Skin in the game. That’s the phrase being used to describe the capital market regulator’s recent directive that has made it mandatory for mutual fund houses to pay 20% of the compensation (net of taxes and statutory contributions like PF and NPS) of their key employees in the form of units of schemes in which they have a role or oversee.
Such key employees include the CXOs including CEOs, CIOs, CROs along with the Compliance Officer, fund managers, sales head, and department heads among others. SEBI has also mandated that such unit-based compensation will be locked-in for a minimum period of three years or the tenure of the schemes, whichever is lower. While barring redemptions during the lock-in period, SEBI has allowed fund houses to lend against such units ‘in exigencies such as medical emergencies or on humanitarian grounds, as per the policy laid down by the AMC’ – something akin to buyback.
It seems that the regulator was concerned with the high remuneration of fund managers especially when the schemes of fund houses were not performing well. There were also some regulatory concerns that emerged during inspections and forensic audits of certain fund houses. It was found that few key employees were putting their own interest over the interest of unitholders, thereby failing in their fiduciary responsibilities. Hence, SEBI thought of linking incentives of key employees of the AMCs to the performance of the schemes which they oversee.
Surprisingly, however, this new policy has come without any discussion paper or public comments thereby leaving the market guessing at its rationale. Issued under a legal provision that empowers SEBI ‘to remove any difficulties in the application or interpretation’ of Mutual Fund Regulations, this circular has the potential of opening a Pandora’s Box. The circular will come into effect from July 1, 2021.
While the industry is rife with questions – and theories as well - there could be a few potential issues with this new policy.
Firstly, the wide definition of key employees (covering even the non-senior employees) and the basis for introducing the threshold of 20% compensation and three-years’ lock-in without taking into consideration risk-suitability of employees. Secondly, SEBI has extended its jurisdiction into employment and service conditions for personnel of public and private mutual funds. Finally, the unintended encouragement to fraudulent and unfair trade practices by building an inherent conflict of interest situation.
The “minimum” 20% compensation in unit-form could make it challenging for mutual fund houses to retain or attract talent. More importantly, the circular directly contradicts the various judgements of constitutional courts that have held salary to be a right to property under Article 300-A of the Indian constitution. Courts have also held that employment conditions cannot be changed to the detriment of employees during employment, based on the whims and fancies of any entity, as it is a facet of right of life and profession.
Interestingly, such policies do not seem to exist in any country globally. Especially in the manner SEBI has sought to achieve.
A study done in the US in 2019 by the National Bureau of Economic Research found that fund managers became less aggressive when they had their own personal commitments in the fund. The study, however, also argued that while it resulted in better returns, there was lower participation by outside investors. This study analysed the performance and investor characteristics of 720 hedge funds registered with the Securities and Exchange Commission (SEC).
Incidentally, SEC has encouraged performance-linked incentives in its speeches though it has never made it mandatory for any category of fund managers, the way SEBI has done.
On the contrary, a detailed reading of some of the enforcement orders of the SEC would show that the so-called ‘skin in the game’ approach actually puts the interests of the investors and the fund managers in direct conflict. It further encourages fund managers to violate their fiduciary responsibilities by deliberately distorting the disclosures to avoid disclosing under-performance among other things, including tweaking expenses and related party disclosures.
Aligning the Interest or Building Conflict of Interest?
SEBI wants to align the interest of key employees of AMCs with the unitholders of MF schemes. It is based on the assumption that key employees would share the risk and reward with the unitholders and hence be more cautious. It is akin to thinking that a chauffeur will not be reckless and put passengers’ lives on the line because he shares the same risk. This is theoretical.
SEBI’s recently introduced Code of Conduct for Fund Managers and Dealers mandate them to act fairly, professionally, independently and at arm’s length basis. The recent circular conflicts with this Code as well. SEBI’s latest diktat has made the medicine causing the pain. Doctors, lawyers and other professionals are required by law to act on the best-effort basis. By law, they are required to not have their ‘skin in the game’ or ‘personally engage’ to avoid conflict of interest.
The latest move has made many wonder if such a policy would be extended to fund managers of AIFs or Portfolio Managers (having a sponsor lock-in similar to a MF) or the key employees of Merchant Bankers (who are not underwriters) that sell public issues. One could argue that the ‘skin in the game’ logic could lead to better IPOs in the market!
Also, in-built in this policy is an incorrect signal – for the investors - that the fund manager or the fund house has invested its own money and so the fund will operate better. It is not necessary that the correlation between ownership and risk reduction would apply in a situation where professional judgement is required.
SEBI has not made available any empirical study, which leads to the belief that perhaps such a study is yet to be conducted.
The Way Ahead
SEBI has been bringing new policies for regulating the MF industry on a regular basis. Whether it was about the colour codes of schemes or the risko-meter or even introducing Code of Conduct for Fund Managers and Dealers, SEBI has been quite active in this segment. However, the frequency of new circulars, clarifications and amendments to SEBI Regulations would show that the industry has always been struggling with compliance of these sweeping strokes of law that change the way the business has to be done. Maybe it is time, India – and SEBI in particular – could mull over some long-term vision or strategy in terms of regulating the MF industry. It would undoubtedly be better than the current approach of plugging one hole at a time that emerges after every episode that questions the role of the fund manager or the fund house.
Government of India recently notified new SEBI Annual Report Rules directing SEBI to provide progress or impact assessment of the new regulations/rules introduced in the previous year. It will be interesting to see if this circular would be explained therein - technically it is neither regulations nor rules.
Legally, the MF industry has the option to request SEBI to reconsider the circular or challenge it in the High Courts. It could even request the Ministry of Finance to intervene, but it is an open secret that a regulated entity is always weighing the cost of a miffed regulator against the cost of compliance!
Respectfully, ‘skin in the game’ should not mean that SEBI decides the manner in which key employees of fund houses should get their compensation. A better approach could be setting deterrents in the form of exemplary punishments to thick skinned fund houses and their key officials but sadly, the statistics are abysmal.
The author is the Founder, Regstreet Law Advisors, author of a book on SEBI Act & a former SEBI Officer. The views are his own.