What prompted SEBI to ban entry loads ?

SEBI has dropped the feared bombshell ! The three decisions taken by the SEBI Board on 18 Jun 2009 are widely reported and well known :

1. No entry loads on any MF schemes
2. Investors to pay commissions to distributors directly, based on individual negotiations
3. Distributors to disclose trail and other commissions to their investors

But, what is perhaps less known is SEBI’s internal thinking behind taking these drastic steps – which are bound to radically change the MF distribution business.

We are in receipt of a note that is believed to be SEBI’s Board Note - the note that was put up to the SEBI Board recommending these three steps and the rationale for them. A copy of this note is provided in this piece. If this is indeed the SEBI Board Note, it actually raises some serious issues.

Before going into the full note, here are some key comments from the note – together with our own observations on these comments :

1. Size versus quality

SEBI says that today, AMCs decide the quantum of commission payable to distributors – and this is dependent on the total collections made by the concerned distributor for the AMC – rather than the quality of advice and service rendered by the distributor to his client. This should change. Investors must be empowered to decide how much they would like to pay for the advice and service they receive.

Wealth Forum fully supports this notion – and has been advocating removal on the ban on rebating for precisely this reason. Advisors who added value were not under pressure to rebate, whereas those that did not, did see significant pressure to rebate. Quality always comes at a price. The issue is how the price is to be determined and paid : expecting an investor to cut a second cheque for advice is highly impractical. Rebating would have been a better option, one that recognises ground realities.

2. Conflict of interest

SEBI says that since commissions vary across schemes and AMCs, there can be conflicts of interest situations, where advisors/distributors recommend schemes based on their own commission income rather than the merits of the schemes.

Wealth Forum agrees with this concern – we do have a number of instances where distributors aggressively sell products that fetch them higher commissions. Unfortunately, advisors who put their clients’ interest ahead of their own, will now pay the price for the acts of other distributors who flouted this cardinal principle.

3. Feedback from the public on variable entry load proposal

SEBI says that an analysis of the feedback received by it to its variable entry load proposals reveals that over 93% of ALL respondents (distributors, investors, AMCs) opposed the variable entry load proposal. Only 0.7% of all respondents favoured the two cheque model. Among distributors, about 94.5% opposed the variable entry load proposal.

Yet, SEBI has gone ahead with the two-cheque model – despite overwhelming opposition to the proposal. SEBI’s rationale : “From the above analysis, there appears to be an overwhelming opposition to the concept of variable load. However, many responses used an identical language and were written in a similar fashion though were coming from different persons/ email ids. Such multiple and similar responses may have led to distortion in the analysis and hence a definitive conclusion cannot be drawn.”

Wealth Forum view : Distributors views are being disregarded since they chose to speak a common language ! There is no other justification that SEBI has given for disregarding the view of 93% of respondents and favouring the view of 0.7% of respondents. Why go through the whole “consultative process”, if a decision had already been taken ? All of us have wasted time and energy to respond to SEBI – which has completely disregarded the views of an overwhelming majority, and gone ahead and taken its decision – which is supported by less than 1% of the public who responded to SEBI’s proposal.

4. Higher trail fees to compensate for absence of entry loads

SEBI says that AMFI had initially proposed variable entry loads in Oct 07, but changed its stance in Mar 09 and asked for the implementation of multiple share classes. One of the share classes – the “no load class” would not have any front end loads but would allow AMCs to charge 0.75% higher annual expenses to the scheme – which would enable them to pay a higher trail to their distributors. SEBI found AMFI’s proposals unacceptable. SEBI also believes that though the higher expense ratio would be in line with developed markets like USA, it would impose higher costs on investors and therefore is an unwelcome step.

Wealth Forum believes that there is an easy way of enhancing the effective expense ratio, without moving the slab rates. The existing slabs were formulated several years ago and are unrealistically low in today’s context. The first slab applies only to the first Rs. 100 crores, the next slab applies to the next Rs. 300 crores and so on. Due to this slab rate methodology, the effective expense ratio for a fund of some scale – like Rs. 2000 crores, works out to around 1.9%. If the slabs were to be maintained, but the thresholds increased to bands of Rs. 1000 crores (first Rs. 1000 crores at 2.5%, next 1000 crores at 2.25% etc), the same Rs. 2000 crores equity fund can now charge an expense ratio of 2.38% - which is almost 50 bps more. This incremental 50 bps can be passed on to distributors by way of enhanced trail. Increasing the thresholds can be easily justified due to inflation alone – while increasing the slabs can understandably be seen as politically incorrect.
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Here is the transcript of the purported Board Note that we received a copy of – which spells out SEBI’s rationale for making these dramatic changes.

