New Regulatory Regime for Portfolio Managers
Indian securities market regulator, the Securities and Exchange Board of India (“SEBI”), on January 16, 2020, standardized its regulation for Portfolio Managers (“PM”). The publication of SEBI (Portfolio Managers) Regulations, 2020 (“PMS Regulations, 2020”) resulted in an overhaul of the 1993 Regulations governing Portfolio Management Services (“PMS”).
Portfolio Management Services (“PMS”)
PMS involves the management of a pool of shares and other investments owned by a particular person or organization. It is the art and science of making investment decisions, matching investments to objectives and allocating assets. PMS encompasses ascertaining strengths, vulnerabilities, prospects and risks in the selection of investments with the ultimate goal of maximizing the returns at the client’s risk appetite. According to JP Morgan, PM is a person or entity responsible for making investment decisions of the portfolio to meet it’s specific investment objective or goal. He/she plays a strategic role in catering to investors by aiding them to manage investments across a wide range of products according to their preferences. PMS Regulations, 2020 define PM as follows:
“a body corporate, which pursuant to a cot with a client, advises or directs or undertakes on behalf of the client (whether as a discretionary Portfolio Manager or otherwise), the management or administration of a portfolio of securities or goods or funds of the client, as the case may be”
Cause of Overhaul
The Indian Portfolio Management Industry (“PMI”) has mushroomed. At the end of April 2019, the combined Assets Under Management (“AUM”) of the PMI stood at INR 18,07,938 while the number of clients stood at 151618 clients. Simultaneously, the per capita disposable income has increased from INR 80,472 in March 2012 to INR 1,51,618 in April 2019, which indicates prospects of further mushrooming of the industry.
With the significant growth of this industry, challenges are also anticipated that not only touch the distribution side of the business but also affect the core portfolio selection and management decisions. In light of this, SEBI foresaw the need to overhaul the SEBI (Portfolio Managers) Regulations, 1993. A Working Group was set up by the regulator, which published its report in August 2019. SEBI, with a few modifications, gave its assent to most of the recommendations therein. As a result, the PMS Regulations, 2020 were published bringing in significant structural changes to the regulation of PMs.
Notable changes include the introduction of a defined role for Principal Officer (“PO”) and eligibility criteria for a PM’s employees; enhanced capital adequacy requirement for PM and increased ticket size for investments from clients, restrictions on permissible investible instruments and standardization of fees charged to clients.
1. Role of PO defined and eligibility criteria
The PMI has seen a growth of 18% Compound Annual Growth Rate (“CAGR”) in the past five years with a rise in AUM from INR 6.04 Lakh Crore to INR 13.70 Lakh Crore. Discretionary PMS has grown even higher at 41% CAGR in the same timeline. As a result, PMI has seen a 5.5 times growth with AUM of discretionary PMS raised from INR 18,166 Crore to INR 99,825 Crore. PMS Regulations, 2020 brought in the following sway of changes to business structure requirements.
1.1 Role of PO
The erstwhile PMS Regulations provided for a mere human resource prerequisite for registration of PM without drawing out the roles and responsibilities of such persons. It required mandatory employment of a qualified PO and a minimum of two qualified employees.
According to SEBI, a PO is a key person accountable for core functions and activities of Portfolio management. He may/ may not be titled as PM, but may be in the ranks of Chief Investment Officer/ Chief Executive Officer/ any other person in charge for key investment decisions in PM. The PMS Regulations 2020, brought clarity in this regard by defining PO as follows:
“Principal Officer” means an employee of the portfolio manager who has been designated as such by the portfolio manager and is responsible for:- (i) the decisions made by the portfolio manager for the management or administration of portfolio of securities or the funds of the client, as the case may be, and (ii) all other operations of the portfolio manager.”
1.2 Enhanced eligibility requirements
The Working group opined that the nature of fund management process calls for evaluating educational qualification at par with work experience. Accordingly, it recommended dual eligibility criteria with both aspects being covered. PMS Regulations, 2020 incorporated this recommendation and provided a thirty-six-month window for POs and PMs registered under the erstwhile regulations to make themselves compliant.
