SEBI revises norms for portfolio managers

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The portfolio management services (PMS) industry has witnessed robust growth of 18% CAGR (compound annual growth rate) in the past five years, with assets under management (AUM) rising to ₹13.7 trillion (US$183.86 billion) from ₹6.04 trillion.

Further, disruptions in the market, including technological advances, have affected the core portfolio selection, management and distribution side of the industry. In view of the rapid growth of the industry and the challenges that come along with it, the Securities and Exchange Board of India (SEBI) constituted a working group to review the SEBI (Portfolio Managers) Regulations, 1993 (former PMS regulations).

The recommendations of the working group were taken into account in overhauling these regulations and formulating the SEBI (Portfolio Managers) Regulations, 2020 (2020 PMS regulations), to revise and standardize norms and catch up with certain limits and requirements.

Following are key highlights from the 2020 PMS regulations, notified on 16 January 2020, and the Circular on Guidelines for Portfolio Managers dated 13 February 2020, which will apply from 1 May 2020.

Net worth requirement

The minimum net worth required for portfolio managers has been increased from ₹20 million to ₹50 million. A grace period of three years has been afforded to presently registered portfolio managers to increase their net worth. While it is intended to curb dubious operators, this may restrict players who fulfill other eligibility criteria, but do not meet the high-net-worth threshold.

The minimum investment amount per client has been increased from ₹2.5 million to ₹5 million. This may be beneficial, as small savers can be prevented from taking exposure in PMS that carry higher risks, such as concentration risk, illiquidity, and a wide investment mandate. However, it is anticipated that this may slow down the growth of the PMS industry.

The 2020 PMS regulations allow portfolio managers offering non-discretionary or advisory services to clients to invest or provide advice for investment up to 25% of the AUM by such clients in unlisted securities, in addition to the securities permitted for discretionary portfolio management.

Further, portfolio managers may invest in units of mutual funds only through direct plans, but are prohibited from charging any kind of distribution-related fees to the client.

Fees and commission

As per the 2020 PMS regulations, the portfolio manager is required to charge an agreed fee from the client without guaranteeing any return, but it shall not charge an upfront fee, directly or indirectly. Brokerage at actuals shall be charged to clients as an expense. Operating expenses shall not exceed 0.5% per annum of the client’s average daily AUMs.

Further, it was observed that 100% of the upfront fees charged to the client were being paid as commission to the distributor by the project manager. To curtail mis-selling and to prevent distributors pushing upfront products (where distributor commissions are paid at the time of investment), the SEBI working group had recommended that the distributor commission shall be paid only on a trailing basis (where the commission is paid at the end of every year, or when the investment is withdrawn).

While this recommendation was included when the 2020 PMS regulations were issued in January, the same have been included in the circular, which states that fees or commission to distributors be paid only on a trailing basis. Further, any fees or commission paid shall be only from the fees received by portfolio managers.

In case a client portfolio is redeemed, the exit load charged shall be: (1) in the first year of investment, a maximum of 3% of the amount redeemed; (2) in the second year of investment, a maximum of 2% of the amount redeemed; (3) in the third year of investment, a maximum of 1% of the amount redeemed; and (4) after a period of three years from the date of investment, no exit load.

Employee eligibility criteria

The former PMS regulations did not specify the roles and responsibilities of the principal officer of the portfolio manager and its employees, but they assign the following functions to the principal officer: (1) the decisions made by the portfolio manager for the management or administration of the portfolio of securities, or the funds of the client; and (2) all other operations of the portfolio manager.

The principal officer is required to have: (1) professional qualification in finance, law, accountancy or business management; (2) experience of at least five years in related activities in the securities market (at least two years of relevant experience is required to be in portfolio management or investment advisory services, or in areas related to fund management); and (3) a relevant NISM (National Institute of Securities Markets) certification.

A portfolio manager who was granted a certificate of registration prior to the commencement of the 2020 PMS regulations is required to comply with requirements (1) and (2) above within three years. Further, certain qualifying criteria are set out, which shall be met by at least one employee of the portfolio manager other than the principal officer and compliance officer.

The PMS sector did not have the formal concept of an “investment approach”. An investment approach is a broad outlay of the types of securities and permissible instruments to be invested in by the portfolio manager for the customer, taking into account factors specific to clients and securities.

