Resolve Franklin debt fund crisis fast

Radhika Merwin | Updated on June 16, 2020

Adding to the woes There are several ambiguities in the regulations   -  bluebay2014

In the interests of the debt fund industry and investors, it’s time the regulator and courts stepped in to clarify critical issues

As if the idea of a fund house winding up six of its popular debt funds overnight and closing the exit window for investors was not harrowing enough, investors are now faced with a bigger uncertainty — the recovery of their money. In light of the recent Gujarat High Court order, the e-voting process seeking the approval of unit-holders for the winding up of the schemes has been suspended. With other cases being filed and the matter being heard in other courts, investors may be in for a long wait to get their money back.

While the case mired in court battles can prolong the pain for investors, it appears that the ambiguity in the regulations laid down by SEBI has left investors with little choice. After all, investors cannot rely on the fund house or its trustee’s constant assurance alone that winding up was the only viable option available to preserve value and ensure equitable exit to investors.

Given that there is hardly any precedent for such cases in India, it is critical to ascertain the actual rights of investors under such circumstances, and quickly. SEBI’s clarification on whether the winding up decision by Franklin was indeed within the ambit of its regulations and a clear communiqué to investors on their rights in such cases, would have been welcome, but is sadly missing.

Retail investors have been caught unawares in a string of defaults and downgrades of bonds over the past two years, mostly owing to gaps in the regulatory framework, credit rating exercises, and gross mis-selling of risky products. Investors in DHFL’s once top-notch rated secured NCDs (non-convertible debentures) have been stuck in the endless drama surrounding the insolvency proceedings of the housing finance company, with no recovery in sight yet. Retirees who had fallen prey to YES Bank’s AT1 bonds (written down fully post the crisis) were left with no recourse whatsoever.

If the battered faith of retail investors in debt funds has to be restored, then they cannot be left hanging for answers this time around.

What the regulations say

Often, it is only when an event occurs that the gaps around the said rules and regulations come to the fore. In the Franklin episode, the existing regulations pertaining to the winding up of the schemes, under SEBI Mutual Fund Regulations, 1996, are grey in areas and not conclusive according to various legal experts.

There are several regulations that currently deal with winding up of funds.

Regulation 39(2)(a) states that a scheme may be wound up after repaying the amount due to the unit-holders, ‘on the happening of any event which, in the opinion of the trustees, requires the scheme to be wound up’.

The first notice to investors from Franklin Templeton sent on April 23, had cited this Section, ‘the Trustees of Franklin Templeton Mutual Fund in India, after careful analysis and review of the recommendations submitted by Franklin Templeton Asset Management…are of the considered opinion that an event has occurred, which requires these schemes to be wound up.’

The second, Regulation 41(1), that deals with winding up of schemes, states that ‘the trustee shall call a meeting of the unit-holders to approve by simple majority…. for authorising the trustees or any other person to take steps for winding up of the scheme.’

The e-voting notices sent to unit-holders of the six schemes subsequently, were in pursuant to Regulation 41(1) which sought the approval of unit-holders for taking further steps for winding up of the schemes.

But there is another regulation that deals with winding up — Regulation 18(15)(c) — that states that ‘the trustees shall obtain the consent of the unit-holders when the majority of the trustees decide to wind up or prematurely redeem the units’.

Examining each of these regulations (based on our interaction with various legal experts) few things can be inferred. Regulation 39 applies when trustees form an opinion that a scheme is required to be wound up.

Here, the trustees do not require the consent of the unit-holders to form an opinion. But they require consent of the unit-holders under Regulation 41 (1) to take further steps towards winding up of the scheme. The e-voting notice sent by Franklin, seeking simple majority of unit-holders for the winding up process, appears in line with these regulations.

But then several other ambiguities in the regulations and Franklin’s communiqué throws open unsettled questions.

One, where does Regulation 18(15)(c) come into the picture, which states that consent of unit-holders is required. What is that consent? In its e-voting communiqué, Franklin makes a statement: ‘Voting ‘No’ to the Authorization will not change the winding-up status of the Scheme’.

How should one read this statement against the consent mentioned under Regulation 18?

Two, Regulation 39(2)(a) states that a scheme may be wound up after repaying the amount due to the unit-holders. What is this ‘amount due’ and how can it be determined?

Three, and importantly, what happens if the winding up decision of the trustees does not pass muster with unit-holders? The regulations are silent on this and do not provide any solution.

Franklin, in its e-voting notice, had stated that if unit-holders (by simple majority) reject the winding up then the trustee will be required to propose other options to unit-holders, and again seek their authorisation by a voting exercise. What these other options could be, are unclear as of now.

Time to step up

With no clarification from SEBI on the matter yet, Franklin’s constant reminder to the investors that voting against the winding up action will only delay the process of monetisation of the assets and return of money, has put investors in a tight spot. With the recovery of entire money appearing a long drawn process even under the winding up of the schemes, investors may only be coerced into believing that the fund house’s decision to shutter the funds and wait for opportune time to liquidate the assets is the only feasible option. It is time that the regulator and courts step in to clarify these critical issues quickly before irreparable damage is done to the debt fund industry.

While Franklin has been ardently defending itself for investing in low-rated bonds, the higher credit risk strategy followed in seemingly lower risk ultra-short term and low duration bond funds cannot be dismissed by a caveat of ‘investors beware’ alone. After all SEBI’s categorisation norms in 2017 had sought to remove such ambiguity across funds within a category.

But by focussing only on duration and not credit risk in its norms across most debt funds, SEBI may have left some loose ends that now need to be tied. The manner in which funds calculate the maturity of a fund — where even a barbelled strategy of investing in very short and long bonds and put/call options in bonds can shorten the maturity technically — may also need a relook.

The Franklin episode that stands at crossroads now can have adverse implications on the industry unless the regulator and courts step up quickly to safeguard the interests of investors.

Published on June 16, 2020

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