PMS Regulations, 2020 mandate a PO to have a professional qualification (in finance, law, accountancy or business management) from a university or an institution recognized by the Central Government or State Government or a foreign university or a CFA Charter from the CFA Institute.
Additionally, a PO must also have experience of at least five years in similar activities in the securities market (including as PM, Stock Broker, Investment Advisor, Research Analyst or Fund manager). Of this, at least two years of experience must be in PMS or Investment Advisory Services or areas related to Fund management.
Finally, the PO must procure the relevant NISM Certificate as specified by SEBI from time to time.
1.3 Mandatory employment of one person in addition to PO and Compliance Officer
The PMS Regulations 2020 introduced a binding obligation for PMs to employ minimum one person in addition to the PO and Compliance Officer in compliance with the following eligibility criteria:
Graduation from a university or an institution recognized by the Central Government or any State Government or a foreign university; and
Experience of at least two years in related activities in the securities market, including as portfolio manager, stockbroker, investment advisor or as a fund manager.
However, if such employee has decision-making authority related to fund management, the same minimum qualification and experience would be attracted to such employee as are prescribed for PO. A twelve-month window has been provided for PMs registered under erstwhile Regulations to become compliant with this requirement.
2. Enhanced Capital Adequacy Requirement
The PMS Regulations 2020 raise the minimum net worth requirement for PMs to INR 5 Crore from earlier INR 2 Crore and provide for a thirty-six-month window to comply for PMs registered under the erstwhile Regulations.
The Working Group thought such enhancement to be appropriate in light of various factors such as inflation, rising income levels, increasing compliance costs, increase in minimum number of employees etc. Additionally, it opined that this would serve as a deterrent to non-serious players during new applications and will put pressure on fringe players coexisting with serious PMs.
In its Meeting, SEBI discussed the discontent against such a move amongst stakeholders who suggested that this enhancement could be detrimental to PMs who have registered in the last one year or so with the INR 2 Crore net worth requirement. SEBI noted comments to the tune that Portfolio Management is a service industry, not being capital intensive and thus there should not be financial detriments to young entrepreneurs and analysts with rich knowledge and work experience to launch startups offering personalized services in portfolio management.
SEBI, however, set aside the criticism by asserting it's finding it essential to retain this proposal because the high net worth criteria would ensure that only well-equipped investors would enter the PMI, particularly as portfolio management has “no skin in the game”. This is a contentious and needless entry barrier as it sifts out candidates for the wrong reasons.
3. Increased Ticket Size
The erstwhile PMS Regulations required the PM to accept a minimum of INR 25 Lakh worth fund of securities from their client. This minimum threshold was increased in February 2012 from the earlier INR 5 Lakh. The Working Group observed that on February 10, 2012, NIFTY was at 5,381.60 and NIFTY as on June 30, 2019, had more than doubled and is at 11,788.85. Similarly, the Consumer Price Index for the same period had increased from 86.81 to 142.00. Thus, the Working Group has perceived this enhancement of ticket size primarily, as long due catchup.
Besides this, the rationale that PMS are complicated and riskier and are meant for investors with higher risk appetite. Thus, the Working Group thought to increase the limit would be prudent so as to avert retail investors with limited understanding of volatility and risk from entering this product.
SEBI noted the stakeholders’ concerns to the tune that such a massive increase in ticket size would discourage industry participants as INR 50 Lakh is too big an amount to park in a single investment. Despite this, SEBI approved the Working Group recommendations by citing that the lack of prudential norms for investments in PMS make it complex and risky and therefore largely suitable for persons with high-risk taking capacity.
4. Permissible investments
PMS investments under the erstwhile regime were observed in listed, unlisted, equity and debt structured instruments. This was so because the 1993 Regulations did not bar PMs from investing in any specific sort of investments on behalf of the clients.