SECURITIES AND EXCHANGE BOARD OF INDIA

Transparency in Payment of Commission to Mutual Fund Distributors

1 Objective

1.1 The memorandum proposes to introduce a system in which the investor decides the commission to be paid directly to distributors depending upon the level of service desired, thereby enhancing transparency and empowering the investor. Currently commission is paid to the distributor by AMC from an entry load charged to the investor by deducting it from the amount invested.

1.2 The memorandum also elaborates the existing structure of distribution, current practices and proposes comprehensive disclosures with regard to the commission receivable by distributors under various schemes.

2 Current Status

Structure of Distribution for mutual fund products

2.1 Mutual fund products are sold to investors through two main channels: by Asset Management Companies (AMCs) directly (investor service centers / Branch offices / internet) and by entities variously known as distributors / agents / brokers (referred to as ‘distributors’ hereafter).

2.2 Traditionally, there has been a large reliance placed on distributors for reaching out to the investors for mutual fund products. As per the data submitted by the registrars for mutual funds for April - March 2008-09, 86% of the gross subscriptions were received through distributors and the share of direct applications in gross subscriptions was 14%. The various categories of distribution channels are given in Annexure A.

Regulatory Structure for distributors

2.3 Distributors are not registered with SEBI. Association of Mutual Funds of India (AMFI) registers distributors. As a pre-requisite for registration, distributors have to undergo AMFI certification (barring a few exemptions provided by SEBI). AMFI is neither a Self Regulatory Organization (SRO) nor an intermediary registered with SEBI.

2.4 AMFI has prescribed a code of conduct for the mutual fund distributors. SEBI has advised mutual funds that all their distributors should strictly follow the code and that they should monitor the activities of their distributors to ensure that they do not indulge in any kind of malpractice or unethical practice while selling/marketing mutual funds units. It was further stated that in case any distributor does not comply with the code of conduct, the mutual fund should report it to AMFI and SEBI and no mutual fund should deal with those distributors who do not follow code of conduct.

Remuneration/ Commission to Distributors

2.5 Mutual funds compensate the distributors from funds collected by way of entry load, exit load and annual recurring expenses paid out of the scheme assets.

2.6 The distributors receive the commission in the following modes:

2.6.1 Upfront commission: A fixed charge is deducted from the investor’s subscription by the AMC (known as entry load) and is kept in a separate load account and the balance subscription amount is invested in terms of the scheme objectives as specified in the offer documents. The upfront commission to the distributors is paid out of this load account.

2.6.2 Trail commission: From the annual recurring expense charged to investor for various expenses incurred in running the scheme, trail commission is paid to the distributor. Trail commission may also be paid from the balance in the load account1 (which has credits from entry as well as exit
loads).

2.7 While the aforesaid payments are made by the AMC from the funds collected from the investors, the AMCs are free to pay the distributors from its own account through various modes including, inter-alia:
• Cash
• Gift vouchers
• Sponsorship for training programmes (local / overseas)
• Sponsorship for trip (domestic / abroad)
• Adhoc payment for ongoing support (reimbursement of mailing expenses / advertisement in their magazines / investors events etc)

Generally, the commissions and incentives depend on the scale of business procured by the AMC through the concerned distributor. The distributors thus get paid for advice rendered to the investors and for acting as agents of the AMCs for selling mutual fund schemes. While the AMC has a right to decide the extent of payment to the distributor, at present the investor has no right to decide the extent of payment for services (including advice) rendered to the investor.

2.8 SEBI regulations permit mutual funds to charge a maximum load (entry plus exit) of 7%. In equity schemes, the entry load does not generally exceed 2.25% of the subscription. Some fund houses also charge exit load in equity schemes linked to period of holding. In liquid schemes, the industry practice is to charge nil entry and exit loads. However, in case of debt oriented schemes, while the entry loads are generally nil, exit loads may be charged depending on the period of holding of the investors (the load is higher for lesser holding period)3

2.9 Further, Mutual Fund Regulations also permit AMCs to charge the scheme (under the annual recurring expense) for marketing and selling expenses including distributor’s commission. While the Regulations specify an upper limit on the annual recurring expense depending on the average weekly net assets (a maximum of 2.50% in case of equity schemes and 2.25% in case of debt schemes), there is no limit specified separately for selling and distribution expenses.

2.10 While presently the amount paid to the distributors is shown in the scheme’s revenue account, there is no requirement to disclose separately the amount paid out of the loads collected or from AMC’s account.

3 Issues with the current system of commission payment

3.1 The current system of commission to distributors has led to issues of lack of transparency and the right of investors to decide the extent of payment for services rendered to them by the distributor.

3.2 The distributor may advise the investor to exit from an existing investment and make a new investment, thereby increasing his inflow of commission without disclosing the same to investor and at times at the cost of right advice for the investment. This conflict can be resolved by mandating disclosures of commissions.

