Home >Opinion >The daunting task of taming compliance risk

When I look back at 2014 for financial intermediaries in India, it sends the same kind of chill down my spine as would the weather in any cold December.

In traditional behavioural finance, we often note that when the markets are euphoric, you are at the point of maximum financial risk. This gets amply demonstrated when you start receiving a lot of “tips" on buying stocks via WhatsApp, SMS and, of course, cold calls. It also is a point where retail investors flock for penny stocks in the hope of making a quick buck and typical operators in the market start an initial public offering frenzy, making stocks hitherto unknown hit circuit filters.

It is also a time when there is a deluge of new financial products in the market—new mutual fund offers, new insurance plans, new stock portfolio management schemes. All old wine in a new bottle is what it really is.

It is also a time when the makers of wine (read the manufacturers or creators of financial products) provide the maximum margins to intermediaries to push their wine out of their attic. Well, if the marketplace is anyway going to get drunk on wine (be it Christmas or otherwise), why not get my lion’s share of the sales by offering additional incentives? Fair thought, Mr Manufacturer!

Consumers on the other hand, in the euphoria of upward index movement, lose sight of fundamentals, earnings, risk to business, geopolitical risks affecting economy, and seem to be on a high.

This is the perfect combination for financial intermediaries to get their business volumes to multiply manifold: customers are greedy, manufacturers are doling out good commissions—why shouldn’t I make use of this opportunity? Fair thought, Mr. Intermediary!

Given this background, what baffles me is that the intermediaries seem to have not really prepared themselves on the stringent requirements of product suitability, financial advice and documentation of such sales to comply with not only the specific product regulations but also with other regulations such as the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Markets) Regulations, 2003 (PFUTP; which deals with mis-selling) and Securities and Exchange Board of India (Investment Advisor) Regulations, 2013 (which deals with providing investment advice to any client).

Securities and Exchange Board of India (Sebi) regulations are very clear that every asset management company (AMC) is supposed to do an annual review of their distributors and satisfy themselves with the fact that these Association of Mutual Funds in India (Amfi) registration number (ARN) holders are fit and proper to sell their products. This means that the onus of allowing ARN holders to sell their product squarely lies on the AMC’s evaluation of the preparedness of ARN holders complying with the mutual fund product regulations. Should an AMC not find an ARN holder fit and proper, they are supposed to snap ties and stop business with such distributors. On the other hand, the ARN holder is now brought under the ambit of the PFUTP regulations. This means that if any mis-selling instance can be established, then, such acts by the distributor will be punished as per regulations. In such cases, the only defence that any person would have are the documents and records that prove suitable advice was given to the client. In the absence of evidence, it is natural that the “customer is right" unless proved wrong concept gets applied.

If I take recent examples, the amount of closed-end products that have been belted out in the Indian market is substantial. Anybody and everybody, who wanted to invest in equity mutual funds was offered a closed-end product as if that was the only way to do it. When everything is nice and rosy, no customer will bother. But two years from now, if the closed-end funds show negative returns, some of them will demand an explanation as to why I can’t exit and why did you put me in here? Was the product suitable for all these clients? Do you have proof to evidence suitability? This is just a possibility, but nevertheless possible.

Not too far away are those who are providing equity portfolio recommendations including equity strategies to clients. Neither do they have registrations as an investment adviser nor do they have registration under the Sebi (Research Analysts) Regulations, 2014. In the absence of the above registrations, I don’t quite understand how such advice can be provided. Already, multiple orders have come into light from the Sebi website which has told such entities to cease and desist from providing such advice.

The rules of the game have substantially changed for mutual fund distributors, research analysts and in general for all financial intermediaries. However, despite this change, we have failed to see a natural “compliant" alignment in the intermediation space. Many intermediaries in the capital market now are shying away from even continuing as a sub-broker and rather signing up as authorized persons. This is an indication that the stringent compliance in the equity market is forcing market participants to get down to the minute details and ask themselves: are we prepared to take on these compliance tasks? The mutual fund intermediation is also pretty much moving in that direction. The inclusion of mutual fund mis-selling under PFUTP is a huge one for the ARN holders to make note of. ARN holders are yet to understand the effect it can have if post a secular bull run, clients change colours during the downturn and question their advice/claim mis-selling not blaming the market, but blaming the intermediary for not doing the suitability study before selling. This is good enough to keep the ARN holder busy for a few months, if not more. And all of this tells me, as we enter 2015, financial intermediation in India is at its point of highest compliance risk.

Rajesh Krishnamoorthy is managing director, iFast Financial India Pvt. Ltd, the firm that runs

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