On Monday, the Securities and Exchange Board of India (SEBI) found Franklin Templeton Asset Management (India) guilty of wrong-doing and mismanaging its debt funds.
SEBI’s order comes a little over a year after the fund house suddenly wound up six of its debt funds. The regulator has now asked Franklin Templeton India AMC to return the fund management charges it had levied over the last three years on the six wound-up schemes, and back to the investors. It has additionally levied a monetary penalty of Rs 5 crore.
Broadly speaking, SEBI found Franklin Templeton India guilty of five charges. A study of its order gives us a taste of how fund houses can (mis)interpret SEBI regulations and how things could spiral out of control.
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‘FT ran many funds the same way despite SEBI’s norms’
SEBI observed that Franklin Templeton mutual fund ran multiple schemes in similar ways. This was in contravention to its 2018 rule. It had then carved out 36 scheme categories, drew up their unique characteristics and allowed only one fund per category. But the six wound-up schemes of Franklin Templeton looked pretty similar on their investment strategies.
The wound-up schemes were found having similar portfolios (40-70 percent common holdings) and all of them had invested more than 65 percent of their portfolios in securities that were rated AA and below. According to SEBI’s reclassification rules, only a credit fund (Franklin India Credit Risk Fund) is allowed to make such allocations.
SEBI also brushed aside Franklin Templeton’s defence that the scheme categories, as defined by SEBI in 2018, were not exclusive. The fund house said that SEBI’s rule did not bar a duration-strategy oriented scheme from taking credit risks, for instance. SEBI’s response was that though duration-based schemes could take credit risks, the “predominance of such papers (being over 65 percent) can only be the unique scheme characteristic of a credit risk fund”. “(Franklin Templeton) has completely misread and misinterpreted the legislative intent here,” says the SEBI order.
Long-duration securities in short-duration funds
Duration-based debt schemes cater to investors wanting to deploy money for specified timeframes. Fund houses offer debt schemes meant for investments of, say, a few weeks (liquid and overnight funds), a year (low duration or money market funds), between 1-3 years (short-term fund) and so on. Then, they buy securities in such a way that the portfolio’s Macaulay Duration corresponds with the scheme category.
SEBI’s investigation revealed that Franklin Templeton pushed long-term securities into short-term funds by manipulating the security’s own Macaulay duration.
It invested in longer maturity securities but those that came with clauses to reset interest rates at periodic intervals. These intervals were then considered to be the maturity date of the holdings as it was assumed that every time a security’s interest rate and spread (over benchmark) get changed, the paper adorns a new avatar. The problem, as SEBI found out, was that much of this was only on paper.
As per an audit done by the SEBI-appointed forensic auditor, it was found that of the many companies the fund house had invested in, the contract terms did not favour the fund house. The investee companies (Edelweiss Rural and Corporate Services, Aasan Corporate Solutions, Motilal Oswal Housing Finance, to name a few) had the upper hand. The fund house was the only investor in these securities.
Failure to safeguard its own interest and entering into one-sided contracts meant that these securities’ original maturity date had to be accounted for, and the not the intermittent reset dates. That makes them long-term securities. But Franklin Templeton had them in many of its six wound-up schemes.
The fund house did not act in investors’ interests
Indian debt markets are particularly illiquid. But due to the credit crisis that started in 2018 with the collapse of Infrastructure Leasing & Financial Services (IL&FS) and of a few other later on. COVID-19 worsened matters. SEBI observed that despite many chances to either reset its interest rates or exercise the put and call options on illiquid and low-rated securities, Franklin Templeton did not take them.
Among its six schemes, there were 19 to 45 chances for the fund house to exit in 2019-20. It just took a couple of those chances. This, despite repeated presentations made to the AMC’s Board in July, October and December 2019 and March 2020.
Debt securities were valued incorrectly
In 2017, four of the six wound-up schemes had invested in a company names OPJ Trading in 2017. It was a three-year instrument with a call and put option at the end of each year. Coupon rates were agreed upon for each of the three years. In 2019, the company suffered financial stress and was unable to pay its interest.
Instead of exercising its ‘put’ option and existing, Franklin Templeton readily extended the payment deadlines four times, in a matter of few months. SEBI also observed that the amended debenture trust deed was unsigned. The fund house also did not inform the valuation agency of the revised terms and its custodian. By law, SEBI reiterates in its order, the fund house was obliged to inform the valuation agency, which would have impacted its net asset values adversely, as OPJ Trading was under financial duress. “By ‘artificially maintaining’ a high valuation between October 16, 2019 and March 23, 2020, (Franklin Templeton) had violated principles of fair valuation and failed to ensure fair treatment to all investors,” says the SEBI order.
Franklin Templeton managed funds recklessly
As per a circular that SEBI had issued in the year 2000, all fund houses must maintain an Investment Process Note (IPN). This note must detail broad guidelines for investments and also have notes carrying its justification for investing in various securities. The absence of these documents showed that Franklin Templeton didn’t monitor its investments properly. “(Franklin Templeton) had failed to produce any document evidencing proper credit analysis and an ongoing monitoring of credit risk,” the order says. In fact, SEBI observed that the fund house didn’t even do its financial due diligence, given that OPJ Trading – to which it extended a long rope in 2019 – had actually posted losses in 2017-18 (Rs 23.62 crore) and 2018-19 (Rs 6.3 crore).