3.3 In the current system of load being fixed by the AMC, the investors in effect do not have any say in the commission that is paid to the distributor as the load is aggregated and paid by the AMC depending on the scale of business procured through the concerned distributor. This can be remedied by changing the system to empower the investor to decide the payment for services rendered.

3.4 The current practice of payment of the commissions to distributors by the AMC has raised issues of transparency. Since varied commissions are paid on different schemes by different AMCs, doubts have been raised whether the advice rendered by the distributors is in the best interest of the investor or is influenced by the quantum of commissions. There is an apprehension that to maximise their income, the distributors might tend to sell the scheme or plan that pays them the best.

4 Steps taken by SEBI towards empowering investors in respect of payment of commissions

A. Waiver of Load for Direct Investments

4.1 As a first step towards empowering the investor class, SEBI has mandated that no load be charged for direct applications received by the AMC (i.e. applications routed without distributor intermediation). This is in force since January 4, 2008. Prior to this, all investors irrespective of whether they applied through or without a distributor were required to pay a fixed entry load.

B. Towards transparency in commission payments

4.2 While deliberating the issue of waiver of load on direct applications, a suggestion on the mechanism of variable load was also examined. The basic concept is that the commission paid to the distributor may be determined by the investor in consultation with the distributor depending upon the quality and extent of advice and service desired by the investor. It was suggested that within the application form there would be a section where the investor would mention the entry load that he wants to pay – signed off by the investor and the distributor. Accordingly that percentage would get deducted from the amount received from the investor. However, a view emerged that if implemented, variable load may lead to lot of disputes between the investor and the distributor.

4.3 The pros and cons and the operational feasibility of the variable load model were discussed in the meeting of Advisory Committee of Mutual Funds last year (2008). The Committee discussed the alternative models of implementing variable load and desired that a concept paper on variable load be placed on SEBI website for public comments.

4.4 Accordingly, a concept paper titled ‘Proposal on Variable Entry Load’ was placed on SEBI website and public comments were sought. The concept paper had proposed two options; first, within the application form itself, the investor would indicate the commission payable to the distributor which would be signed off jointly by the investor and the distributor and the AMC would then pay the distributor. Second, the investor would issue two cheques – one for his investment in the name of the scheme and the second one in the favour of distributor towards the commission agreed to be paid. The concept paper also sought comments on the suggestion to make it mandatory for distributors to disclose the commission being paid to them for the different schemes which are being recommended to the investor as transparency in this area will work to the benefit of the investors.

5 Feedback and Analysis

5.1 An analysis of the responses received from distributors, AMCs and individuals revealed that 93% did not favor variable load, 2.8% favored variable load in application form (first option),0.7% favored the two cheque system (second option) and 3.5% agreed with only the concept of variable load (without indicating choice of option). Of the responses received from distributors, 94.5% were not in favour of variable load and in case of individuals, 88% were not in favour of the same. Only 3 AMCs replied with 2 against and 1 in favour of variable load.

5.2 In respect of disclosure of commissions, only 11 responses were received out of which 6 were in favour of disclosures of commissions by distributors.

5.3 From the above analysis, there appears to be an overwhelming opposition to the concept of variable load. However, many responses used an identical language and were written in a similar fashion though were coming from different persons/ email ids. Such multiple and similar responses may have led to distortion in the analysis and hence a definitive conclusion cannot be drawn.

5.4 AMFI feedback on variable load : AMFI had in October 2007 while giving its comments on ‘no load’ for direct applications stated that variable load is the most suitable proposal and would usher in a new architecture in the business of distribution of mutual funds. However, in March 2009 they stated that in view of the current extremely depressed market situation characterized by very low net inflow particularly to the equity segment, variable load concept may not be introduced immediately. Further, they recommended that instead of introducing variable load concept in isolation, it should form an integral part of introduction of the Multiple Share Class Structure differentiated by loads (on lines of Multiple Share Classes of mutual fund units in a few foreign markets) which is elaborated below:

Plan A (Dividend or Growth) – In this plan, variable entry load would be as agreed by investor and distributor; and exit load/CDSC4 and annual recurring expenses would be as per current provisions of Regulations.

Plan B (Dividend or Growth) – In this plan, there would be no entry load; exit load/CDSC would be as per current provisions of Regulations and; annual recurring expenses limit would be uniformly increased by 0.75% across existing slabs.

5.5 According to AMFI, introducing variable load structure as part of Multiple Share Class Structure would give choices to investors without impacting distributors in terms of commissions. The distributor would either get upfront commission and lower trail in plan A or low / no upfront commission and higher trail commission in plan B. AMFI also states that higher trail commission (paid out of higher annual recurring expense) would reduce the incentive to the distributor to churn the investors portfolio and also discourage New fund Offer (NFO) trend.

