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By Sumit Agrawal & Param Pandya
The Securities & Exchange Board of India (SEBI) in its recent board meeting allowed debt mutual funds to segregate illiquid assets. Side-pocketing or segregated portfolio, as it is popularly known, in simple terms means that in the event an asset (usually a commercial paper or bond) no longer remains investible, such asset is separated from the portfolio of a mutual fund scheme.
Such scheme then has two sets of units with two Net Asset Value (NAV), one of an illiquid or segregated asset which cannot be redeemed until the asset is sold and the other of the liquid portfolio which is akin to any other mutual fund unit which can be subscribed or redeemed.
SEBI’s decision is particularly relevant in times when the IL&FS crisis looms over the Indian financial sector and the stock market witnessed stress due to a certain mutual fund selling bonds of a housing finance company which also led to a steep fall in share prices of major housing finance companies.
In 2015, side-pocketing was resorted to for the first time in India when the exposure of two schemes of JPMorgan MF in Amtek Auto bonds was suddenly rated below investment grade on account of inadequate information and/or persistent liquidity issues. Despite the clamour of the Indian mutual fund industry, SEBI did not adopt a liberal view of the said practice. In fact, when in August 2015, JP Morgan MF had restricted redemptions from two of its debt schemes — Short Term Income Fund and India Treasury Fund, the move followed a decline in NAVs of the schemes due to fund house’s exposure to stressed Amtek Auto’s debt papers. This led to investors suing the MF on one hand and violation of SEBI’s regulations relating to ‘code of conduct’ and ‘principles of fair valuation under mutual fund norms’. Though eventually, SEBI settled the matter with JP Morgan for regulatory violations, it was time SEBI took a serious note on need of policy review on side-pocketing.
The recent decision of SEBI in relation to side-pocketing is certainly a welcome move, though delayed.
SEBI vide December 28, 2018 circular (Circular) has allowed the Asset Management Company (AMC) to segregate assets upon occurrence of a credit event at the issuer level i.e. downgrade in credit rating by a SEBI registered Credit Rating Agency (CRA) when such debt or money market instrument is rendered ‘below investment grade’ or any subsequent downgrades thereof. However, another additional factor that needs to be considered and missing is whether sudden default by an issuer constitutes a trigger for side-pocketing since such sudden default will also render the debt instrument illiquid.
In case there is a difference in rating by CRAs, SEBI has clarified that the most conservative rating must be considered for determining whether an asset must be segregated or not. This is particularly a fallout of the JPM-Amtek case wherein two CRAs downgraded Amtek Auto bonds at different time-frames citing different reasons. SEBI has also clarified the manner of valuation of the segregated portfolio, processing redemptions, and the subscription to the units of the liquid (non-segregated) portfolio.
Creation of side-pocket has been left optional at the discretion of the AMC. However, the Circular is silent on whether SEBI can direct a fund house to segregate an asset in investors’ interest. One may argue that SEBI can direct the fund house to segregate asset/s pursuant to the wide power conferred under Section 11B of the SEBI Act, 1992.
Approval of the trustees of the mutual fund is required for segregation the Circular envisages framing a detailed policy for side-pocketing. By casting the responsibility of overseeing the operations of the segregated portfolio including any recovery thereof, SEBI aims to rely on the fiduciary duty of the trustees to determine that side-pocketing is in the best interest of the mutual fund investors.
Further, SEBI has put in place a robust disclosure regime which requires adequate disclosure at all stages – in the scheme documents, at the stage of approval/ rejection of the proposal to side-pocket by the trustees, and if segregation is allowed then disclosure of the NAV and other relevant details.
Providing an exit option to investors who hold units of the side-pocketed portfolio is indeed a positive step taken by SEBI. SEBI has required that such units are listed on stock exchange/s so that market forces determine the price of the segregated portfolio and existing investors get an opportunity to exit. However, the actual success of this mechanism would depend on the development of a market for the segregated portfolio.
If an AMC needs to introduce side-pocket in an existing mutual fund scheme then it needs to adhere the rigorous compliance requirements as provided in the Regulation 18(5A) of the SEBI (Mutual Funds) Regulations, 1996. This Circular classifies side-pocketing as ‘change in fundamental attributes’. Thus, to amend the scheme documents to allow side-pocketing would require adequate disclosure to unit-holders and providing dissenting unit-holders an exit option without charging any exit load. If not adequately handled by AMCs by taking all unit-holders into confidence, providing such an exit option may lead to increased redemption pressure.
Finally, the fear of abuse of side-pocketing is a concern that has been raised and a loop-sided framework may incentivize fund managers to take undue credit risk. To allay the fears, this Circular envisages the trustees to put in place a mechanism which negatively impacts the performance incentives paid to fund managers, chief investment officers in case a side-pocket has been resorted. The amount so deducted must be clawed back to the segregated portfolio. Further, SEBI has warned of strict action against misuse of this provision to the detriment of investor’s interest.
Sumit Agrawal is the Founding Partner of RegStreet Law Advisors & has previously worked with India’s securities and commodities regulator SEBI from 2007 to 2016. Param Pandya is Research Fellow at the Corporate & Financial Law Vertical at Vidhi Centre for Legal Policy, New Delhi. Views are personal.