Lessons From The Franklin Templeton Debacle

[By Neha Koppu]

The author is a student at the Symbiosis Law School, Hyderabad. 

The COVID-19 pandemic has cast a shadow upon the Indian economy.  The financial sector was in turmoil after the imposition of the first lockdown back in March 2020. The mutual fund industry was no exception to this crisis. There was a negative return on equity-oriented mutual funds of around 25% to the investors in March 2020. The outbreak of COVID-19 led to a decrease in the net asset value of several mutual fund schemes resulting in a decline in income levels of the investors.

One of the biggest AMCs, Franklin Templeton Mutual Fund (‘FTMF’) announced the winding up of six mutual funds due to the hit of the COVID-19 pandemic as the debt markets turned volatile and illiquid. This move surprised and disappointed the investors. The Indian mutual fund industry is now recovering from the horrors of the second wave of COVID-19. The present article aims to critically analyse the curious case of FTMF in light of the Supreme Court ruling and the corollary measures undertaken by the Securities Exchange Board of India (‘SEBI’).

BACKGROUND

In April 2020, the trustee of FTMF decided to wind up six of their debt schemes viz. (i) Franklin India Ultra Short Bond Fund; (ii) Franklin India Low Duration Fund; (iii) Franklin India Short Term Income Plan; (iv) Franklin India Income Opportunities Fund; (v) Franklin India Credit Risk Fund; and (vi) Franklin India Dynamic Accrual Fund.

The decision to wind up came due to the illiquid market because of the COVID-19 pandemic. Due to the reduced liquidity in the market, most of the investors were looking to redeem their mutual funds, thereby reducing the value of the funds. Moreover, all credit risk funds earn high interest as the borrowers also pay high-interest charges in order to compensate for their low credit rating, making these schemes riskier than other debt schemes. A forensic audit carried out by Choksi and Choksi revealed that around 2 billion dollars were withdrawn from the six debt schemes of FTMF just a few weeks before the winding-up announcement, terming these activities “unusual”.

Several petitions were filed in the High Courts of India by the aggrieved unitholders. The Supreme Court directed the Karnataka High Court to provide a decision in the instant case regarding the requirement of consent of the unitholders for closure of the mutual fund schemes.

After a careful analysis of the SEBI (Mutual Fund) Regulations, 1996 (‘Mutual Fund Regulations’) the Karnataka High Court,[i] held that the consent of the unitholders is required to be obtained before winding up the mutual fund schemes. At the outset, the Court adopted a purposive interpretation of all the regulations akin to the winding up of mutual funds and held that the consent of the unitholders is sine qua non to the winding-up procedure. Thus, the Court stayed the process of winding up until the vote of the unitholders is taken.

RULING OF THE SUPREME COURT

Franklin Templeton approached the Supreme Court of India[ii] against the judgment passed by the Karnataka High Court. One of the main issues dealt with by the Supreme Court was whether the consent of the unitholders is a prerequisite for winding up mutual funds.

The challenge before the Court was that the unitholders do not fall under the purview of Regulation 39(2) (a) and 39(2)(c) of the Mutual Fund Regulations, when SEBI and the trustees decide to shut a scheme. The trustee’s contention was as per Regulation 39(2(b), only when the unitholders want to wind up a scheme, a resolution of 75% majority is mandated.

While interpreting these Regulations, the Court adopted a harmonious interpretation. In most cases, the courts adopt a three-pronged approach while interpreting statutes, (i) the words are interpreted as per its grammatical meaning in the literal sense, (ii) the context of the words are understood as to whether it is logical and workable, or (iii) applying interpretative tools to understand the provision.

Firstly, the Court interpreted the term “consent” under Regulation 18(15)(c) to mean ‘consent of a majority of the unitholders.’ The term ‘consent’ as per the Black’s Law Dictionary means “a voluntary yielding to what another proposes or desires; agreement, approval, or permission regarding some act or purpose, esp. given voluntarily by a competent person; legally effective assent.”[iii] The Court observed that the underlying principle of Regulation 18(15)(c) was to provide the unitholders with information, cause and reason of winding up schemes by giving them an opportunity to accept/reject the proposal.

