By Shivanjali Shukla, Student at Jindal Global Law School
“Mutual fund investments are subject to market risks. Please read the offer document carefully before investing.”
Franklin Templeton is one of the leading mutual fund houses in the country and a premier organization for global investment management. On 24th April, the company announced that it would be winding up six debt schemes. The schemes which were announced to be wrapped up are: Franklin India low duration fund, dynamic accrual fund, credit risk fund, short term income plan, ultra-short bond fund and income opportunities fund. These schemes consisted of investor’s assets worth around INR 30000 crore. The schemes which were wound up by the company were credit risk funds. Credit risk funds are basically those kinds of funds which lend 65% or more to the low-credit quality debt securities. People who have low credit rating, try to compensate by agreeing to pay a higher rate of interest in comparison to those people who have a decent credit rating. However, since they have low credit ratings, the chances of defaulting are very high, thus this creates huge risk for the lenders.
In May 2020, Franklin Templeton AMC gave investors a choice to choose who will be responsible for this process. Whether the trustees of the mutual fund should administer the process of winding up or Deloitte along with Kotak Mahindra Bank. At this point, the consent of the unit holders was sought as to who shall administer the process and not whether or not winding up of the schemes should happen. This announcement of voluntary winding up schemes was first of a kind in India and created huge chaos among the unitholders and the investors. Within few weeks, cases were filed against the fund house in different states throughout the country.
Why did Franklin Templeton India decide to shutter these funds?
In the current scenario, the trustees of Franklin Templeton decided to wound up the schemes to protect value for investors via a managed sale of the portfolio. The trustees felt that in the current scenario, they would not be able to manage the schemes in a very productive manner and they would not be able to do justice to the current investors. Another factor for taking this decision was COVID 19 pandemic which had caused severe illiquidity and market dislocation.
What did this mean?
For investors, this meant that as of April 23rd, 2020, they would not be able to invest in those six schemes or withdraw or redeem their money from those six schemes till the time the mutual fund house is able to liquidate the entire underlying investments and recover money from these portfolios. They can recover money either by selling the whole scheme for a fair value or by interest payments or on the maturity of the debt instruments. This primarily means that whenever those schemes recover the money, payments will be made to the investors in instalments over a period of time.
Legal Procedural history of the case-
Following the notice by the Franklin Templeton Mutual Fund, four writ petitions were filed in the High Courts of Delhi, Gujarat, and Madras. All the petitions were primarily challenging the decision of the house to wind up the six schemes. In Madras High Court, a criminal petition was filed as well, and a mandamus writ was sought against the respondents who were supposedly involved in the decision of winding up of the schemes. Finally, on June 19th, 2020, in a Special Leave Petition and Transfer petition, the Apex Court transferred all the four cases of the High Courts regarding this matter to the Karnataka High Court. The main issues deliberated by the court have been discussed below-
Issue 1- Whether the provisions of winding up are constitutional and is that permitted?
The foremost issue that the court has dealt with in the case is that whether the winding up Regulations (39, 40 and 41) are violating fundamental rights of the unitholders? It was argued that these regulations are arbitrary and discriminatory. A common man invests his hard-earned money in mutual funds for gaining money and therefore these winding up schemes are violating right to live with dignity under Article 21 of the constitution. Now technically speaking, winding up of mutual funds is allowed under the SEBI (Mutual Funds) Regulations, 1996. According to Regulation 39, a scheme of a mutual fund may be wound up in three scenarios. Firstly, in the opinion of trustees. Secondly, in scenarios where 75% of the unit holders pass a resolution for winding up of the scheme. Thirdly, if the Board directs for winding up of the scheme. The court held that investments in mutual funds are subject to certain risks and unitholders are aware of this before investing. There is no guaranteed return in such investments. The unit holders in the present case did not have a right to return. Therefore, the court dismissed this issue and held that the winding up regulations were valid and constitutional.
Issue 2- Taking consent of the unitholders.
The second issue before the court was that whether obtaining consent of the unitholders in according to Regulation 18 (15) (c) is a condition precedent to Regulation 39 (2) (a). According to Regulation 18 (15) (c), in situations where a mutual fund has been wound up according to the opinion of the trustees, the house must take the consent of the unitholders. SEBI has claimed that this clause is inaccurate, and Regulation 39 (2) (a) is an unrelated provision and should not be read along with Regulation 18 (15) (c). Additionally, Franklin Templeton contended that the consent from the unit holders will have disastrous consequences because it would interfere with the working of trustees. Trustees are the experts in the field and have a fiduciary relationship with the unit holders and will work for their benefit. Nevertheless, the court held that Regulation 18 (5) (c) ensures that the trustees do not have arbitrary power and it puts a check on their authority and is therefore valid and constitutional. The order upheld the decision of the trustees to wind up the six schemes but only after obtaining the consent of unitholders through a simple majority.