The Working Group had suggested that PM investments be limited only to listed securities on behalf for the clients, with specific condition for mutual fund investments. However, SEBI after due consideration chose to relax this stipulation in case of non-discretionary/ advisory PMS. The 2020 Regulations thus allow discretionary PMs to invest client funds in the securities listed or traded on the stock exchange, money market instruments, units of mutual funds and other securities as would be specified by SEBI from time to time.
However, the relaxation for non-discretionary/ advisory PMs from limiting investment to listed securities is not unconditional. Such PMs may invest or provide advice for up to 25% of the Client’s AUM in unlisted securities, in addition to the securities permitted for discretionary PM.
Specific restrictions are drawn out for investment in mutual funds, such as, that investment in units must only be through a direct plan and that PM cannot charge any sort of distribution or referral fees in this regard to the client.
Finally, PMS Regulations, 2020 bar PMs from investing the client’s funds in portfolio managed or administered by another PM.
5. Restriction on off-market transfers
Taking learning from the recent Karvy debacle, the PMS Regulations 2020 move onwards in a precautionary manner by curbing off-market transfers from/to client account with explicit exceptions to enable operational convenience. These exemptions are as follows:
for settlement of the client’s own trades’
for providing margin/ collateral for client’s own position
for dealing in unlisted securities in accordance with the regulations
with the specific consent of the client for each transaction;
for any other reason specified by the Board from time to time.
6. Standardization of payment of commission
A Circular is expected to be issued soon by SEBI for effecting the following changes.
6.1 Fee Structure
The Minimum standards for PMs to charge fees were laid down by virtue of SEBI Circular, Cir/IMD/DF/13/2010 dated October 05, 2010. This mechanism uses the High Watermark Principle, without mention of Catchup. The Working Group noted that the different variations of catchup clauses in practice, lead to lack of understanding and transparency in terms of fee range, distributor commission, exit loads and operational costs. Thus, standardization and rationalization of fee structure and mechanism were recommended.
It was observed that 100% upfront fees were being charged to Client were thereafter paid as commission to the distributor which made the distributor push for upfronted products. The Working Group recommended in order to curtail this misdoing, Distributor Commission must be charged only on trail basis. Trail-based income would not strain business calls, per the Working Group.
In light of varying versions of catchups for Performance Fee, SEBI avowed that Performance Fee shall be charged only on the amount over and above the hurdle rate, by following “high watermark principle” and that it shall issue a Circular detailing finite set of models of calculating the same.
Another recommendation was of disclosure of range of fees charged under various heads to prospective clients in the Client Agreements to enhance transparency. The Working Group also recommended that operation expenses (excluding brokerage) which are over and above the annual management fees be capped at 0.05% p.a.and be subject to limits:
6.2 Exit Load Structure
Under erstwhile Regulations, the practice was such that exit loads varied from PM to PM from 1% to 8% and for up to 5 years. The Working Group felt the need to do away with this variance and standardize exit load structure, as exorbitant exit loads are against investor interest.
Further, for the cap based exit loads, period of computation of charging exit fees shall be from the date of each inflow/ top-ups. Working group recommended max 3%, 2%, 1% exit fees must be charged to the clients if he/she redeems his/her portfolio (in part or full) in the first, second or third year of his investment with PM respectively. No exit fees can be charged to clients after period of three years from date of investment.
6.3 Cap on services availed to Group Companies
Introduction of capping on services availed to Group companies is also a notable feature. The Working Group had recommended that in order to ensure arm’s length relationship between PM and his associates, a limit of 20% by value per associate (or such percentage as prescribed by Regulations) per calendar quarter may be imposed. The said requirement shall also apply in case where PM is also registered as Stock Broker, Depository Participant, Custodian etc and execute transactions through these registrations. Additionally any charges/ fees paid to associate shall not be more than those paid to non-associate intermediaries providing similar services.
PMS Regulations 2020 see the deletion of “change in its managing director or whole-time director” from the definition of “change of status or constitution” of PM. It also made the appointment of custodian mandatory for all PMs. Disclosure and Reporting requirement have been streamlined.
 Report of the Working Group on SEBI (Portfolio Managers) Regulations, 1993.
 Distribution to the PM from the returns until a certain agreed percentage is reached.