[By Deepanshu Agarwal]
The author is a student at the University of Petroleum & Energy Studies (UPES), Dehradun
In July 2020, the Securities & Exchange Board of India (SEBI) notified the Investment Advisers (Amendment) Regulations to bring some regulatory changes to the Investment Advisers Regulations, 2013 (the Regulations). SEBI received a plethora of complaints from the investors regarding the malpractices done by the investment advisors (like charging excess fees, making fake promises for higher returns, non-disclosure of the complete service fee, extracting money in the name of various charges) due to which it became necessary to bring these changes. Thus, the main objective behind this new regulatory amendment is to give primary importance to the interest of investors over the interest of the investment advisors (IAs).
As per regulation 2(m) of the Regulations, ‘investment adviser’ means any person, who for consideration, is engaged in the business of providing investment advice to clients or other persons and includes any person who holds out himself as an investment adviser, by whatever name called. Investment advice in this regard means advice relating to investing in, purchasing, selling, or otherwise dealing in securities or investment products, and advice on investment portfolio containing securities or investment products for the benefit of the client (regulation 2(l)). Putting it in simpler terms, investment advice means advising the client regarding the best suitable investment options he can avail, by looking at his risk appetite and long term goals.
With this backdrop, this post analyses the key highlights of the new amendment brought by SEBI and the way it affects the advisory market in India.
Segregation of Advisory and Distribution Services
Advisory service refers to the investment advice given by the IAs to the clients, whereas distribution service refers to making a product (or a scheme) available to the clients. Prior to the amendment, individual and partnership firms were not allowed to provide distribution service along with the advisory service. Only banks, NBFCs, and corporate entities (Non-individual entities) were authorized to do so subject to the condition that the IA shall maintain an arms-length relationship between its activities as an investment adviser and distribution services. This had to be achieved by ensuring that in such cases, the investment advice is given through the Separate Identifiable Division or Department (SIDD).
According to the new amendment in Regulation 22 of the Regulations, non-individual entities are now required to segregate the advisory and distribution services at the client level itself. This means that even though such entities have different departments for both the advisory and distribution services, they cannot provide both of these services to a single client. An Individual adviser, on the other hand, shall have the option to register as an IA or provide distribution service as a distributor.
This change brought by SEBI is a positive step towards ensuring the protection of investors. An investment adviser should act in the best interests of his/her/their clients when providing advisory services and should disclose to the client any actual or potential conflicts of interest. Due to the multiple roles played by the entities, it was necessary to segregate both the activities so as to minimize any such conflicts. This segregation will ensure the availability of complete information with the clients and the same may result in informed investment decisions by them. Moreover, there may be cases where the IAs distribute products on which they could earn higher commissions, thus leading to a serious conflict of interest with the client’s goals. In such cases, the advice given by the IAs may not be in the best interest of its client. Therefore, in order to tackle this issue arising out of the dual roles played by the IAs (both as adviser and distributor), it was imperative to segregate both the activities.
No Consideration for Implementation Services
Prior to the amendment, it was observed by SEBI that the IAs were charging extra consideration from the clients in the name of implementation (execution) fees. This practice followed by the IAs has been banned by SEBI. Now, the IAs are allowed to provide the implementation services only through direct schemes/products, without charging any consideration for the same.
Agreement Between Investment Adviser and Client
Unlike the erstwhile regulations, the requirement of an advisory agreement between the client and the adviser has been made mandatory by the new amendment. This will make the clients aware of the terms and conditions, provide transparency in the process, and would also ensure that the clients are able to prove their claim and exercise their rights with much ease.
As per the code of conduct specified under the Regulations, the IAs were required to charge a fair and reasonable fee for the advisory services given to its clients. There was no cap upon the fees to be charged and thus the amount of ‘reasonable fee’ was kept subjective. Thereafter, SEBI received more complaints from the investors regarding exorbitant fees charged by the IAs.
In order to solve this issue, SEBI has prescribed two ways to calculate the amount of fees. IAs can charge either 2.5% of ‘Asset under Advice’ (AUA) or a fixed fee of INR 75,000 per annum. As per the regulation 2(aa) inserted by the new amendment, AUA means the aggregate net asset value of securities and investment products for which the investment adviser has rendered investment advice irrespective of whether the implementation services are provided by an investment adviser or concluded by the client directly or through other service providers.
Practically, this model is very difficult to follow. There are certain portfolios that contain high-risk products that require more skills and essential time to provide any investment advice. These cases are to be treated differently, and therefore, fixing a maximum ceiling to be followed in every case may not be a good option.
Before the amendment, the IAs which are body corporate were required to have a net worth of not less than twenty-five lakh rupees and IAs who are individuals were required to have a net worth of not less than rupees one lakh. This limit has been increased through amendment in regulation 8, to rupees fifty lakh for body corporate and rupees ten lakh for individuals IAs. Additionally, the existing IAs are given a period of 3 years to comply with the net worth criteria.
However, the enhancement of the net worth limit can be too onerous upon small scale IAs and the newcomers into the industry. They would be overthrown if they could not satisfy the new criteria within the span of 3 years which is indeed a short period of time keeping the economic slowdown due to COVID-19 pandemic, in view. Moreover, the assumption here that financial capability is an important factor in determining the skills or the capabilities of a person is totally flawed. It is erroneous to judge someone’s advisory skills on the basis of his net worth.
Another change brought through the amendment is that the individuals registered as IAs whose number of clients exceeds 150 in total, shall compulsorily apply to SEBI for registering as non-individual IAs (inserted through regulation 13(e)). However, the purpose of SEBI to encourage individuals to work as corporate bodies is still unexplained here. If an individual adviser is doing well and maintaining a great portfolio, it is redundant to force him to comply with the provisions of corporate laws.
It was found that the persons dealing in the distribution of securities used to refer themselves as “Independent Financial Adviser” or “Wealth Adviser” or by any other similar name. This created confusion in the mind of investors as to the exact nature of activities performed by such persons. To tackle this situation, SEBI has inserted Regulation 3(3) in the Regulations which debars any person dealing in the distribution of securities to use the nomenclature “Independent Financial Adviser or IFA or Wealth Adviser or any other similar name” unless registered with the SEBI as an Investment Adviser.
In the present scenario, a healthy regulatory framework administering the advisory industry is the key to ensure the honesty of the advice given by the IA’s. The sturdy changes made by SEBI will definitely inject more transparency in the advisory process than before, thereby ensuring the investor’s protection in a better way. However, there are a few lacunas that could only work as a dissuading factor for the IA’s and therefore, need to be reanalyzed.