5.6 The following regulatory changes would be required to introduce the multiple plan structure:

• The regulatory limit for annual recurring expense in Plan B will need to be increased by 0.75%.
• Expense limits would be at plan level, not scheme level which would mean that there would be two limits for annual recurring expenses.
• Management fee payable to AMC will require to be made fungible with other expenses within limit on annual recurring expense.
• Reimbursement of Service Tax on various annual expenses to be taken outside the regulatory limit for annual recurring expense. 

5.7 An examination of the AMFI proposal brings out the following pit falls:

• In the rationale given that- long term investment will be promoted by distributors since they will get a higher trail commission– the cost to investors has not been factored. As stated in Cadogan Report5 “In theory a trail commission rewards loyalty, but the loyalty it rewards is the distributor’s and not the client’s. In fact for a long-term client the continued payment of marketing expenses out of the fund may act as a positive disincentive to hold for the long term.”

• There is no limit suggested on exit loads in either plan unlike the international models.

• The increased annual expense which is stated to be used for trail commission is at par with the 12b-1 fees6 charged by mutual funds in the US. However, this fee is subject to checks and balances in the US.

AMFI proposal on Multiple Share class would not lead to desired transparency in disclosure of commission, does not appear to be beneficial to the long term investors and will not result in simplification of the already complex terminologies for schemes and plans used in the market.

5.8 In the first of the two options suggested in the concept paper, there is a possibility of increased disputes between the distributors and the investors while there is still some lack of transparency as to how much of the entry load paid by the investor is received by the distributor. In view of the above, the second option of direct payment of commission is a better alternative.

The second proposal about distributors disclosing all the commission paid to them under various schemes is obviously in favour of transparency.
6 Proposals:

6.1 The present system of payment of commission has led to a lack of control by the investor over the quality of service vis-à-vis the commission being borne by him. This has also led to a situation where the advise rendered to the investor could be influenced by factors other than investor’s interest.

There appears to be a need to empower the investor in deciding the commissions paid to the distributors and also to ensure transparency in commissions being paid for mutual fund products.

6.2 Accordingly, the following proposals are placed before the Board for consideration:

6.2.1 There shall be no entry load for all schemes launched by an AMC.

6.2.2 The upfront commission to distributors shall be paid by the investor to the distributor directly. The scheme application forms may carry a disclosure that the investor shall pay the commission to the distributors directly based on his assessment of various factors, including the service rendered by the distributor. (It might not be desirable to provide an upper limit as any such limit is likely to be made the norm by the distributors.)

The aforesaid proposals will segregate the streams of payment for the two roles of distributor, an agent of the AMC and an adviser to the investor.

6.2.3 The distributors shall disclose all the commissions (in the form of trail commission or any other mode) payable to them for all the different schemes/ different mutual funds which are being distributed by them irrespective of the scheme(s) which is/are being recommended to the investor. The AMCs shall monitor the compliance of the same by their distributors.

The board may approve the above proposals and may authorize the Chairman to make such amendments to SEBI (Mutual Funds) Regulations, 1996, and issue such guidelines as may be necessary, consequential and appropriate to give effect to the above proposals. 

Annex A

Categories of Distribution Channels

Currently, the main categories in the distribution channel of mutual funds are:
Banks, National / Regional distributors and Independent Financial Advisors (IFAs). While National/ Regional distributors have larger presence and generally a corporate set up, IFAs cater to the needs of the local/ neighbourhood investor class. Based on gross sales of equity schemes during April-March 2008-09, IFAs, National/ Regional distributors and banks have a share of 33%, 32% and 26% respectively. In debt schemes, where retail participation is generally low, IFAs have a negligible share of 3% of gross sales, National / Regional distributors have a share of 60% followed by banks with 23% of gross sales (based on the data for April to March 2008-09). A pie chart representation of the share of the various distribution channels in equity schemes and debt schemes for April–March 2008-09 is given below:

The top 20 distributors on the basis of total commission paid (upfront and trail) are either banks (11) or National/ Regional distributors (9). Of the total commission paid, 27% was paid to the 11 banks among the top 20 distributors and 13% was paid to the 9 National/ Regional distributors, thus the top 20 distributors have a 40% share in the total commission paid.

These distributors advise on/ sell not only mutual funds but a whole array of other products like insurance (life and general), savings products originating from government (post office deposits/ schemes, PPF/ other small savings scheme), bank deposits and corporate deposits. Unlike the insurance industry where there is a tied agency concept i.e. an agent can sell insurance product from one life insurance company only, distributors can sell products of any registered mutual fund.