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This post is authored by Pranay Bhattacharya, a fourth-year student of B.A. LL.B. at the Maharashtra National Law University, Aurangabad.
Introduction: What is Franklin Templeton Fiasco?
The sustained fall in liquidity and the net value of assets (NAV) in the securities market due to Covid-19 crisis has hit the mutual funds (MFs) market badly. Amidst this fall, global investment giant Franklin Templeton Mutual Fund (Franklin Templeton), one of India’s largest Asset Management Company (AMC or Company) announced voluntary winding-up (on April 23rd) of 6 debt funds schemes with an erosion of approx. Rs 25,856/- crore, as a last resort to preserve the value of unitholders and enable equitable exit for all investors.
The Franklin Templeton trustees have decided that no business activity shall be allowed to “create/ cancel/ issue or redeem” of any unit within the scheme. In this view, the article will focus on Franklin Templeton crisis and fall in liquidity faced by AMCs in the MFs market due to the economic slowdown.
Winding-up Mutual Funds Scheme under SEBI Regulations
For a successful winding-up scheme, an AMC is required to get 3 levels of approval under SEBI (Mutual Funds) Regulations, 1996,[i] i.e. 1) Trustees, 2) consent of 75% unitholders of the mutual fund scheme, and 3) finally SEBI (to exit the market).
In view of the above procedures, Section 39(2)(a) of Mutual Funds Regulation allows the trustees “on the happening of any event which, in the opinion of the trustees, requires the scheme to be wound up” to preserve unitholders value and equitable exit mechanism for all investors.
Hence, the trustees are required to give a notice disclosing the circumstances leading to the winding up, and shall ask the AMC to cease to carry on all business activities of such schemes as underlined in Regulation 40 of Mutual Funds Regulation.
Potential Reasons for failed Mutual Funds Schemes
The conscious strategy of investment in high-risk schemes and low-credit rating funds worked over the years for Franklin Templeton. However, the liquidity crunch due to economic slowdown and Covid-19 effect made things out of control for the company.
Franklin Templeton citing Covid-19 impact coupled with rising redemption requests from investors, the spike in yields (higher yield indicates higher risk) and lower trading volumes of its securities reduced the company’s liquidity to a bare minimum.[ii]
However, it is to be noted that market slowdown may not be the sole criteria for Franklin’s rising illiquidity. Other possible reason for such failure can be analysed below:
Wrong Investment choices by Franklin Templeton: High Risk means High Returns?
“Despite the regulations being clear, some mutual fund schemes seem to have chosen to have high concentrations of high risk, unlisted, opaque, bespoke, structured debt securities with low credit ratings and seem to have chosen not to rebalance their portfolios even during the almost 12 months available to them so far.”
– SEBI’s statement on Franklin Templeton dated May 7, 2020
The main reason for fallout of illiquidity can be analysed from the wrong investment choices made by Franklin in highly volatile and low-rated bonds, i.e., below the AAA category (considered as non-investment grade) having exposure category of high risk to moderately high risk against returns (Refer Image).[iii]
Since low-grade rated bond offers less security and more profit potential, Franklin continued to invest in such bonds even after SEBI 2019 framework,[iv] which warned AMCs not to invest in such schemes due to the risks involved. Further, most of Franklin’s investments were concentrated with risky schemes such as Yes Bank, Piramal-Shriram, Vodafone Idea debt, etc., which made it prone to market volatility.
The image represents the risk factor for unit holders on investment schemes decided by an AMC. [v]
Exiting the market due to stricter SEBI Norms
The second possible reason for such exit can be due to stricter SEBI disclosure norms[vi] for AMCs to compulsorily disclose schemes, investments, and profits in unlisted bonds. Additionally, SEBI has also directed such companies to lower the investment in unlisted non-convertible debentures (NCDs) to not more than 10%[vii] by June 30, 2020 (now extended to 31 December in view of Covid-19),[viii] which ultimately reduces the liquidity in unlisted bonds. Therefore, the stricter disclosure and capping investments in unlisted NCDs could be another possible reason for Franklin Templeton’s scheme closures.[ix]
What Winding-up means for Investors?
