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It was the proverbial lull before the storm. The period between SEBI's IAB recommendations (Jan 2017) and yesterday - June 22nd 2017, marked a rare phase for mutual fund distributors where they weren't looking over their shoulders for the next regulation to hit them and derail their focus from business growth. Our WF Advisor Confidence Survey 2017 which we published only days ago, also captured this "no fikar, no gham - only acche din" mood (Click Here).
Yesterday, that honeymoon period ended, with SEBI coming up with its "new improved" version of RIA 2.0 - an update over its Oct 2016 proposal, after as it claims, taking into account feedback from market participants. SEBI's latest proposal is available here:
http://www.sebi.gov.in/reports/reports/jun-2017/consultation-paper-on-amendments-clarifications-to-the-sebi-investment-advisers-regulations-2013_35152.html
The key features of this "new improved" set of proposals, to my mind are as follows:
Large distributors who operate hybrid models (advice + distribution) using the SIDD route, have been given 6 months to hive off advice into subsidiary companies (down from 3 years as originally proposed) MFDs should ensure product suitability (this was taken off in the Oct 2016 proposal), will be held to a strictly enforced mis-selling framework, but should not get into risk profiling and financial goal setting as those activities are the exclusive purview of advisors MFDs have to make an explicit declaration, which their clients have to sign off each time a transaction is executed, stating that they may not be acting in the client's best interests Educational criteria, net worth requirements and initial fees have been relaxed for RIA registration to make it easier for existing MFDs to make the transition to RIA easier.
I have 3 specific observations to make on this "new improved" RIA paper:
Product suitability: In trying to achieve its basic objective of denying a distributor any "advisory" role, while at the same time trying to ensure investor protection, SEBI has come up with another untenable definition of the role of a distributor in ensuring product suitability, which is contrary to specific IOSCO guidelines on this issue (SEBI is a member of IOSCO) and is also contrary to what its own International Advisory Board has asked it to do. SEBI first scrapped product suitability responsibility in its Oct 2016 proposal, then realized the folly of its anti-investor stance, and has now reinstated this responsibility, while at the same time denying any advisory role to an MFD. Product suitability is an integral part of advice - as defined by IOSCO - SEBI is clearly violating international guidelines in its zeal to ensure that an MFD is not seen to be offering advice, while in reality, he is asked to do so. Asking an MFD to get a declaration signed by a customer that acknowledges that he may not be acting in the client's best interests is downright defamatory and humiliating and has to be appropriately redrafted SEBI is clearly ignoring its own International Advisory Board's explicit recommendations that state that (1) Commission based as well as fee based approach to investment advisory can co-exist for the time being, (2) The transition from commission to a fee based approach has to be gradual and (3) Such transition has to happen in tandem across regulatory segments to have uniformity in regulatory stringency across competing segments like securities market, insurance and pension businesses.
Before elaborating on these three points, it is useful to put out here extracts from the four documents I have referred to - the June 2017 RIA proposal, the Oct 2016 RIA proposal, an extract from SEBI's IAB Board minutes and an extract from IOSCO guidelines on product suitability.
June 2017 SEBI RIA Proposal extract
In order to have clear segregation between advising on mutual fund products and selling/distribution of mutual fund products, it is proposed that Mutual Fund Distributors (MFDs) can only explain/describe the features of mutual fund schemesof which they are distributorsanddistribute themwhile ensuring suitability of thescheme to the investors.
They can distribute suitable mutual fund schemes to the investors describing material facts of the scheme and the associated risk factors of the scheme, etc., subject to the following conditions:
i. MFDs should not give any investment advice.
ii. MFDs should offer suitable scheme to the investor considering all the available schemes distributed by them.
iii. MFDs should not offer any financial planning services to the investor which requires risk profiling, financial goal setting, etc.
iv. MFDs shall stop usage of nomenclature 'Independent Financial Adviser'or"Financial Adviser"; rather use the term "Mutual Fund Distributor" only;
v. MFDs shall refrain from mis-selling of mutual fund schemes.
There shall be strict enforcement action on mis-selling of mutual funds and constant supervision towards ensuring suitability of mutual funds sold to investors.
vi. MFDs shall be required to clearly disclose the following in a form to the investors which would be signed off by the investors before making any investment inmutual fund scheme through such distributor:
a. The list of mutual funds where he is acting as a distributor
b. the commission earned/ to be earned,
c. suitability of the product sold to the investor,
d. Disclaimer that he/she may not be acting in the best interest of investor
Oct 2016 SEBI RIA Proposal extract
4.1.2 Under the existing framework, a mutual fund distributor can sell mutual fund products and also provide incidental or basic advice on mutual fund products and can also help inexecuting the transactions. Such distributors are required to conduct risk profiling and comply with the requirement of appropriateness of the product. Distributors are getting the commission from the fund houses i.e. AMCs and additionally can also charge execution/advisory fee to the client.
