Compensation Regulation of Key Employees in Mutual Funds - Key Features & Impact Assessment

Overview:

The Securities and Exchange Board of India (“SEBI”) vide its circular dated April 28, 20211 (“Circular”)2 has introduced a regulatory framework for alignment of interest of the key employees (“Key Employees”) of asset management companies (“AMCs”) with that of the unitholders of the mutual fund scheme. While SEBI has taken steps to standardise the mutual fund scheme categories and characteristics of each category3, the management of risk return profile of the mutual fund schemes rests with the AMCs and the Key Employees. The Key Employees of an AMC hold the position of trust and responsibility and have access to all the price sensitive information. The code of conduct for fund managers and dealers introduced by SEBI4 prohibits the Key Employees from unfair use of such information and places a fiduciary duty upon the Key Employees to not engage in any unethical practices with respect to such information. However, basis various observations received from the market stakeholders and analysis of audit reports by SEBI, it was observed by that certain employees and trustees of the AMCs took undue advantage of the price sensitive information they had about the company which led to a conflict of interest between the Key Employees and the unitholders of the mutual fund schemes.5 This also led to abuse of individual position of trust and responsibility by the Key Employees and the trustees of the AMCs.

In the aforesaid background, SEBI, on the recommendations received from the SEBI Mutual Fund Advisory Committee, mandated the payment of compensation of the Key Employees of the AMCs in the form of units of mutual fund schemes in which they have a significant role as a good stewardship practice and to ensure an increased trust of investors in mutual funds. This article briefly with the framework prescribed under the Circular and its overall impact.

Salient Features:

The Circular prescribes the framework for compensation of the Key Employees of the AMCs in the form of units of the scheme(s). The salient features of the Circular are as under:

S.No. Reference Details
1. Applicability of the Circular
  • Key Employees of the AMC to include:
    • Chief Executive Officer, Chief Investment Officer, Chief Risk Officer, Chief Information Security Officer, Chief Operation Officer, Fund Manager(s), Compliance Officer, Sales Head, Investor Relation Officer(s), heads of other departments, Dealer(s) of the AMC;
    • Direct reportees to the CEO (excluding personal assistant/ secretary);
    • Fund management team and research team; and
    • Other employees as identified & included by AMCs and trustees.
  • Not applicable to Key Employees having role/ oversight only over exchange traded funds, index funds, overnight funds and existing close ended schemes.
2. Compensation of Key Employees
  • Compensation of the Key Employees of the AMCs to be paid in the form of units of the scheme(s).
  • Minimum of 20% of the salary/ perks/ bonus/ non-cash compensation net of income tax and any statutory contributions of the Key Employees of the AMCs to be paid in the form of units of mutual fund schemes in which they have a role/ oversight.
3. Proportion of compensation
  • Compensation paid in the form of units to be proportionate to the assets under management of the schemes in which the Key Employee has a role/oversight.
  • Exchange traded funds, index funds, overnight funds and existing close ended schemes excluded from the purview of this provision.
4. Period of compensation
  • Compensation paid in the form of units to be paid proportionately over 12 (twelve) months on the date of payment of salary/ perks/ bonus/ non-cash compensation.
  • If the compensation is paid in the form of employee stock options, the date of exercising such option shall be considered as the date of such payment.
5. Lock-in period Lock-in period of minimum 3 (three) years or the tenure of the scheme, whichever is less.
6. Option of diversifying the unit holdings In case of dedicated fund managers managing only a single scheme/ single category of schemes, 50% of compensation may be by way of units of the scheme managed by the fund manager and the remaining 50% may be by way of units of those schemes whose risk value as per the risk-o-meter is equivalent or higher than the scheme managed by the fund manager.
7. Redemption of the units
  • Restriction on the redemption of units of scheme(s) during the lock-in period.
  • Key Employees may borrow from AMC against such units in exigencies such as medical emergencies or on humanitarian grounds, as per the policy laid down by the AMC.
8. Redemption of units in case of resignation and superannuation
  • No redemption of units of scheme(s) to be allowed within the lock-in period in case of resignation or retirement of the Key Employee before attaining the age of superannuation.
  • In case of retirement on attaining the superannuation suchage, such units to be released from the lock-in.
  • Key Employee to be free to redeem the units, except for the units in close ended schemes where the units shall remain locked in till the tenure of the scheme is over.
9. Clawback
  • Units allotted to the Key Employees to be subject to clawback in the event of violation of code of conduct, fraud, gross negligence by the Key Employees.
  • Upon clawback, the units to be redeemed and amount to be credited to the scheme.
10. Oversight of compliance
  • AMC to ensure compliance with the provisions of the Circular, further monitored by the trustees.
  • Non-compliancesto be reported in the quarterly compliance test report and half yearly trustee report.
11. Disclosure of compensation Every scheme to disclose the compensation, in aggregate, paid in the form of units to the Key Employees on the website of the AMC.

W&B View
The implementation of the Circular shall surely introduce greater accountability in the scheme performance as the key employees shall share the investment risk at par with the unitholders of the scheme. This shall ensure a deeper commitment from Key Employees in their own schemes, thereby positioning mutual fund investing as a preferred and trusted route for investors. However, by introducing a wide definition for who would be classified as a “Key Employee” for the purposes of the Circular, SEBI has inadvertently put small fund houses who do not offer a hefty package to its key personnel in a tough spot, particularly in the current COVID struck times as such fund houses risk losing its key talent. In other fund houses also the junior talent that squarely falls within the definition shall be forced to lock twenty percent (20%) of their income for a period of three (3) years which shall create cash flow issue. Further, creates a window of regulatory arbitrage in favour of exchange traded funds, index funds, overnight funds that have been explicitly excluded from the purview of the Circular. The clawback of the units being triggered in the event of violation of code of conduct, fraud and gross negligence shall be beneficial from a market standpoint. Overall, the Circular is a double edged sword as it introduces greater accountability which is a positive for the market, and at the same time it throws up several implementation challenges and it shall be interesting to see how the market responds and adapts to the same.

  1. SEBI Circular No. SEBI/HO/IMD/IMD-I/DOF5/P/CIR/2021/553 dated April 28, 2021. Available at https://www.sebi.gov.in/legal/circulars/apr-2021/alignment-of-interest-of-key-employees-of-asset-management-companies-amcs-with-the-unitholders-of-the-mutual-fund-schemes_49979.html.
  2. The Circular shall be effective from July 1, 2021.
  3. SEBI Circular No. SEBI/HO/IMD/DF3/CIR/P/2017/114 dated October 6, 2017. Available at https://www.sebi.gov.in/legal/circulars/oct-2017/categorization-and-rationalization-of-mutual-fund-schemes_36199.html
  4. Available at https://www.sebi.gov.in/sebi_data/meetingfiles/oct-2020/1602839577069_1.pdf.
  5. See e.g., Some employees of Franklin Templeton Mutual Funds redeemed their investment in their own funds just prior to the announcement of closure of six debt schemes on account of investment gone bad. It led to violation of insider trading regulations.
Dated: May 3, 2021
Author: Prashaant Vikram Rajput - Partner and Head of Capital Markets; Arohi Londhe, Associate

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