Firstly, all the 6 schemes will be restricted in terms of subscription/ redemption or trading until the winding up takes place, which will ultimately stop the investors to purchase/ sell/ dispose off their shares/debentures where the company has invested. This means that inventors shall face the burden and continue remain invested in such schemes without any exit opportunity.
Secondly, the schemes would be in a lock-in period until the date of maturity and the amount to existing investors will be paid in a staggered manner as per the maturity dates of the schemes, coupon, and pre-payments. As per Regulation 41(2), the following order will be followed for liquidation proceeds:
Outstanding dues > Investors with shorter maturity period > Existing investors
It means that investors will have to wait until their portfolio maturity period to receive their dues out of the investments made by the company.
Thirdly, in case of any gains or profits on redemption of debentures, such amount shall be taxed as capital gain from the investors. Therefore, even if the investors gain from the winding up scheme, whatever meager amount of profit or gain, shall be taxed at the time of redemption or closing of the schemes.
Measures taken by the Company
The AMC as a measure to mitigate the risks associated with the schemes and in order to preserve the investor’s asset value, has taken the following steps:
1. In rare cases, SEBI allows AMCs to borrow up-to 20% of their assets to meet liquidity needs for making the payments of investors on redemption requests. Franklin has already availed 30% for some schemes and 40% for another.[x] However, the same is not enough due to continued and large amounts involved on redemption requests.
2. Secondly, the company as a measure to generate funds and pay-off the redemption requests from investors to further raise the liquidity has taken certain measures such as the sale of assets, pre-payments, facilitated payout to investors before scheduled maturity, etc. However, it could not generate enough funds as the number of redemption requests outnumbered the liquidity measures taken by Franklin.
Finding a fine balance: Solution and Analysis
Given the present market situation of illiquidity, the following steps should be helpful to restore investors’ confidence:
1. Availing Special Liquidity Facility by RBI: Companies facing liquidity strains can avail Special Liquidity Facility-Mutual Funds (SLF-MF) introduced recently by RBI in light of the present Covid-19 crisis. This includes a relief support package of Rs 50,000 crore.[xi] Under the SLF-MF scheme, the AMC can enter into collateral short term borrowings to meet redemptions sought by the investors, having their investment in corporate bonds, commercial papers, debentures and certificates of Deposit.
2. Creation of a segregated portfolio as a credit enhancement mechanism: The AMCs can make a side pocket (formally called creation of a segregated portfolio) of the distressed, illiquid asset that can be used for credit requirements. A side pocket is nothing but is a fixed maturity plan with no entry or exit date till the scheme matures.
As a measure of precaution, Franklin Templeton has already created side pockets of some schemes in January 2019. However, the AMC is facing redemption pressure from other large schemes, making it difficult for the company to arrange monies. Therefore, the hard-hit liquidity crunch is a lesson for companies to think upon their contingency plans and create a segregated portfolio as a precautionary measure to meet credit requirements.
3. Lowering the exposures: Further, it is pertinent that deposit-taking institutions should focus on investments with demonstrated high-quality bonds having low to moderately-low-risk on investments. Short liquid investment funds are more volatile in nature as funds keep coming and going out. Therefore, sustained redemptions can pressurize a company to balance liquidity its needs.
4. Making use of put option schemes: A put option scheme allows an AMC to make early repayment demands from the schemes in which a company has invested. Schemes under put option do not indicate the maturity timeline and AMCs have the right to seek repayments out of the schemes anytime, for advanced payments to investors. Therefore, this can be considered as the safest form of agreement between the investment schemes and AMCs.
5. Investor should not make the single credit strategy their core portfolio but rather allocate small proportions: In mutual funds scheme, the liquidity depends upon the proportion of sovereign bonds, high or low rated bonds, and cash surplus. In Franklin’s case, most of the core investments were in papers low rated bonds besides a large proportion of investments to certain business groups, which should be avoided in all cases.
6. Accessing secondary market (stock exchange) for early exit: In the best interest of the investors, it is most suitable that Franklin explore opportunities to monetize assets through stock exchange market transactions where securities can be directly traded. This will help the locked-in investors to monetize their schemes out of the maturity period by an early exit. However, the underlying bond quality may have a direct impact in exchange of depressed prices.
