Enforcement, the key

Suresh Krishnamurthy

...the real key to our success is more basic.

It lies in the safeguards, unique to our industry, that are the backbone of regulation under the Investment Company Act. Redeemability, daily marking to market, strict limits on borrowing, full and fair disclosure, prohibitions on affiliated transactions, and oversight by independent directors. We in the industry are so used to these investor protections that we take them for granted. But it is these simple, common-sense protections that have kept our industry free from serious problems and have earned us the trust and confidence of our shareholders. -- Extracted from the 1999 keynote address of Matthew P Fink, President, Investment Company Institute, US.

THIS year, SEBI came out with quite a few circulars affecting the functioning of mutual funds. Beginning with severe restrictions on participating in private placement of securities, followed by tightened regulations on advertising and requirements to record a reasonable basis for every single transaction conducted along with norms for valuation in debt schemes, the changes had far-reaching significance.

However, it seems like bolting the stable door after the horse has fled. The restriction on private placement of securities came after the excesses of the industry in the private placement market in late 1999 and early 2000. And the advertising regulations came long after sizeable funds were mobilised in 1999 and early 2000.

The SEBI circular that requires mutual funds to record the basis for every transaction claimed that, on inspection of records, it found some funds had recorded heavy losses, even NPAs, in their books. The moment something goes wrong, the basis on which such investments were made immediately comes into question.

However, an investor has reason to wonder if the funds, by definition, were not required to invest with a reasonable basis and record the same even earlier. Similarly, uniformity in debt valuation should have been thought of in the first place, before mutual funds were allowed to enter the market for funds, not six years later.

In short, an investor may be pardoned for asking why these restrictions were not part of the regulatory framework in the first place. This is especially confounding given that American laws, on which Indian laws are more or less based, incorporate such restrictions.

Enforcement vital: In the keynote address to the Investment Company Institute, its President, Mr Mathew P. Fink, noted in 1999 the important role of the legal and regulatory framework in the success of mutual funds in the US. The enforcement of these regulations by the US Securities Exchange Commission also played a significant part.

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In India, the power of enforcement, in general, is lacking. Two issues come to mind in this context. One, the circular on compulsory diversification. In this case, Alliance Equity Fund immediately reduced its holdings in stocks such as Infosys Technologies after SEBI noted that Alliance was violating the rules. However, other funds, including Birla Advantage and Morgan Stanley Growth, continued to maintain a higher weightage in a few stocks. It was not clear if they were granted exemptions. Overall, uniform enforcement was lacking.

More important, the failure of various funds to file annual and semi-annual disclosures goes unchallenged by SEBI. Funds such as Zurich and Kothari Pioneer maintain separate accounts for unrealised gains and losses while others maintain consolidated accounts. In the disclosures to the notes to accounts, there is considerable disparity. None of these disclosures provides any easily understandable information to the investor. Overall, the impression is that SEBI is content with mere rule-making.

Rule making: Lacks transparency: Even in rule-making, SEBI's approach is low on transparency. The procedure followed in the US regarding rule-making is admirable. Persons in responsible positions, such as the SEC Chairman or mutual fund officers, take note of important developments in speeches delivered on important occasions. A draft note is then submitted and suggestions invited from various participants. The rule is then notified.

In India, there are rarely discussions of substance before a new rule is put out. What is more, people in responsible positions, such as those in SEBI and AMFI, never shed light on any questionable practice by mutual funds. Even some of the advertisements by funds appear to cross the limit of what constitutes fair claims. When funds invest sizeable sums in the private placement market, there are no adverse comments from anyone in authority. Then, all of a sudden, SEBI issues a circular changing the rules of the game overnight.

Obviously, before the norms were notified SEBI would have taken the players into confidence, ascertained their views and then introduced the rules. However, what the industry's views were, and what the basis is for the views of either side, will always remain beyond public knowledge.

Need of the hour: The need of the hour is full, fair and meaningful disclosure. The lack of uniformity in disclosures is glaring. Efforts need to be made to ensure that these disclosures make sense to a normal retail investor. What is being disclosed now is more the means to information, and not information itself. This needs to be corrected.

There is also a need to incorporate some of the relevant US rules, such as those on personal investments by persons associated with mutual funds as part of the Indian legal framework. The additions need to be made on a case-to-case basis and not after a crisis. More important, in the US, discussions on one subject or the other are the norm, as is the case with most regulated markets worldwide. Such discussions and the transparency they bring to an issue need to be part of the Indian framework too.