Snowballing Role of Trustees in Mutual Funds

The Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 (SEBI MF Regulations) prescribe a three-tiered structure consisting of:

i. Sponsors

ii. Trustees (Trustee Company or Individual Trustees)

iii. Asset management company (AMC)

Under Regulation 2(x) of SEBI MF Regulations, a ‘sponsor’ is defined to mean any person who, acting alone or in combination with another body corporate, establishes a mutual fund and is akin to a promoter. In order to become a sponsor, one must be a ‘fit and proper person.’ Indeed Regulation 7 of the SEBI MF Regulations sets out several conditions for one to qualify as a ‘sponsor’, including a five-year track record, and profitability post interest deprecation and taxes, in three out of five years, including the fifth year. The sponsors typically become shareholders in the mutual fund company. In any event, if anyone shareholder has more than 40% shareholding, he is deemed to be sponsor. One might even query the continuous requirement of having a ‘sponsor’ once the trustee and AMC are appointed since thereafter the role of the sponsor, is effectively minimal. There are several provisions which highlight a strict code for conflict of interest and under Regulation 25(20) of the SEBI MF Regulations, the sponsor (along with the AMC) remains liable for compensating the investor ‘for any unfair treatment to any investor as a result of inappropriate valuation.’

The AMC manages the funds raised from the investors, and while they are regulated by the Securities and Exchange Board of India (SEBI), the trustees serve as an independent body to protect the interests of the investors and ensure compliance with the SEBI MF Regulations. One might even consider the trustee board as a first-level regulator.

As the term ‘Trustee’ suggests, the trustee group has an enhanced fiduciary role to play; when compared to the AMC and its directors. Within the group of trustees, there is a further category of independent trustees, who have an additional fiduciary responsibility – largely pertaining to the dealings of AMC with the sponsor company, its related parties.

Under Section 3 of the Indian Trusts Act, 1882 a ‘trust means an obligation annexed to the ownership of property, and arising out of a confidence reposed in and accepted by the owner, or declared and accepted by him, for the benefit of another, or of another and the owner.’ A trustee is the person who accepts ‘confidence.’ The law supports such a construct and the Third Schedule of the SEBI MF Regulations stipulates that the trustees ‘shall take into their custody, or under their control all the property of the schemes of the mutual fund and hold it in trust for all the unitholders.’ Indeed, the AMC must be ‘appointed’ by the trustees, as well as a custodian to hold the property of the Mutual Fund. The trustees are also mandated to ensure independent auditors for the mutual fund and AMC. Every declaration of dividend also needs to be approved by the trustees. The trustees are also charged with requirements to obtain consent of unitholders in certain instances. One might argue that these are onerous responsibilities on all counts.

As comes with any fiduciary office, there is an exposure to liability for failure to carry out the required functions. Recently, a first information report (FIR) was filed against Franklin Templeton India, its trustee company, and senior management, including the fund manager, for allegedly defrauding the 300,000

unitholders when it abruptly closed its debt schemes. While this matter remains, sub-judice, in another matter, the Calcutta High Court in the case of ITC Limited v. J. P. Morgan Mutual Fund India Private Limited and Ors.1 (ITC Case), allowed the trial against the directors of the trustee company, on the ground that the plaint contained the necessary elements of the tort of negligence; namely a duty of care owed by the applicants/defendants, a breach of the duty by the applicants/defendants and the consequences of such breach (allegedly suffered by the plaintiff in the case). The suit is still pending before the Calcutta High Court but has prima facie found that the trustees owe duties towards the unit holders as per the SEBI MF Regulations. The Calcutta High Court also held that the scope of duties of directors cannot be restricted to what is provided under the Companies Act, 2013 and held that:

“ . . . (T)o restrict the noble (and high-sounding) undertone of a relationship of trust and confidence to the strangehold of Section 166 of The Companies Act, would be doing immense injustice to the vision contemplated in the duty itself. Any undertaking of a responsibility, whether of person, property or the safe-keeping of another, would imply an entrustment of a duty to take care and to ensure that a sense of security is inseparable to the entrustment. Hence, a failure to ensure that due care is taken to protect that which another has handed over in trust, would constitute breach of the obligation.”

In another matter arising out of the same facts involving Franklin Templeton India’s trustee and its AMC, the Karnataka High Court2 while dealing with the primary question of the requirement of obtaining the consent of unitholders for winding up of the scheme, noted that SEBI had failed to reply to the letter addressed to it by the trustees seeking permission and guidance of SEBI for the winding up of the mutual fund schemes. The High Court observed that this was perhaps the first case in the history where Regulation 39(2)(a) of the SEBI MF Regulations was invoked, that SEBI ought to have been cautious and ought to have played very active role. Even for SEBI, such a winding-up was an extraordinary event. SEBI did not bother to even enquire about the compliance with Regulation 39(3) by the Trustees. Prompt action by SEBI was necessary to sustain the confidence of the investors. As a watchdog, SEBI was expected to play a very proactive role by questioning AMC, Trustees and Sponsor about the compliances with the provisions of the SEBI MF Regulations. It may be argued that if SEBI had responded to the clarification and guidance sought by SEBI that the trustees would have taken a guided winding-up decision. While the matter is sub-judice as the trustees have moved the Supreme Court against the order of Karnataka High Court in relation to obtaining the approval of unitholders for winding-up of the scheme, it is interesting to note that due to absence of guidance from SEBI, the responsibility fell on trustees to address the issue of winding up of schemes under the SEBI MF Regulations.

How is the trustee empowered legally or operationally to deal with these high responsibilities?

Recently, with a view to providing administrative assistance to the trustee in monitoring activities of the AMC, SEBI has vide circular dated August 10, 2020 directed trustees to appoint a dedicated officer who will assist the trustee and carry out the activities assigned to him by the trustee. Till date, that was not required. The circular also requires trustees to have standing arrangements with independent firms for special purpose audit and/or to seek legal advice in case of any requirement as identified and whenever considered necessary. These measures have been taken by SEBI to require trustees to efficiently oversee activities of AMCs which is a statutory obligation on them under the SEBI MF Regulations. The circular, originally scheduled to be effective from October 1, 2020, has now become effective from January 1, 2021.

The circular also clarified that appointment of an officer / having arrangement with firms, will not result in dilution of role of the trustees as the circular clearly specifies that notwithstanding the directions of SEBI in the circular, the trustees shall continue to be liable for discharge of various fiduciary responsibilities as cast upon them in the SEBI MF Regulations. So hitherto, the trustees had no option but to rely upon the resources of the AMC for several critical functions. This ability to appoint and retain assistance is very welcome for the trustees is very welcome. Notwithstanding this, the trustees remain dependent on SEBI to truly enforce their powers.

On paper, trustees have the power to appoint or dismiss the AMC, only with the approval of SEBI. Trustees are effectively the eyes and ears of SEBI and play a vital role in the governance structure of mutual funds in India. Keeping in view the extensive duties and obligations that have been cast on the trustees, trustees need to be more conscious of the decisions made by AMCs and evaluate its policies from time to time to ensure compliance with the SEBI MF Regulations.

Note: The article has been Suhail Nathani (Managing Partner), Manendra Singh (Associate Partner), Tanvi Goyal (Associate Manager)