7. Invest only in listed holdings: To create more transparency, it is advised that the AMCs invest only in listed securities and re-calibrate their portfolios from unlisted holdings. In October, 2019, SEBI ruled along similar lines to reduce shareholding to 10% by June, 2020 to ensure maximum investments are directed towards listed securities.
Conclusion
The quagmire of failed liquidity has already engulfed unresolved cash stranded mutual fund giants like IL&FS, DHFL, Yes Bank et al., with Franklin Templeton as an addition to the list, which has jolted the mutual fund industry. The wrong investment choices by companies are no less to blame to maintain their liquidity crisis apart from the bouts of economic impact faced due to Covid-19. The Franklin fiasco is the classic one-off case that sets an example for investors about their choices in less liquid, riskier, and unlisted securities, which are prone to risks due to debt aversions in the market. It sets a precedent in wake of the present economic slowdown for other AMCs to think upon and amend their portfolios to de-risk their schemes soon before the “debt market” becomes the “dead market”!!
Endnotes
[i] Regulation, SEBI (Mutual Funds) (Amendment) Regulations, Gazette of India, pt. II sec. 3(ii), https://www.sebi.gov.in/sebi_data/commondocs/mutualfundupdated06may2014.pdf. [ii] Winding up of 6 Yield-Oriented Fixed Income Schemes- FAQs, Franklin Templeton (Apr. 23, 2020), https://www.franklintempletonindia.com/downloadsServlet/pdf/faqs-on-winding-up-of-6-yield-oriented-fixed-income-schemes-k9fminww. [iii] Franklin Templeton schemes, Groww, https://groww.in/mutual-funds?q=Franklin%20Templeton%20Mutual%20Fund. [iv] SEBI, Review of Risk Management Framework of Liquid Funds, Investment Norms and Valuation of Money Market and Debt Securities by Mutual Funds, Securities and Exchange Board of India, https://www.sebi.gov.in/sebi_data/meetingfiles/sep-2019/1568030594032_1.pdf. [v] Product Labeling For Schemes Of Franklin Templeton Mutual Fund, Franklin Templeton (April, 2016), https://www.franklintempletonindia.com/downloadsServlet/pdf/product-labelling-for-funds-riskometer-april-2016-ipqsvj19. [vi] SEBI Circular, Norms for investment and disclosure by mutual funds in derivatives, SEBI/HO/IMD/DF2/CIR/P/2019/17 (January 16, 2019), Securities and Exchange Board of India, https://www.sebi.gov.in/legal/circulars/jan-2019/norms-for-investment-and-disclosure-by-mutual-funds-in-derivatives_41670.html. [vii] Securities and Exchange Board of India (Mutual Funds) (Second Amendment) Regulations, 2019, (September 23, 2019), Gazette of India, pt. III sec. 4, 2019, http://egazette.nic.in/WriteReadData/2019/212752.pdf. [viii] Jayshree P. Upadhyay & Neil Borate, Sebi gives 3 months to unlisted bond issuers in debt funds to list, Live Mint (July 10, 20200, 5:47 PM IST), https://www.livemint.com/news/india/sebi-gives-3-months-to-unlisted-bond-issuers-in-debt-funds-to-list-11591790405023.html. [ix] SEBI Circular, Review of investment norms for mutual funds for investment in Debt and Money Market Instruments, SEBI/HO/IMD/DF2/CIR/P/2019/104 (October 01, 2019), Securities and Exchange Board of India, https://www.sebi.gov.in/legal/circulars/oct-2019/review-of-investment-norms-for-mutual-funds-for-investment-in-debt-and-money-market-instruments_44556.html. [x] Winding Up Of 6 Yield-Oriented Fixed-Income Schemes: Myths Debunked And Frequently Asked Questions Answered, Franklin Templeton, https://www.franklintempletonindia.com/investor/market-insights/winding-up-of-6-yield-oriented-fixed-income-schemes-myths-debunked-and-faq. [xi] Press Releases, RBI Announces ₹ 50,000 crore Special Liquidity Facility for Mutual Funds (SLF-MF), Reserve Bank of India, https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49728.