would run in single digits. It is not economically viable to be pure a play advisor. Dangerously, such a regulatory fatwa would force distributors, not to register as advisors, but rather to stop their advisory role. People assume this will hurt distributors. In fact, distributors will be happy to give up the advisory role which imposes a cost and a fiduciary obligation on them and little revenue. The sole loser of this move will be the investor. Distributors will not only obtain the ability to sell products without a basic check on the risk profile and risk appetite of the client, but the law will force the distributor to sell unsuitable products to investors, for without proper advice there can never be a proper sale. This is an avoidable regulatory self-goal.

The second proposal of the SEBI paper is to disallow a division of the investment advisor to provide distribution and execution or orders. Instead, it mandates the separate arm to be set up as a separate subsidiary. For this it relies on RBI mandating banks to set up separate subsidiaries to provide advice and not directly by the bank. The reason RBI has mandated the subsidiary model is not to help investors, but to protect the banks from investors claiming that they have been defrauded or sold unsuitable products by the bank. This too would be investor unfriendly.

The third proposal is the most innocuous sounding, but the most dangerous. It seeks to curb providing securities specific recommendations through SMS, email, blog, chats, social media etc. unless that person is a registered investment advisor. Not only that, it proposes to categorise such communications by itself as fraudulent. The charge of fraud requires proving intent to defraud, material mis-statement, causation and actual harm. All four seem not required to prove fraud if you share an honest opinion about a listed company on WhatsApp. In addition, it would make Warren Buffet (if he were based in India) a criminal as he shares his views on a large number of companies. The following statement from his annual letter to shareholders could land him in jail for up to 10 years “Precision Castparts Corp. (“PCC”), a business that we purchased a month ago for more than $32 billion of cash. PCC fits perfectly into the Berkshire model and will substantially increase our normalized per-share earning power.” However, a graduate who wishes to register with SEBI is fine commenting on all and sundry companies. The proposal will chill whistle blowing, chill factual and analytical communication about listed companies in general, and impose a constitutionally impermissible restriction on freedom of speech.

Finally, the paper discusses the Research Analyst Regulations of SEBI. Any person who provides research reports giving buy/sell/hold recommendations, or provides an opinion on listed companies is obligated to register with SEBI. The paper seeks to impose suitability obligations on the analyst ensuring “that the research service offered to the investor is based on overall financial situation and investment objectives of the client.” A research report is typically shared en masse often with thousands of people. Imposing a suitability requirement would be unworkable and is the task of the client’s investment advisors.

SEBI is clearly the most open regulator in terms of listening to comments and it is hoped that they will abandon this entire project, perhaps retaining only the full stops.

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