Legal Structure of Mutual Funds — the trust, its constituents and the service providers

Where this chapter sits

Chapter 3 carries 8% of the paper. It is entirely structural — who does what, who appoints whom, and who must be independent of whom.

The single most examinable relationship is: sponsor creates the trust, trustees protect the unitholders, the AMC runs the schemes, and the custodian holds the assets.

3.1 The structure

The definition: "mutual fund" means a fund established in the form of a trust granted registration under regulation 3 and which raises monies through the sale of units to the public under one or more schemes for investing in securities, money market instruments, gold or gold related instruments, silver or silver related instruments and such other assets and instruments as may be specified by SEBI.

And a structural requirement: the firm must set up a separate Asset Management Company (AMC) to run a mutual fund business.

SEBI has stipulated the legal structure under which mutual funds in India need to be constituted. The structure, which has inherent checks and balances to protect the interests of the investors, works as follows:

• Mutual funds are constituted as Trusts. Therefore, they are governed by the Indian Trusts Act, 1882
• The mutual fund trust is created by one or more Sponsors, who are the main persons behind the mutual fund business
• Every trust has beneficiaries. The beneficiaries, in the case of a mutual fund trust, are the investors who invest in various schemes of the mutual fund, called unit-holders
• The operations of the mutual fund trust are governed by a Trust Deed, which is executed between the sponsors and the trustees. SEBI has laid down various clauses that need to be part of the Trust Deed
• The Trust acts through its trustees. Therefore, the role of protecting the interests of the beneficiaries (investors/unit-holders) is that of the Trustees. The first trustees are named in the Trust Deed, which also prescribes the procedure for a change in Trustees
• To perform the trusteeship role, either individuals may be appointed as trustees or a Trustee company may be appointed. When individuals are appointed as trustees, they are jointly referred to as 'Board of Trustees'. A trustee company functions through its Board of Directors
• Day to day management of the schemes is handled by an Asset Management Company (AMC). The AMC is appointed by the sponsor or the Trustees
• The trustees execute an investment management agreement with the AMC, setting out its responsibilities
• Although the AMC manages the schemes, custody of the assets of the scheme (securities, gold, gold-related instruments & real estate assets & silver or silver related instruments) is with a Custodian, who is appointed by the Trustees
• Investors invest in various schemes of the mutual fund. The record of investors and their unit-holding may be maintained by the AMC itself, or it can appoint a Registrar & Transfer Agent (RTA)

The unitholders are the beneficiaries. That is the answer the exam wants — not the AMC's employees, not the distributors, not the trustees.

3.2 The key constituents

Sponsors

The application to SEBI for registration of a mutual fund is made by the sponsor(s). Thereafter, the sponsor invests in the capital of the AMC.

The eligibility conditions:

• The sponsor should have a sound track record and reputation of fairness and integrity in all business transactions
• The sponsor should be carrying on business in financial services for not less than 5 years
• The sponsor should ensure a positive net worth (share capital plus reserves minus accumulated losses) in all the immediately preceding 5 years
• The sponsor should be a fit and proper person for this kind of operation

Note the definition of net worth given — share capital plus reserves minus accumulated losses — and that 5 years appears twice, for the business track record and for positive net worth.

AMFI's website lists the names of all the Asset Management Companies, which are members of AMFI, in terms of the category of the sponsor, viz., Banks, Institutions, Private sector, etc.

Trustees

The Board of Directors of the Trustees company have a critical role in ensuring that the mutual fund complies with all the regulations and protects the interests of the unit-holders.

The eligibility criteria — a person shall be eligible to be appointed as a trustee only if that person:

(a) complies with fit and proper person criteria specified in Schedule II of the Securities and Exchange Board of India (Intermediaries) Regulations, 2008; (b) is not a director (including independent director), officer or employee of an asset management company; (c) is not trustee of any other mutual fund; and (d) furnishes all such information as may be sought by the SEBI

Conditions (b) and (c) are the independence rules. A trustee cannot sit on the AMC in any capacity, and cannot be trustee of a second mutual fund.

