Last week in a case involving Kotak Mahindra AMC, the Supreme Court ruled that infraction of Securities and Exchange Board of India (Sebi) regulations cannot be justified on the grounds that investors did not incur any losses. Banasree Purkayastha looks at what the order means for mutual fund houses & their investors
l What was the SC ruling?
THE SUPREME COURT ruled that compliance with Sebi regulations are mandatory and cannot be diluted simply because investors ultimately suffered no financial loss or even made gains. The Court held that market integrity and adherence to the regulatory framework take precedence over the outcome of a transaction. “Breaches of the regulatory framework, fortuitously, could ultimately result in gain but excusing a breach which led to profit is likely to incentivise the next breach. Progression from profit to greed, from greed to regulatory breach and from breach to systemic failure is not too unfamiliar,” it said.
The Court also upheld the penalties imposed by the markets regulator, which included a Rs 50 lakh penalty on Kotak Mahindra Asset Management Company (Kotak AMC) and Rs 1.6 crore in penalties on Kotak Mahindra Trustee Company (Kotak Trustee) and six executives, including Rs 30 lakh on MD Nilesh Shah for regulatory infractions in their handling of six fixed maturity schemes (FMP). It also slapped punitive costs of Rs 30 lakh on Kotak AMC and Rs 20 lakh on Kotak Trustee.
l Violations that lead to profits are equally bad
THE COURT REJECTED Kotak AMC’s argument that its actions were taken in good faith and the restructuring of the schemes enabled avoidance of losses for the unitholders. Making it clear that the Sebi (Mutual Funds) Regulations, 1996 do not distinguish between a violation that benefits investors and one that causes losses, it said that a wrongdoer cannot be allowed to use the plea of the investors having gained, notwithstanding the violation, as a shield for evading penalty. Market integrity being the paramount consideration, profit or loss to investors is immaterial to determine whether a regulatory infraction has occurred.
The Court said permitting such defences would weaken regulatory discipline by encouraging fund managers to take unauthorised commercial calls in the hope that a favourable outcome would excuse the breach.
l Origins of the case
KOTAK AMC HAD launched six FMPs between 2013 and 2016. Out of the money collected, `266 crore was invest-ed in zero coupon non-convertible debentures (ZCNCDs) issued by entities within the Essel Group. The securities were backed by a pledge over 22.8% shares of Zee Entertainment Enter-prises (ZEE). In November 2018, as ZEE announced plans to divest part of its shareholding, the value of the pledged shares fell.
Instead of invoking the Sebi-prescribed rollover process as per Regulation 33(4)—which required prior disclosures, written consent of unit holders and an exit option for those not continuing—Kotak AMC restructured the debt securities, effectively extended the schemes’ maturity. It withheld 10-21% of the redemption amounts when the FMPs reached their maturity dates. Around Rs 376 crore out of Rs 2,116 crore payable was released after the schemes had matured. The remaining payments were completed in September, 2019.
l What was Kotak AMC’s argument?
KOTAK AMC ARGUED that it had extended the schemes’ maturity date instead of offloading the pledged shares to prevent a collapse in the share price. Winding up the schemes would have led to losses for the investors. The entire investment amount, along with returns, was eventually recovered and paid back, and thus no actual financial loss was caused to the investors. The decision fell within the realm of commercial wisdom and asset management strategies, aimed at mitigating systemic market risks rather than an intention to circumvent the rules, it said.
l What this means for investors
THE ORDER REITERATES that due diligence, disclosures to investors and Sebi and regulatory compliance matter as much as investment returns. Sebi regulations require that in case a close-ended scheme needs to be rolled over, the fund house has to disclose the entire facts to the investors as well as Sebi, and get written consent from those investors choosing to continue. Unwilling investors must be allowed to redeem their investments. No fund house can unilaterally decide to extend a scheme’s effective maturity only because it believes a better financial outcome is possible at a later date.
l Warning for mutual fund houses
THE RULING IS expected to make mutual fund trustees and compliance officers more cautious. It reinforces that fiduciary duties and regulatory procedures cannot be overridden by commercial judgment, even during periods of market stress. The message is in the warning the Court issued to managers of AMCs/fund houses in its order: “Mandate first, gains later; Sebi compliance, never falter.”
In future, it would be prudent for AMCs not to invoke “investor benefit” to defend procedural violations. Governance is as important as investment performance. Restructurings of schemes will require much stricter compliance. And finally, trustee companies will face greater accountability — they cannot afford to just give assent to the fund house’s decisions but need to ensure that the course taken by the latter is in the interest of the investors.