Fenil's Library

Tensing Rodrigues

Sebi’s circular SEBI/IMD/CIR No 4/ 168230/09 issued on June 30, 2009, mandates two distinct changes in the selling of MF schemes:

1) There shall be no entry load for all mutual fund schemes (Clause 4.a)
2) Distributors should disclose all the commissions (in the form of trail commission or any other mode) payable to them for the different competing schemes of various mutual funds from amongst which the scheme is being recommended to the investor. (Clause 4.d)

Let us first look at ‘entry load’. The Securities & Exchange Board of India (Mutual Funds) Regulations, 1996, amended as of date, do not define entry load, but the term is explicitly used in regulation 49 in a context which defines its meaning.

Regulation 49 sets limits on pricing of units, thus effectively regulating entry loads. It requires that “the sale price is not higher than 107% of the net asset value”, and further that “the difference between the repurchase price and the sale price of the unit shall not exceed 7% calculated on the sale price”.

The regulations do not specify for what this difference between sale price and NAV (that is the entry load) may be used. But it looks obvious that the logic of charging entry load is to not burden existing unitholders with the cost of selling new units/ selling to new unitholders/ creating new accounts.

It is fair that these transaction costs should not be transferred to the existing unitholders. Obviously, the commission paid to the MF agent by the AMC for selling fresh units/ acquiring new unitholders is to be paid from this load.

However, the regulations are more explicit on the use of the ongoing fees to be charged by the AMC.

Regulation 52 (4) lays down: “In addition to the fees mentioned in sub-regulation (2), the asset management company may charge the mutual fund with the following expenses:
…
(b) Recurring expenses including:

(i) Marketing and selling expenses including agents’ commission, if any;
(ii) Brokerage and transaction cost;
(iii) Registrar services for transfer of units sold or redeemed;
(iv) Fees and expenses of trustees;
(v) Audit fees;
(vi) Custodian fees;
(vii) Costs related to investor communication;
(viii) Costs of fund transfer from location to location;
(ix) Costs of providing account statements and dividend/ redemption cheques and warrants;
(x) Insurance premium paid by the fund;
(xi) Winding up costs for terminating a fund or a scheme;
(xii) Costs of statutory advertisements;
…
It is obvious that the same would apply to the entry load. This makes it amply clear that entry load is to meet the expenses of the AMC towards selling new units, selling to new unitholders and creating new accounts; agent commissions are only one of those expenses. The current circular reinforces the above interpretation of the purpose of entry load: “Mutual fund schemes were allowed to recover expenses connected with sales and distribution through entry load” (Clause 1).

Sebi is perfectly within its powers to legislate on the entry load by amending regulation 49, which it seems to be intending to do now. But where Sebi clearly oversteps its jurisdiction is in assuming a quid pro quo relationship between entry load and agent’s commission. The AMC is free to pay any commission to the agent for marketing its products. This is purely its business decision and outside Sebi’s jurisdiction, as long as the cost is not charged to the fund beyond permissible levels.

This is made amply clear by regulation 52(5): “Any expense other than those specified in sub-regulations (2) and (4) shall be borne by the asset management company or trustee or sponsors.”

The fundamental question we need to debate is: Why is a MF agent paid commission? There are two possible answers to this question — therefore two interpretations to a MF agent’s commission.

According to one interpretation, the commission is the agent’s fee for the advice he tenders to the investor. Here, the AMC collects it on the behalf of the agent and passes it on to him.

The Sebi circular seems to have assumed this interpretation when it says, “though the investor pays for the services rendered by the mutual fund distributors, distributors are remunerated by AMCs from loads deducted from the invested amounts.” (Clause 2).
The other interpretation of commission is as a fee the AMC pays to the agent for selling its products. Which of these is the right interpretation?

The interpretation that is implicit in Securities & Exchange Board of India (Mutual Funds) Regulations, 1996 is the latter.

Regulation 52(4)(b)(i), mentioned earlier, explicitly lists “Marketing and selling expenses including agents’ commission” as an expense the AMC can charge to the fund. The current circular reiterates this interpretation when it says: “Sebi (Mutual Funds) Regulations, 1996 also permit AMCs to charge the scheme for marketing and selling expenses including distributor’s commission.”

It is obvious from this that Sebi itself considers agent’s commission as marketing and selling expense. Therefore, by no stretch of imagination, can it be fee for advising the customer.

Therefore, the statement “though the investor pays for the services rendered by the mutual fund distributors, distributors are remunerated by AMCs from loads deducted from the invested amounts” in the circular, is inconsistent with the rest of the circular and contradicts the Mutual Fund Regulations, 1996.

Therefore, Sebi’s claim that the circular is issued under regulation 77 “to remove any difficulties in the application or interpretation” of the regulations is untenable; regulation 77 does not give Sebi power to repeal or amend any part of the regulations through circulars.

Let us now turn to the second part of Sebi’s circular: “The distributors should disclose all the commissions”.

Sebi seems to continue its confusion over the interpretation of commission by clubbing together “distribution” and “advising”.

When you go to buy a toilet soap or a cellphone, the dealer does not disclose to you the commission that the manufacturer or the distributor pays him. And there is no reason why he should.

The customer has to evaluate and compare the value of the product in terms of service that it can render to him, with the price quoted by the dealer; and if the value-price equation seems favourable, buy the product. If he wishes, he can bargain to improve the equation. But he has no business to seek information on the commission the manufacturer or distributor pays to the dealer.

It is often argued that this model is not appropriate to the MF agent-investor relationship; a better model would be that of doctor-patient relationship. The reason being that a financial product is complex and beyond the understanding of a common investor, just like a sickness and the therapy for it.

The argument does not hold good. In case of a doctor, a clear distinction is made between “distribution” and “advising”. A doctor does only advising, or at least is bound by law to do only that; he does not do distribution. The distribution is done by a chemist.

Imagine a situation where an investor goes to a MF agent. The agent recommends funds A, B and C and he discloses that he earns 3.25%, 2.75% and 2.25% commission respectively, on the funds.

How is the investor to judge whether the recommendations are motivated by the suitability of funds or by the commission for the agent?

One way would be to ask the agent to disclose his commission on all the funds he sells. The customer may then find that there are funds which pay the agent only 0.25% or 0.50%. Should the customer buy these funds from the agent rather than the ones recommended by him? The assumption of investor ignorance leads to a contradiction.
The only way out of this situation is to assume that the investor is at least somewhat knowledgeable, can understand the financial products at least to some extent, and can know what is and what is not in his interest.

If that is the case, why does he need to know the agent’s commission to take his investment decision?

The point is, an agent’s commission is redundant information in investment decision making process. Even worse, given insufficient knowledge on the part of the investor, it is positively detrimental to decision making.