Franklin judgement – What’s said and what’s left unsaid

SEBI has come out with its order regarding l’affaire Franklin Templeton debt funds. The 100-page document is categorical in its indictment of the AMC and the ways in which these debt funds were managed. 2 messages are clear from the order: One, investor protection is paramount to the regulator. Two, fund managers and AMCs cannot take their fund management responsibility lightly. 

The principal findings are that:

1. The funds were not managed in keeping with its categories (using a similar high-risk approach across funds in different categories)
2. The fund management misapplied measurement of duration in a way that allowed it to have long-duration papers in portfolios that should not have had them
3. The fund management did not exercise prudence in managing risk and allowed the liquidity crisis to grow to unmanageable levels
4. The fund management did not follow proper debt securities valuation methods, and
5. The AMC did not have proper risk management practices (in preventing an unauthorized person to redeem from a scheme).

One key passage from the order stands out and puts the matter in sharp relief:

“While it is easy to shift the blame for such mishaps onto black swan events, regulatory changes, etc. the Noticee needs to seriously introspect and put in place robust risk control and due diligence mechanisms, given that the rest of the industry has been able to cope with the events and survive through the crisis period of the Covid 19 pandemic, without reaching the point of winding up.”

And the penalties that have been handed out are severe. Principal among these are:

• the refund of ‘fund management and advisory fees’ for 2 years for these funds (with instructions to remit them to investor accounts)
• a fine of Rs 5 crore (stiff by SEBI standards), and a bar on launching new debt funds for 2 years.

Separately, a couple of individuals have been barred from accessing the securities market for a period of time as well.

Of these, the refund of fund expenses will have the most financial impact for the AMC – to the tune of Rs 512 crores. The monetary fine of Rs 5 crore and the disbarment from starting new debt schemes are unlikely to have a serious impact. Can you imagine Franklin Templeton launching a new debt fund NFO now or in a year’s time? Or any other fund for that matter. 

The AMC has disagreed with the findings in the SEBI order and has said that it will appeal. While this was expected, how long this will take to resolve is unknown under the current circumstances. It is likely that the financial penalties won’t be paid until such a hearing is complete. 

Even as the penalty money may not hit your bank account,  you can feel a justified measure of satisfaction that an investigative process has concluded with findings against a financial institution that took for granted the investors who trusted them.

In the larger ecosystem of fund management, this judgement will likely send, in equal measure, a sense of relief and dread. Relief that this episode is (somewhat) behind them and they can move on, but dread the precedent that this ruling establishes. The fact that past revenues (fund management expenses) have been clawed back is a model that could be exercised for all such future events. The clear message from this order is that if funds are mismanaged, there will be significant impact to the revenues – even retrospectively – for the AMC. 

But, it is equally important to note what the order has left unsaid. Two things are conspicuous by its absence.

One, there is no comment or opinion on the decision to wind up the schemes and the manner in which it was done. As we all remember, both these came up for harsh criticism from the honorable High Court of Karnataka in its ruling a few months back. The SEBI regulations in terms of when and how a scheme can be wound up has plenty of ambiguities that we wrote about last year. An AMC managed to abruptly shut down six schemes taking shelter under these ambiguities. The SEBI order is noticeably silent on this question of shutting down open-ended schemes without prior notice. The reason seems obvious – they would end up pointing fingers at themselves. The issue with regard to the manner of winding up of the schemes, though, is still pending with the Supreme Court. 

Two, the document is also silent about the role of the regulators themselves when it comes to the absence of oversight of these mismanagement issues at the AMC. These issues have been at fore since at least the middle of 2018 (assuming the oversight would have begun on new SEBI categorization). For two years, these funds have been issuing monthly portfolios and disclosures for all to see. Where was the oversight function of the regulator? Why did they not observe these discrepancies then? Why were they not protecting the investors proactively? Why did the 2018 new categorization circular not spell out credit risk rules clearly for shorter duration funds? Obviously, these uncomfortable questions do not find a place in this document.

The document says the AMC (quoted earlier) needs to “seriously introspect and put in place robust risk control and due diligence mechanisms”. The same applies to the regulator as well.

The ruling may come as a relief, but, in many ways, it is justice delayed. It is a reminder for you to either do your own due diligence (and a lot of it) or trust the right people with the decision making. In the absence of both of these, stay away from the lure of returns where you don’t understand the product and its risk.

Our earlier call (in April) regarding Franklin funds