Secondly, the Court analysed Regulation 39 to 42 read with Regulation 18(15)(c) at length, in terms of the responsibility of trustees to seek the consent of the unitholders. In general, the term ‘shall’ must be understood as a command. The expression ‘when the majority of the trustees decide to wind up’ under Regulation 18(15)(c) explicitly refers to Regulation 39(2)(a) as it is the only Regulation, that vests the trustees with the right to close a scheme. Thus, the consent of the unitholders is required to be sought before the trustees decide for a scheme to be wound up as per the interpretation of Regulation 39(2) read with Regulation 18(15)(c) of the Mutual Fund Regulations. This consent shall be sought only after the publication of the notice which discloses the reasons for winding up of the schemes.

AFTERMATH

The Franklin Templeton Trustees Services Pvt. Ltd. & Anr. v. Amruta Garg & Ors. has set a precedent in the mutual fund industry by emphasising the importance of seeking consent from the unitholders before winding up the schemes for any reason whatsoever. The Supreme Court of India made it abundantly clear that a combined reading of the regulations under the Mutual Fund Regulations is needed which promulgates that the consent of the unitholders is, therefore, necessary before winding up of mutual fund schemes.

Pursuant to the FTMF debacle, to protect the interests of the unitholders of the mutual funds’ schemes, SEBI rolled out a circular which mandates all the Key Employees to invest a specific percentage of their salaries in their own schemes (popularly known as skin in the game). Now that the Key Employees have a stake in these mutual funds, they are able to demonstrate to their investors that they have confidence and trust in the schemes they manage. This eliminates the possibility of the Key Employees putting their interests over the interests of the unitholders.

On 28th December, 2021, SEBI has also proposed an amendment to the Mutual Fund Regulations wherein trustees decide to wind up mutual fund schemes. Such consent shall be sought by a vote of majority unitholders and the result shall be published within 45 days. The decision of the Supreme Court and the proposed amendment to the Mutual Fund Regulations settles the dust vis-à-vis winding-up procedure.

CONCLUSION

The winding-up six-debt schemes of the FTMF was a peculiar situation. The Order passed by the Supreme Court of India clarifies the much-needed position of the need to seek the consent of the unitholders before the trustees go for winding up of the mutual fund schemes. Winding up of these mutual funds was indeed in the best interests of the investors considering the position of the market, however, the due process of law must be abided by while doing so. The following lessons were learnt from the Franklin Templeton debacle:

Investors: The untimely winding up of several schemes of FTMF teaches the risk involved in the mutual fund industry. It is important for the investors to gather all information about a scheme and analyse the risk involved before investing, rather than blindly chase schemes with higher returns. Risk can be minimised but not completely eradicated.

Trustees: Trustees need to bear in mind the due process of law, the Supreme Court, in this case, settled that the trustees need to seek the consent of the investors before winding up mutual fund schemes. It is important to keep the best interests of the investors in mind before taking any decision.

AMC: AMCs need to lay out contingency plans for situations wherein the liquidity in the market might fall. AMCs could also make investments in only listed holdings, which have lesser risks associated in comparison to unlisted holdings.

SEBI: This crisis highlights the significant role played by SEBI and different SEBI regulations. It led to the introduction of skin in the game regulations of the portfolio managers, to protect the interests of the investors and also proposes an amendment to the Mutual Fund Regulations.

The onset of the COVID-19 pandemic shook the confidence of mutual fund investors in the schemes entrusted with the fund managers of AMCs due to the unpredictability in the market and economic disruptions. Several investors sought for the redemption of mutual fund schemes. However, SEBI has been taking various initiatives to protect the interests of investors and restore their confidence in the securities market. The Key Employees’ skin in the game, boosts accountability and transparency in the whole process of fund management, thereby regaining trust in the schemes invested by the unitholders.

[i] Securities Exchange Board of India v. Franklin Templeton Trustees Services Pvt. Ltd. & Ors., 2020 SCC OnLine Kar 1650 (India).

[ii] Franklin Templeton Trustees Services Pvt. Ltd. & Anr. v. Amruta Garg & Ors, 2021 SCC OnLine SC 88 (India).

[iii] Franklin Templeton Trustees Services Pvt. Ltd. & Anr. v. Amruta Garg & Ors, 2021 SCC OnLine SC 88 (India).

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