4.1.4 In order to have a level playing field in respect of investment advisory services offered on mutual fund products, it is proposed that:
a) Mutual Fund distributors shall not be allowed to provide incidental or basic investment advice in respect of mutual fund products. If they want to engage themselves in providing incidental or basic investment advisory services on mutual fund products, they need to register themselves as an investment adviser under IA Regulations. A period of three years shall be provided for those distributors who seek to migrate as an investment adviser to enable them to obtain necessary certification and to comply with other requirements specified in IA Regulations to act as an investment adviser.
c) The person who seeks to continue to engage in the distribution of mutual fund products shall use the nomenclature as 'Mutual Fund Distributor'. Such person shall not be allowed to provide basic or incidental advice in respect of mutual fund products except describing the product specification without recommending any particular product.
Jan 2017 SEBI International Advisory Board recommendations extract
Commission based as well as fee based approach to investment advisory can co-exist for the time being. The transition from commission to a fee based approach has to be gradual. Such transition has to happen in tandem across regulatory segments to have uniformity in regulatory stringency across competing segments like securities market, insurance and pension businesses. Regulators need to keep in mind the financial viability and the business model of the advisory business. Proper due diligence before transition in regulatory regime is essential. Distinction between retail and sophisticated investors should be clear. There is a felt need for greater awareness among investors on cost of commission versus fees based advisory. More transparency is required on distributors' commission in all financial products. Before undertaking any effective steps, SEBI may consider undertaking a study of migration to fee-based advisory model under RDR, FOFA and robo-advisory models.
2013 IOSCO guidelines on product suitability
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD400.pdf
Here are two of its principles that are relevant in this context:
Protection of customers for non-advisory services
Principle 4: When an intermediary sells a complex financial product on an unsolicited basis (no management, advice or recommendation), the regulatory system should provide for adequate means to protect customers from associated risks.
Suitability protections for advisory services (including portfolio management)
Principle 5: Whenever an intermediary recommends the purchase of a particular complex financial product, including where the intermediary advises or otherwise exercises investment management discretion, the intermediary should be required to take reasonable steps to ensure that recommendations, advice or decisions to trade on behalf of such customer are based upon a reasonable assessment that the structure and risk-reward profile of the financial product is consistent with such customer's experience, knowledge, investment objectives, risk appetite and capacity for loss.
1. Product Suitability
The fundamental internationally accepted understanding on product suitability is that this responsibility is an intrinsic part of advice, and not of non-advisory distribution services. Under current Indian regulations too, distributors are made responsible for product suitability by the MF regulations, and concurrently the RIA regulations provide an explicit exemption for MFDs who offer advice that is incidental to their distribution activity. The moment you say that MFDs cannot offer advice, they operate in the world of non advisory services as defined in Principle 4 of IOSCO guidelines. Principle 4 states that it is the regulatory system and not the individual salesperson who is responsible to protect investors. Suitability protection (principle 5) applies only when advisory services are offered, and one of the basic features of suitability testing is a risk profiling exercise. How else can you figure out whether a product is suitable or not for an investor? By resorting to face reading?
If SEBI has (and rightly so) brought back product suitability responsibilities onto MFDs in its revised RIA proposal, it follows that MFDs will be offering advice that is incidental to their distribution activities. You can't ask an MFD to be responsible for suitability but not undertake discussions on risk profile or financial goals. If an investor is planning his daughter's marriage 2 years from now and wishes to invest his entire portfolio into a surging equity market, should or should not his distributor ask about the investor's goals and ensure that they are adequately funded with appropriate asset classes that reflect the time horizon? If he doesn't do this, because he is not supposed to get into risk profiling and goal planning, how does he discharge his product suitability responsibilities? And, if he goes ahead and sells equity funds to this investor, is he not exposing himself to mis-selling claims, which SEBI says will now be strictly enforced?
Can SEBI please walk us through exactly how it sees the engagement between an investor and an MFD, which in its opinion entirely meets its objectives on product suitability responsibilities, and is yet completely devoid of any discussions on risk profiling and goals?
It is instructive to note that IOSCO's definition on product suitability clearly states that the advisor is expected to, when recommending a product, satisfy himself that "the structure and risk-reward profile of the financial product is consistent with such customer's experience, knowledge, investment objectives, risk appetite and capacity for loss."
