The essential issue raised recently was, if a mutual fund raises money under certain terms and then it changes them, what is the recourse available to the investor? What do the SEBI (Mutual Funds) Regulations, 1996 (‘the Regulations’) provide for this? When do such changes amount to change in ‘fundamental attributes’ which would require giving exit to the unit holder at the prevailing NAV? Can SEBI limit and define by a circular what are ‘fundamental attributes’? What are the implications of SEBI’s circular explaining what are ‘fundamental attributes’? If the mutual fund changes ‘fundamental attributes’ without following the prescribed procedure, what relief does the law provide to the investor? What if the mutual fund does not provide such relief? Is the only recourse available to investors to file a civil suit to obtain relief? These and other issues are dealt with in the recent decision of the Securities Appellate Tribunal (‘SAT’) in (Appeal No. 111 of 2010, decision dated 3rd May 2011, unreported but available on SEBI’s website).
The primary facts of this case as detailed by SAT are as follows. The appellants (husband and wife) had invested almost the whole of their life’s savings (about Rs.2.50 crores) in an open-ended Gilt scheme (called the ‘HSBC Gilt Fund’ or ‘the Scheme’) of the HSBC Mutual Fund (‘the Fund’). The appellants had chosen to invest in the Short- Term Plan which the offer document stated was suitable for investors seeking to obtain returns from a plan investing in gilts (including treasury bills) across the yield curve with the average maturity of the portfolio normally not exceeding seven years and modified duration of the portfolio normally not exceeding five years. The investment was made between October 2008 and November 2008.
In around February 2009, on receipt of the statement from the fund, they found that the Net Asset Value (NAV) had inexplicably and substantially depreciated by 10% and that too (as they later came to know) within a span of three days. On further inquiries, they came to know that the fund had wound up its ‘Long-Term Plan’ and modified the ‘Short-Term Plan’ by increasing the existing time frame of five to seven years to not exceeding 15 years. The benchmark index was also changed.
The appellants complained that these changes were changes in ‘fundamental attributes’ of the Scheme and were made without following the Regulations, which require informing the unit holders and, more importantly, giving them a chance to exit at the prevailing NAV before the proposed change. The relevant clause (5A) of Regulation 18 of the Regulations provides as follows:
“18. (15A) The trustees shall ensure that no change in the fundamental attributes of any scheme or the trust or fees and expenses payable or any other change which would modify the scheme and affects the interest of unitholders, shall be carried out unless, —
(i) a written communication about the proposed change is sent to each unit holder and an advertisement is given in one English daily newspaper having nationwide circulation as well as in a newspaper published in the language of region where the Head Office of the mutual fund is situated; and
(ii) the unit holders are given an option to exit at the prevailing NAV without any exit load.”
The unit holders were not informed through direct communication or through advertisement, nor were they given an option to exit at the prevailing NAV without any exit load.
The appellants, who feared further depreciation in the NAV, exited the Scheme and lodged complaints with the distributor, the fund, etc. and the Securities and Exchange Board of India (SEBI).
SEBI investigated the matter and passed an Order. Though the Order does refer to the complaints made by unit holders, the unit holders were not given an opportunity to be parties to the proceedings. Of course, the allegations made were violations of the Regulations and hence SEBI can proceed independently and directly against the person who allegedly violated them. However, this is emphasised, because when the appellants appealed against this Order of SEBI, the respondents — and even SEBI — claimed that the appellants did not have any locus standi to appeal!! Of course, SAT rejected this contention (as discussed later), but it is strange that even SEBI raised such a technical objection.
SEBI investigated the matter and heard the fund and its related parties. SEBI did find that there were substantial changes adversely affecting the unit holders. However, strangely, it took a stand that since it had issued a circular in 1998 explaining what fundamental attributes are and even gave a list of them, the fund is not guilty since the changes were not given in that list. This aspect is discussed in more detail later.
SEBI, however, did find the fund guilty on certain other charges and issued a warning to the fund, etc. to strictly comply with the law. This obviously left the appellants without any relief from their loss.
The appellants appealed against the Order of SEBI before the SAT. The fund — and even SEBI — as per the SAT Order, first raised a preliminary objection that the appellants had no locus standi to appeal. The SAT rejected these contentions firmly. I find it strange and even unjust that SEBI, after not having granting relief to the unitholders who suffered from the changes made to the Scheme, and after having passed such Order without directly hearing them, raises this technical objection that the appellants could not appeal against such Order! I wonder then who, if at all, would appeal against such Order?
Anyway, the more substantive issue was whether the changes made in the Scheme were changes to the ‘fundamental attributes’ of the Scheme. Also, even if they were, whether the changes can be limited only to those specified in a clarification by SEBI.
The term ‘fundamental attributes’ has not been defined in the Regulations. SEBI, however, had issued a circular dated 4th February 1998. In the circular, certain changes were specified as ‘fundamental attributes’, but apparently the changes made to the Scheme as per the facts in the present case were not specifically covered.