Franklin Templeton had further contended that they had taken consent from the unitholders. On 28th May, 2020, the Trustees had issued notices of e-voting and unit-holders for seeking approval of unit-holders for one of the two options. The first option was whether trustees should carry out the process of winding up or it should be contracted to Deloitte Touche Tohmatsu India LLP. So, another issue which popped up was the interpretation of consent. The court reminded the company that they had taken the consent of shareholders and who should take the decision and not on the subject of the decision. The court explained that regulation required taking consent of the subject matter that whether or not unit holders’ consent to winding up of schemes and not on who should carry out the process of winding up.
Issue 3- Role of the SEBI
SEBI further claimed before the Karnataka Court that the court does not have jurisdiction over this case. The reasoning behind this claim was that since SEBI is a specialised sectoral regulatory authority and it has initiated a Forensic Audit or investigation or investigation, the High Court does not have jurisdiction over this issue. To this the court said that SEBI was acting as a silent spectator in this whole fiasco and to sustain the confidence of the investors, SEBI must play a proactive role and it must ask questions from the AMC, and the trustees.
“One of the main obligations of SEBI is to protect the interest of the investors. The second obligation is to ensure that the Trustees and AMC of Mutual Funds strictly abide by the provisions of the SEBI Act and the Mutual Funds Regulations.”
The primary holding of the Karnataka High Court was that Franklin Templeton cannot wind up six of its schemes unless it has sought consent from the majority of the unitholders. The High Court further stayed its own order to give the mutual fund house a chance to conduct a vote of the unit holders and to give some time to Franklin Templeton to file an appeal to the Supreme Court.
Following this judgment, on 8th November 2020, Franklin Templeton took permission from SEBI to hold a vote of the unitholders asking their consent for winding up of the schemes. On 3rd December 2020, a two-judge bench was constituted in the apex court to hear the appeal by Franklin Templeton. The court ordered a stay on the redemption requests that were being asked by the unitholders and further allowed the Franklin Templeton Asset Management (India) to convene a meeting of its unitholders to seek their consent for winding down the six schemes. However, the court clarified on 12th December 2020 that this should not be treated as precedent in other cases. The court further ordered SEBI to appoint an observer for the e-voting which is scheduled to happen between 26th -29th December. The result of which should be declared only in front of the court along with the Forensic Audit Report which was conducted by the SEBI. On 3rd February, the division bench directed Franklin Templeton to distribute Rs 9,122 crore to unitholders of the six schemes that were wound up in April. The apex court further directed SBI Mutual Fund to carry out this exercise of disbursement.
In the next hearing on 12th February, the Supreme Court upheld the validity of the e-voting process which was held from 26th to 29th December for getting the consent of the unitholders for winding up mutual fund schemes. The court further clarified the terms like majority and consent in such voting processes. It held that for the purpose of Regulation 18 (15) (c), a majority would mean a majority of the unitholders who participated in the process of voting and not a majority of the unitholders who are enrolled in the scheme. According to the e-voting results, 95% of the unitholders who had participated, had voted in favour of winding up the schemes.
Aftermath of the crisis
Post-crisis, SEBI has made quite a lot of changes in the policy to ensure that situations like this would not repeat. Some steps which have been undertaken by SEBI are-
- In-house credit risk assessment- SEBI has asked mutual fund houses to enact in-house policies to conduct due diligence and credit risk assessment regularly. This would help investors by providing proper assessment of the particular scheme. The regulator further advised incorporation of a system where the issuer can get early warning signals in distress situations.
- Portfolio and Yield disclosure- A recent SEBI guideline has made it mandatory for mutual fund companies to declare their full debt portfolio. This should be updated on every fortnight and would therefore give now further clarity to investors. Furthermore, to increase transparency in the system, the companies must also disclose yields of the underlying instruments.
Following this announcement, the Reserve Bank of India on 27th April 2020, announced Rs.50,000 crores Special Liquidity Facility for Mutual Funds (SLF-MF). The reasoning behind this announcement was the heightened volatility in capital markets.
The above discussed case “Franklin Templeton v. Amruta Garg and Ors” was not an ordinary case and highlighted numerous gaps in the current enforcement system of the SEBI. Both the Apex Court and the Karnataka High Court pointed out that SEBI could have had a more proactive role in this case. It is quite ironic that although SEBI is a specialized authority in this area and it was formed 28 years ago to help the courts clear backlog, but now again the court is being stressed to interfere in the cases. Moreover, the court even felt justified to call SEBI a silent spectator in this case.