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Recently, the Indian Supreme court directed SBI Mutual Fund to hold back the next tranche of payments to investors of Franklin Templeton (FT) Mutual Fund. This was in response to the mutual fund distributors’ body seeking payment of distributor commissions, accrued after April 2020. 

Are distributors owed a trail fee accrued after the scheme closure announcement? The answer partly depends on the purpose of trail fees. For fund management companies, client acquisition is costly, and extending clients’ holding periods, by paying distributors a trial fee makes good business sense. For distributors, maintenance of client relationships or branch networks (in the case of banks) and associated regulatory and compliance burdens can be expensive, and trail fees go some way towards defraying these costs and allowing them to invest in training on the latest regulations and product updates. 

If distributors are compensated only for client acquisition or compliance, then it follows that they should continue to be compensated till the assets are fully wound up. But what about their responsibility to investors? Distributors must conform to a suitability standard, which means recommending schemes appropriate for the investor’s risk profile and needs. FT schemes were high risk, and as long it was sold to clients who had the risk appetite and understood the product features, that standard was met. 

However, the distributor code of conduct also requires them “to consider investor’s interest as paramount and take necessary steps to ensure that the investor’s interest is protected in all circumstances".  Was this standard met? The closed FT schemes promised high returns by predominantly investing in illiquid debt instruments. When the bets soured, the fund did not provide timely market signals by adjusting the valuation or exercising its put options (which would have triggered a default), even as informed investors were redeeming their investments by selling off high-quality securities. 

Some of the facts were discernible only in hindsight, and FT India was a respected fund house. But it is fair to say that when investors’ funds are being stuck for nearly two years, the distributors who recommended the schemes and earned commissions when the going was good, bear some responsibility and partake in the pain. 

If the principles are hard enough to sort through, the process which followed FT schemes closure has been chaotic. Mutual funds schemes have been closed before, but typically by merging with other schemes, so the issue of distributor commissions after a closure announcement would not have come up. FT scheme closure is a unique event. In an ideal scenario, the fund house would have a clear, contractually pre-agreed process to sort through the claims of both distributors and investors in the event of wind-up during extreme market events. Practically, there should have been clear communication with distributors, and an attempt at a fair solution, instead of transferring the entire trail fees to unitholders’ kitty, under regulatory directions. 

Distributors should perform better due diligence on both the product and the firm.  Trail fee is better than upfront commissions, but it does not eliminate the potential for product bias. Is fee-based advice the answer? The commissions vs fees debate frequently boils down to a trade-off between better alignment with investor interests and improving investors’ access to advice. In recent years, the distributors’ remit in offering advice has been shrinking with the emergence of registered investment advisors (RIAs). Distributors are not allowed to call themselves advisors or provide financial planning services.  RIAs face their own challenges—from  high capital requirements to onerous compliance rules, and their numbers are puny compared to distributors. 

The FT fiasco has led to several regulatory responses. But we also need to figure out how to improve the quality and access to advice. Unfortunately, conflict-of-interest disclosures don’t work well. Distributors must disclose the commission structure of various mutual funds they recommend. However, this disclosure-based approach can backfire, increasing consumers’ trust in distributors and giving distributors ‘moral license’ (i.e., when people allow themselves to do something bad after doing something good) to recommend biased choices to their customers. 

The second option is to reduce financial and non-financial barriers to entry for RIAs. We must raise standards to weed out bad actors, but not place excessive bureaucratic burden on ethical advisors seeking to enter the market.  Finally, we need to raise investor awareness around advice. The experience with low-cost investments is instructive. While the low-cost National Pensions Scheme (NPS) struggles to capture investor attention, advertisements for ETFs are increasingly found during the IPL seasons. Perhaps Sachin Tendulkar can advise us whether it is okay to pay for financial advice. 

Sivananth Ramachandran, CFA, CIPM, director of Capital Markets Policy (India), CFA Institute.

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