And: prior approval of SEBI needs to be taken before a person is appointed as Trustee.

The independence threshold: at least two-thirds of the trustees on the Board of the trustee company would need to be independent directors who are not associates of the sponsor or the AMC or the trustee company.

Two-thirds independent. That number is heavily examined.

The rights and responsibilities of Trustees:

1. Appointment and termination of asset management company
2. Addressing conflict of interest and broker empanelment
3. Regulatory compliance and trustee responsibilities
4. Trustee oversight for investor interests
5. Additional trustee oversight
6. The trustees shall also exercise due diligence on such matters as may be specified by the Board

The "core responsibilities" on which trustees must exercise independent due diligence:

• Ensuring fairness of the fees and expenses charged by the AMCs
• Reviewing the performance of AMC in its schemes vis-a-vis performance of peers or the appropriate benchmarks
• Ensuring that the AMCs have put in place adequate systems to prevent mis-selling to increase AUM and valuation of the AMCs
• Ensuring that operations of AMCs are not unduly influenced by the AMCs Sponsor, its associates and other stakeholders of AMCs
• Ensuring that undue or unfair advantage is not given by AMCs to any of their associates/group entities
• Addressing conflicts of interest, if any, between the shareholders/stakeholders/associates of the AMCs and unitholders
• Putting in place adequate systems to prevent misconduct including market abuse/misuse of information by the employees, AMC and connected entities of the AMCs

And a resource for the job: the trustees of mutual funds can now seek administrative assistance to monitor various activities of asset management companies.

The mutual fund trust

A mutual fund is constituted in the form of a trust and the instrument of trust is in the form of a deed, duly registered under the provisions of the Indian Registration Act, 1908, executed by the sponsor in favour of the trustees named in such an instrument.

Two Acts to keep apart. The trust is governed by the Indian Trusts Act, 1882; the deed is registered under the provisions of the Indian Registration Act, 1908.

The Asset Management Company

Day to day operations of a mutual fund is handled by the AMC. The sponsor or, the trustees if so authorized by the trust deed, shall appoint the AMC with the approval of SEBI.

The requirements for its people:

• The directors of the AMC need to be persons having adequate professional experience in the finance and financial services related field
• The directors as well as key personnel of the AMC should not have been found guilty of moral turpitude or convicted of any economic offence or violation of any securities laws
• Key personnel of the AMC should not have worked for any asset management company or mutual fund or any intermediary during the period when its registration was suspended or cancelled at any time by SEBI

And on appointments: prior approval of the trustees is required before a person is appointed as a director on the board of the AMC.

What the AMC actually does: the AMC is responsible for conducting the activities of the mutual fund. It, therefore, arranges for the requisite offices and infrastructure, engages employees, provides for the requisite software, handles advertising and sales promotion, and interacts with regulators and various service providers.

Its duty of care: the AMC has to take all reasonable steps and exercise due diligence to ensure that the investment of funds pertaining to any scheme is not contrary to the provisions of the SEBI regulations and the trust deed. Further, it has to exercise due diligence and care in all its investment decisions.

And how it can be removed — two routes: the appointment of an AMC can be terminated by a majority of the trustees, or by 75 percent of the Unit-holders. However, any change in the AMC is subject to prior approval of SEBI and the Unit-holders.

A majority of trustees, or 75 percent of unitholders. Both numbers are examinable.

The Custodian

The custodian has custody of the assets of the fund. As part of this role, the custodian needs to accept and give delivery of securities for the purchase and sale transactions of the various schemes of the fund. Thus, the custodian settles all the transactions on behalf of the mutual fund schemes.

Registration and appointment: all custodians need to register with SEBI under the SEBI (Custodian) Regulations 1996. The Custodian is appointed by the trustees. A custodial agreement is entered into between the trustees and the custodian.

The independence rule: if the sponsor or its associates control 50 percent or more of the voting rights of the shares of a custodian, or if 50 percent or more of the directors of a custodian represent the interest of the sponsor or its associates, then, unless certain specific conditions are fulfilled, that custodian cannot be appointed for the mutual fund operation of the sponsor or its associate or subsidiary company.

