Sebi's role in Franklin Templeton crisis draws ire of Karnataka HC

Some legal experts believe that the High Court’s observation may lead Sebi to review the regulations governing winding up of mutual funds
The Securities and Exchange Board of India (Sebi) has drawn flak from the Karnataka High Court (HC) for its handling of the Franklin Templeton (FT) crisis that led the asset manager to shut six of its debt schemes.

Sebi did not possess a copy of the resolution dated April 23 passed by the board of directors of FT trustees providing for winding up and did not respond to the email of April 14 sent by the asset management company (AMC), the court observed in its judgment on Saturday.

Sebi also failed to reply to the letter dated April 20 addressed by the trustees, in which permission and guidance of the regulator was sought for winding up the schemes.

FT Mutual Fund (MF) shut six of its debt schemes on April 23, citing redemption pressures and lack of liquidity in the debt market.

The court further observed that Sebi was not aware whether compliance of sub-clauses (a) and (b) clause (3) of Regulation 39 was made by the trustees. This clause deals with the trustees giving notice disclosing the circumstances leading to the closure the scheme to the board and in two daily newspapers and a vernacular one.

“Even for Sebi, such a wind-up was an extraordinary event. Sebi did not bother to even enquire about the compliance with clause (3) of Regulation 39 by the trustees. Sebi did not bother to ascertain whether redemptions and borrowings ceased, assuming that compliance of clause (3) of Regulation 39 was made,” the court stated in its 336-page judgment.

The court also criticised Sebi for not placing on record a copy of an order appointing a forensic auditor, and producing it before the court on September 2, even though the hearing had commenced on August 12.

“As a watchdog, Sebi was expected to play a very proactive role by questioning the AMC, trustees, and sponsor about the compliances with the provisions of the MF regulations. The investors/unitholders of the said schemes will be justified in their criticism that Sebi was a silent spectator,” the court observed.

Some legal experts believe that the HC’s observation may lead Sebi to review the regulations governing the cessation of MFs, which give power to the trustees to conclude schemes after taking unitholders’ consent without requiring any approval from Sebi.

“While MFs are set up as trusts and the decision-making has currently been left to trustees and unitholders, the fact that Sebi encourages retail investors to use MFs as a mechanism to invest in the securities market could lead to stricter regulation,” said Vaneesa Agrawal, founder, Thinking Legal.

“The requirement for consent of a simple majority of unitholders essentially impairs the fiduciary authority of the trustees to solely decide on winding up a scheme,” added Suneet Barve, partner, IC Universal Legal.

According to him, there is already a provision in Regulation 39 (2)(a), whereby 75 per cent of unitholders may require a scheme to be wound up. Moreover, he said, there may be practical difficulties in obtaining prior consent of unitholders since not everyone may be qualified or technically equipped to understand the intricate aspects of the scheme’s investments to decide on consent.

“The present regulations may have to be relooked at, so that the flexibility to wind up a scheme at the sole decision of trustees is retained, with proper caveats, if so desired,” said Barve.

While upholding the validity of Regulations 39 to 40 of the MF regulations, the court has observed that when the trustees decide to wind up a scheme by taking recourse to sub-clause (a) of clause (2) of Regulation 39, the trustee company is bound by its statutory obligation under sub-clause (c) of clause (15) of Regulation 18 to obtain the consent of unitholders.

The former sub-clause says a MF may be wound up on the happening of any event because of which the trustees believe the schemes need to be shut. The latter sub-clause says trustees shall obtain the consent of unitholders when the majority of the trustees decide to wind up or prematurely redeem the units.

Sebi now has the option of challenging the judgment by filing a special leave petition before the Supreme Court (SC). “Sebi may not immediately change the regulation pertaining to winding-up of schemes, but will appeal to the SC on the observation that it didn’t act proactively,” said advocate P R Ramesh.

Key highlights of Karnataka HC's order

  • FT Trustees’ decision to wind up schemes cannot be implemented without unitholders’ nod 
  • Regulations 39-41 of Sebi’s mutual fund regulations legal and valid
  • Trustees to provide true copies of board resolutions to unitholders of six schemes
  • Sebi directed to take action within six weeks from receipt of final forensic audit report
  • Unitholders not entitled to receive copy of forensic audit report

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