The SAT held that the changes made to the Scheme as discussed earlier were indeed changes to the fundamental attributes observing as follows:
“10. Having regard to the changes made in the scheme by which the duration of the investments therein was altered from five to seven years to a period not exceeding 15 years, we are of the considered opinion that this change is one which affects the fundamental attributes of the scheme and also modifies the same affecting the interest of the unit holders. The words ‘fundamental attributes’ have not been defined in the regulations and, therefore, they have to be understood according to their ordinary dictionary meaning. Fundamental is something which is basic or serves as a foundation or goes to the root of the matter. In the context of an investment scheme, one of the important factors that an investor looks at is the duration for which the investments are going to be made in that scheme. In this sense, the duration of the investment constitutes one of the fundamental attributes thereof. In the instant case when the scheme was launched it had two plans — short-term plan and long-term plan the duration of both was different and the investors took an informed decision in investing in one or the other plan . ….what respondents 2 to 5 did was…. they increased the duration of the short-term plan to a long-term without informing the investors. This was most unfair. Since the duration of the investments was substantially increased, we have no doubt in our mind that one of the fundamental attributes of the scheme was altered. Even the whole-time Member has recorded a finding in the impugned order that the change in the duration virtually modified the short-term plan into a long-term plan and this is what he has observed:
“The sudden change in investing substantial funds of the scheme in long-term gilt instruments from short-term instruments had in turn changed the average maturity and the modified duration of the scheme portfolio, drasti-cally varying them, so as to modify the scheme virtually into a Long-Term Plan.”
Interestingly, note also the following observations of the SAT with regard to the findings of SEBI itself in its Order:
“The whole-time Member himself has recorded a finding that the changes affect the interest of the unit holders of the scheme. It is pertinent to refer to this finding in his own words:
“The change in the duration of the scheme is a change which certainly affects the interest of the unit holders of the scheme. Any fund house making any changes so as to modify the scheme which affects the interests of the unit holders would be liable for the contravention of Regulation 18(15A) of the Mutual Funds Regulations, if they had effected such changes without complying with the procedure mentioned therein.”
Can SEBI limit the list of changes that amount to ‘fundamental attributes’ by means of a Circular? In any case, does the Circular limits the list? The SAT observed and held as follows:
“Having recorded the aforesaid findings, the whole-time Member holds that the aforesaid changes in the scheme did not alter its fundamental attributes merely because they did not fall within the clarifications issued by the Board as per its Circular of 4th February, 1998. We cannot agree with him. The Circular was issued giving clarifications in regard to some of the fundamental attributes of a scheme. What is elaborated therein is only illustrative and in the very nature of things it cannot be exhaustive. Apart from the attributes referred to in the Circular, there could be other fundamental attributes of a scheme like the duration of a scheme as in the present case. We agree with the learned senior counsel for the respondents that if the nature of the investments were to change, the fundamental attributes of a scheme would get altered. He was right in contending that if investments were to be made in equity or money market instruments instead of Government securities as originally stipulated, the fundamental attributes of a scheme would undergo a change. But those could not be the only fundamental attributes of a scheme. As already observed, there could be other attributes as well, depending upon the nature of the scheme.
11. We are really amazed that the whole-time Member after recording a finding that respondents 2 to 5 had changed the scheme which affected the interest of the unit holders without complying with Regulation 18(15A) of the Regulations failed to issue directions to these respondents for complying with the provision. The finding recorded in this regard has already been reproduced above and we agree with the whole-time Member that respondents 2 to 5 had brought about changes in the scheme which affected the interest of the unit holders. This being so they were obliged to comply with the provisions of Regulation 18(15A) which they have not and the grievance of the appellants is justified that the Board failed to issue appropriate directions in this regard.”
SEBI had also held that adverse directions against the fund could not be passed since, according to SEBI, no such allegation was made in the show-cause notice issued to the respondents. SAT, however, found otherwise and held as follows:
“The reason given by the whole-time Member for not issuing the necessary directions is that there was no such allegation in the show-cause notice dated 7th August, 2009 that was issued to the respondents. This reason, to say the least, is most untenable. The details of the changes made in the scheme have been elaborated in the show-cause notice and there is a clear allegation in para 16 thereof that the respondents had violated, among others, Regulation 18(15A) of the Regulations. It is this Regulation which required the respondents to give an exit route to all those who were the unit holders on the date of the change including the appellants. We are satisfied that the whole-time Member grossly erred in not issuing the appropriate directions in this regard.”
The final contention was that the disclosure was made in the offer document that the fund manager could make changes as market conditions warrant. The SAT held that such a disclosure does not permit making of fundamental attributes without following the prescribed procedure and giving the prescribed relief under the Regulations.
Accordingly, the SAT set aside the Order of SEBI and directed that, subject to due verification, etc. that the appellants be compensated for the loss suffered by them for the amount being the difference between the relevant NAV and the sale price of their units.
In my view, it is also sad though that no costs were given and the investors were merely restored to the NAV which they were otherwise entitled to. The investors had of course at stake a large loss of around Rs.25 lakh and could fight till SAT for relief. However, though their claims were clearly upheld, they had to bear the costs out of their pockets. The issue is: Is this fair?