The way I see it - which is the way IOSCO sees it - is that product suitability is an intrinsic part of advice. You cannot impose suitability responsibilities on intermediaries who cannot call themselves advisors. Because they are in fact advising, when they take on product suitability responsibility. Stripping away this responsibility is grossly anti-investor. So really, the only tenable option is what already exists - to recognize that MFDs offer advice that is incidental to their distribution activity. It's a different matter that you don't want them to call themselves IFAs - call them MFDs, but don't say that an MFD offers no advice, but is somehow responsible for product suitability and will be held liable for mis-selling.
2. Declaration of malafide interest
You ask a distributor to disclose commissions on the product proposed as well as all competing products that he distributes. You ask him to get a sign off on this from a client for every transaction. You anyway ensure commission disclosure through CAS statements of absolute amounts of commission and not percentages. You mandate that the cost of every junket and freebie that the distributor has availed be included in this commission disclosure. You mandate product suitability responsibilities on MFDs and ensure strict enforcement of mis-selling guidelines.
And if that's not enough, you want a declaration to be made by the distributor and acknowledged by the investor - every time a transaction is executed - that the distributor may not be acting in the investor's best interests?
Let's take a parallel to get this context right. There exists a disclaimer for all MF material put out which says "Mutual Funds are subject to market risks". What if that were to be amended to say "Mutual Funds may not be in your best interests"?
If mutual funds are permitted in this country, the thinking is that despite the market risks associated with them, on balance, they have the potential to do a lot more good than bad for investors. But you do want to caution investors about market risks anyway.
If MFDs are permitted in this country rather than being banned, the thinking ought to be that on balance they offer an important service by helping investors invest in "appropriate" mutual fund schemes - schemes that are found by them to be suitable for the investors. If that is indeed the thinking, why on earth ask for a declaration of potential malafide intent, when you have so many disclosures any way that establish without any doubt in an investor's mind that the MFD is being compensated by fund houses for products that he sells?
If you are so worried that MFDs are a bunch of crooks, shut down the activity. But don't permit its existence and then humiliate it by making every member of this profession state each time he executes a transaction for every client, that he has potentially malafide intentions. This is plain defamatory, insulting and humiliating.
I have a basic issue with SEBI's ivory tower thinking that MFDs would generally tend towards malafide intentions while RIAs would generally tend towards bonafide intentions. There are, like in any profession, good and not so good players. It is completely unbecoming of a regulator to brand one set of legitimate intermediaries as potentially damaging and another set as "doodh ka dhula" as we say it in Hindi. Let's just take one hypothetical example (not that I have anything against the RIA model - I like the model - but this is about the belief that RIAs can do no wrong). If an RIA's fees are a percentage of overall financial assets advised, and he advises his client to sell a property and reinvest the proceeds in financial assets, can he not be an interested party in such advice? Would his fees not go up directly as a consequence of this advice? Should he also then put out a disclaimer that he may be potentially acting with malafide intent?
3. What happened to SEBI's IAB observations?
If SEBI's IAB makes some observations and recommendations - which are put out in public domain - does SEBI have a responsibility to address them or can they simply ignore them. If they can be ignored, why have an IAB anyway and why waste their time? As recently as in Jan 2017, SEBI's IAB made a number of specific recommendations including one where it stated that advisory models under commission and fee structures should co-exist for the moment and that the journey towards fee only advisory should be gradual, should be calibrated and importantly, should be executed in consonance with regulatory moves on competing products including insurance and pensions. None of these recommendations seem to have been adhered to in the latest avatar of proposed RIA regulations.
SEBI ought to publish, along with its RIA proposals, an action taken report on its own IAB's recommendations. If they indeed believe they are acting in the best interests of investors, and if an IAB is seen as a useful mechanism to guide SEBI towards mature decision making, then SEBI ought to, in investor interest, tell the investors what action it has taken on the IAB's recommendations and if it decided not to act on them, the reasons for its decision.
To conclude
I can't help but get a strong feeling that the entire objective of this and the Oct 2016 proposal starts and ends with only one dimension: reduce the role of a distributor to an extent that it drives them to register as RIAs. So, if you have to concede product suitability in this round because not doing so was patently anti-investor, why not introduce a malafide intent declaration to even the score?
Logically, one would imagine that a review of an existing RIA framework should start with what went wrong with the exemption to MF distributors - in terms of disservice to investors; what went wrong by explicitly permitting advice that is incidental to MF distribution. Do we have any insights into what SEBI thinks went wrong? Were there huge number of complaints of distributors misusing this "advice that is incidental to distribution" activity? Or is it simply that someone is not happy with the number of RIA registrations and is keen to tweak regulations to drive up the numbers - whether or not there is any evidence of investors not being well served under current regulations?
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