SEBI’s circular on due diligence to be done by large distributors is yet to be taken seriously. Some banks are not even aware of it!
Six months after the Securities and Exchange Board of India (SEBI) got a new chairman, the market watchdog issued a new circular that aims to regulate the distributors by putting in place a due-diligence process to be conducted by the asset management companies (AMCs). The objective is noble—to protect the interest of investors. The circular has stated that the due diligence process shall be initially applicable for large distributors. But are the distributors following these rules?
As per the SEBI circular, mutual funds are supposed to ensure that customer relationship and transactions shall be categorised either as ‘advisory’ or ‘execution only’. For the advisory function, the distributor will sell “only that product categorisation that is identified as best suited for investors within a defined upper ceiling of risk appetite. No exception shall be made.” For the ‘execution-only’ relationship, if “the distributor has information to believe that the transaction is not appropriate for the customer, a written communication be made to the investor regarding the unsuitability of the product. The communication shall have to be duly acknowledged and accepted by (the) investor.”
SEBI has also specified that “customer confirmation to the effect that the transaction is ‘execution only’ notwithstanding the advice of inappropriateness from that distributor be obtained prior to the execution of the transaction.” SEBI has also specified that the compliance and risk management functions of the distributor shall include a variety of elements such as review of products and the periodicity of such review; factors to be included in determining the risk appetite of the customer; review of transactions; exceptions identification; escalation & resolution process by internal audit; recruitment, training, certification and performance review of all personnel engaged in this business, etc.
All this is a lot of work, but the key question with any regulation in India is simple: What if the rules are not followed? Indeed, some aspects of the SEBI circular are impractical and have nothing to do with returns, which is the only thing that can serve customer interest. After all, if a distributor can recommend a lousy fund and still can easily prove that he has worked in the ‘best interest’ of the customer given the available information, this regulation is of no meaning.
In any case, we wondered whether these rules are being followed and in what form? We asked a savvy investment advisor based in Chennai for his feedback from the ground. His response: “I checked with some active advisors. They are not even aware of the August circular of SEBI. So there is no question of whether it is being followed. I spoke yesterday to a few bank relationship managers and investment advisors; they are not even aware of SEBI’s August circular.”
In contrast, here is the ground reality of how advice is manufactured by some large distributors, as found out by another smart distributor. “One investment advisor at a foreign bank told me that they charge 2.5% as fee for mutual fund investments. They have a ‘white’ and ‘black’ list. Even in the white list, different funds have different weights, based on which revenue credit would be given to the relationship manager. The weight is given based on the revenue tie-up the bank has with AMCs. The white or black or weight has nothing to do with an investor or his risk profile.” A big target of mis-selling is small businessmen with bank loans. One distributor reported to us: “Some of my SME clients who use the overdraft facility at State Bank of India (SBI) are forced to invest in dud products of SBI MF & SBI Life.” Is there any chance that SEBI would be even aware of any of these incidents and how?
In July, HDFC Bank ran its ‘Power of 3’ campaign: Promoting three funds of HDFC Mutual Fund. The relationship managers were asked to focus only on this product and sell maximum SIPs (Systematic Investment Plans). According to an independent distributor: “I hear that around 90,000 SIPs were sold by HDFC Bank on that month alone. Being a HDFC Bank customer, I happened to visit their branch for some work and I can see RMs (Relationship Managers) aggressively selling the ‘Power of 3’ to everyone including me. The RM told me that they have been told that July performance is critical for their annual appraisal and variable pay. The icing on the cake is that HDFC MF up-fronted the entire 3-year commission (upfront + trail) in one month itself and the entire revenue credit was given to RMs. What more an RM can ask for?” Now, in this case, the customer may not lose because HDFC has some very good funds. But imagine the ‘Power of 3’ campaign by LIC Nomura or JM Mutual Fund!
These episodes also show what the power equation today is. AMCs are really at the mercy of large distributors and SEBI’s move to regulate the latter through AMCs only means looking at the problem of mis-selling from the opposite end! Unless SEBI regulates large distributors directly, the 22nd August circular will have far less meaning than what is intended.