SEBI Modifies Skin-in-the-game Rule. Are Mutual Fund Houses Happy?

September 24, 2021 Mutual Fund

SEBI’s skin-in-the-game rule that aims to align the interest of the ‘Key employees’ of the mutual fund house with the unitholders of its schemes will come into effect from October 01, 2021.

As per the rule, Key Employees of the asset management companies will have to mandatorily invest a minimum of 20% of the salary/ perks/ bonus/ non-cash compensation (gross annual CTC) net of income tax and any statutory contributions i.e. PF and NPS, in the units of Mutual Fund schemes in which they have a role/ oversight.

Investment will be made over a period of 12 months on the day of the payment of the salary. Moreover, the investment will be locked-in for a minimum period of 3 years or tenure of the scheme whichever is less. Additionally, the units will be subject to clawback (will be redeemed and credited back to the scheme) in the event of gross violation of code of conduct / fraud / gross negligence by the key employee/s.

What is the motive behind SEBI’s skin-in-the-game rule?

SEBI expects that getting the key employees to invest in the schemes they manage can lead to better accountability on the part of the fund management team, thus paving way for a better quality of securities and improved performance. Moreover, investors in general will have a better sense of confidence if the fund manager’s interest aligns with their own. It also aims to prevent instances of insider trading as well as discourage fund managers from taking unnecessary risk.

SEBI has relaxed the norms for junior employees

Ahead of the implementation of this rule, SEBI has relaxed the rules for junior employees of the asset management companies. The rules for junior employees will now happen in a phased manner.

In the first year of the implementation junior employees of mutual funds will have to invest 10% of the compensation, instead of 20%. The mandatory investment will increase to 15% in the 2nd year (October 01, 2022 to September 30, 2023) and 20% from the 3rd year onwards (from October 1, 2023).

Any employee below the age of 35 (excluding Chief Executive Officer (CEO), head of any department, and Fund Managers) will be deemed as junior employee. The phased implementation for junior employees will cease to apply from the date the employee attains the age of 35 years.

Earlier SEBI had stated that all non-cash benefits and perks will be accounted for calculating CTC to arrive at the amount that employees will have to invest. It has now clarified that superannuation benefits and gratuity paid at the time of death/retirement, will not be included in the CTC.

Notably, the mutual fund industry had expressed their desire for more flexibility in implementation of the rule and fine-tuning certain parts of the circular. Accordingly, SEBI has provided some relief in the implementation of rule. Furthermore, SEBI has replaced nomenclature ‘key employees’ used in the earlier circular with ‘designated employees’.

The following qualify under the ambit of ‘designated employees’ (as per the earlier circular):

• Chief Executive Officer (CEO), Chief Investment Officer (CIO), Chief Risk Officer (CRO), Chief Information Security Officer (CISO), Chief Operation Officer (COO), Fund Manager(s), Compliance Officer, Sales Head, Investor Relation Officer(s) (IRO), Heads of other departments, Dealer(s) of the AMC
• Direct reportees to the CEO (excluding Personal Assistant/Secretary)
• Fund Management Team and the Research Team
• Other employees as identified & included by AMCs and Trustees

Here are some other clarifications that SEBI has provided to the mutual fund houses:

• Mutual Fund houses will take previous month’s NAV for apportioning the investments across eligible schemes.
• Value of interest on loan availed against the units by designated employees from the mutual fund house will not be included in the CTC.
• Designated employees can set off their existing investments against the fresh investments required in the same schemes.
• Designated employees can set off their existing investments for which the lock-in period of 3 years has expired against fresh requirements to be made in the same scheme. Such units will be locked in for a further period of 3 years.
• Units of designated employees invested in Liquid schemes will get automatically redeemed on the expiry of the mandatory lock-in period.
• For other open-ended schemes the designated employees can redeem their units twice in a financial year after the expiry of mandatory lock-in period. They can do so after getting approval from the Chief Compliance Officer.
• Investment of the designated employees will be made in ‘Growth’ option of the mutual fund schemes.
• In case of Fund of Funds schemes, only the Fund Managers of such schemes will be required to invest.

Are mutual fund houses happy?

The clarification in the rules still does not address certain concerns of the mutual fund houses. One of the major concerns raised by the fund houses is that employees will be forced to invest in an asset allocation plan that may not align with their risk appetite.

For instance, a fund manager of liquid fund will have to invest a substantial portion in the scheme even if his/her investment objective is more suited to an aggressive profile. In addition the units will be locked-in for a period of 3 years, even though the category is meant for short term investments.

Besides, AMCs fear that the rule may hinder their ability to attract fresh talent since the rules will apply to a range of employees who may or may not be directly responsible for making the investment decisions or the performance of the scheme.

Mandatorily investing a fifth of the compensation in the schemes of the AMC may not a feasible option for many employees because it will constrain their cashflows. The mandatory investment and lock-in period of three years could be especially difficult for employees if they have loans to service or other financial obligations.

A better approach would be to consider reducing the scope of the rules to include only those employees that are directly involved in the decision making process of the scheme/s. SEBI can also consider giving higher flexibility to employees to invest in schemes that match their needs.

The way ahead

SEBI’s move is well intended and can prevent fund houses from launching risky investment schemes, but only to an extent, mainly those with a smaller asset size.

Hefty investments by fund houses and/or its employees in its schemes does/will not guarantee improved performance of the scheme, neither does it make riskier categories suitable for investors having conservative and moderate risk appetite. Do note that many fund managers already invest in the schemes that they manage or other schemes of the fund house.

Remember that the final responsibility of choosing suitable schemes lies with you, the investor. When you invest in any scheme, apart from historical performance, give importance to qualitative factors as well. This involves investing in fund houses that follow prudent investment practices and have robust risk management system.

Know the various risks involved before taking any investment decision. Avoid riskier categories such as small-cap fund, sector/thematic fund, and/or credit risk fund (in case of debt investment), if you are uncomfortable taking very high risk.

This article first appeared on PersonalFN here