Portfolio managers use various investment approaches to manage portfolios and market their portfolio offerings through advertisements, disclosure documents and distributors, in their individual ways. If portfolio managers are not permitted to report the performance based on various investment approaches, proper information will not flow to potential clients and to the SEBI. The portfolio manager is required to disclose the investment approach in the disclosure document shared with a prospective client and the same is also to be included in the client agreement.

An investment approach includes: (1) the investment objective; (2) a description of types of securities, e.g., equity or debt, listed or unlisted, convertible instruments, etc.; (3) the basis of selection of such types of securities as part of the investment approach; (4) the allocation of a portfolio across types of securities; (5) the appropriate benchmark to compare performance and the basis for the choice of the benchmark indicative tenure or investment horizon; (6) teh risks associated with the investment approach; and (7) other salient features, if any.

It was further clarified that information about investment approaches offered by portfolio managers shall be uniform across all types of reporting, marketing and disclosure materials.

Disclosure, reporting requirements. Disclosures as per the 2020 PMS regulations include portfolio risks, related party transactions, performance-related disclosures, audited financial statements for the past three financial years, and the range of fees charged under various heads. The disclosure document is not perused by the SEBI.

Further material changes, i.e., changes in control of the portfolio manager and principal officer, fees charged, charges associated with the services offered, investment approaches offered (along with the impact of such changes), and such other changes as specified by the SEBI from time to time, are required to be made in the disclosure document.

Reporting requirements have also been revised and standardized. Portfolio managers are required to make performance reporting to clients, the SEBI, and in their marketing materials. Non-standard reporting formats had made it difficult for prospective clients to compare performances of the portfolio managers, and accordingly make investment decisions.

Unlike the former PMS regulations, a performance report to the clients is required to be submitted every three months, along with a disclosure of default in payment of coupons, or debt security, or downgrading of ratings by the credit rating agency. Reports are to be submitted to the SEBI on a quarterly basis.

The circular provides the format in which quarterly reports are to be submitted to the client. The 2020 PMS regulations state that such reporting should be made uniformly in the disclosures to the SEBI, in marketing materials, in reports shared with clients and on its website.

The circular states the following in this regard:

  • Portfolio managers are now required to report to the SEBI on compliance with the SEBI circular on “Improvement in Corporate Governance”, dated 18 November 2003, on an annual basis and not on a biannual basis;
  • The SEBI circular on “Half-yearly reporting by Portfolio Managers”, dated 12 March 2010, stands superseded. From the financial year 2019-2020, the portfolio manager shall submit: (1) a certificate from a certified accountant certifying the net worth of the portfolio manager as on 31 March every year, based on audited accounts within six months from the end of the financial year; and (2) a certificate of compliance with the 2020 PMS regulations and the circulars issued under it, duly signed by the principal officer, within 60 days at the end of each financial year; and
  • Further in modification of the SEBI circular on “Portfolio Manager Monthly Report”, dated 8 October 2010, portfolio managers are required to submit a monthly report regarding their portfolio management activity on the SEBI intermediaries’ portal within seven working days, at the end of each month.
  • The following are certain considerations in respect of the performance report prepared by portfolio managers as specified in the 2020 PMS regulations and the circular:
  • May disclose performance segregated on the basis of investment approach;
  • Consider all cash holdings and investments in liquid funds for the calculation of performance;
  • Report performance data net of all fees and expenses;
  • Disclose any change in investment approach that may impact the performance of a client’s portfolio;
  • Ensure that the performance reported in all marketing material and the website of the portfolio manager is the same as that reported to the SEBI;
  • Ensure that the aggregate performance of the portfolio manager reported in any document shall be the same as the combined performance of all portfolios managed by the portfolio manager; and
  • Provide a disclaimer in all marketing material that the performance-related information provided is not verified by the SEBI.

Clients can be directly onboarded by portfolio managers without any intermediation by distributors. This option is required to be prominently disclosed by the portfolio managers in the disclosure documents, marketing material, and on their website. At the time of direct onboarding of clients, only statutory charges shall be levied.

The business law digest is compiled by Nishith Desai Associates, a research-based international law firm with offices in Mumbai, New Delhi, Bengaluru, Singapore, Silicon Valley, Munich and New York. The firm specializes in strategic legal, regulatory and tax advice coupled with industry expertise in an integrated manner.