Why independence matters here: an independent custodian ensures that the securities are indeed held in the scheme for the benefit of investors–an important control aspect.

And a second function: the custodian also tracks corporate actions such as dividends, bonuses and rights in companies where the fund has invested.

Unit Holder Protection Committee

The AMC is required to constitute a Unit Holder Protection Committee (UHPC). The UHPC shall be responsible for:

1. Protection of interests of unit holders of mutual fund schemes vis-à-vis all products and services provided by the AMC
2. Ensuring adoption of sound and healthy market practices in terms of investments, sales, marketing, advertisement, management of conflict of interests, redressal of unit holders' grievances, investor awareness
3. Compliance with laws and regulations and other related processes with specific reference to operation of the mutual fund business

Its mandate: (i) review the various compliance issues relating to the protection of the interests of the unit holders, and (ii) keep the unit holders well informed of and educated about mutual fund product, investor charter, and complaint handling procedures.

And its reporting line: the UHPC is required to submit its report to the board of directors of the AMC along with recommendations for action. It will monitor the implementation of these recommendations, too.

Note the UHPC is constituted by the AMC and reports to the AMC's own board — not to the trustees.

3.3 Inside the AMC

Compliance

Compliance Officer needs to ensure all the legal compliances. In the scheme documents of new issues, the Compliance Officer signs a due-diligence certificate to the effect that all regulations have been complied with, and that all the intermediaries mentioned in the scheme related documents have the requisite statutory registrations and approvals.

The independence arrangement: to ensure independence, the Compliance Officer reports directly to the head of the AMC. The Compliance Officer works closely with the Trustees on various compliance and regulatory issues.

And the escalation duty: it is the responsibility of the compliance officer to report any issue of non-compliance directly and immediately to the trustees.

Fund management — three sub-teams

Fund management is the most critical function in an Asset Management Company. It is at the core of the value proposition offered by the firm.

Normally, the team can be broken into three sub-teams, viz., the analysts, the fund managers, and the dealers.

The analysts analyse various opportunities, be it individual securities, or sectors, or the state of the markets, or the economy... Their job is to identify investment opportunities.

The fund managers evaluate the opportunities presented to them by the analysts, the brokers, and other research firms. They may also identify opportunities by themselves. The performance of the scheme is the fund manager's responsibility.

The third sub-team is that of the dealers, whose responsibility is to place orders with securities brokers based on the instructions of the fund managers.

Analysts find; fund managers decide and are accountable; dealers execute.

Operations and customer services

When a customer visits a branch office of an AMC, s/he is attended by the customer services team. Such a team is also called the front office team. With a back office team behind it, both these together are part of the Customer Services Team.

Four functions sit in this group:

The Registrar and Transfer Agency (RTA), which is a big part of this unit, maintains investor records as well as allots or redeems units, processes purchase/redemption/switch requests, dividends, etc. It also generates the account statement that an investor receives.

There is a Custody Team within this group that interacts with the custodian for the purpose of settlement of various transactions that the fund management team initiates.

The Fund accounting team maintains books of accounts of each individual mutual fund scheme and calculates NAV on a daily basis.

The cash management team works as an interface between the banks and the fund management team–they ensure that money received in the bank when investors purchase units are passed on to the fund managers for further investment in securities and the investors get the redemption proceeds when they submit the redemption request.

Sales and marketing

This team reaches out to the investors through mass media, marketing campaigns and through a distribution channel. Their major responsibilities include branding, advertising, management of various events, and distribution of mutual fund products through various distribution channels.

Mostly, it is this team that would interact with the mutual fund distributors, and take care of relationship management and engagement. This team also helps in the growth of the distribution network through various interactions and training programs.

Other functions

Finance/Accounts, Administration, Human Resources and Development (HRD), Information Technology, etc.

The Accounts team handles the finances of the AMC. This unit is different from the fund accounting team.

That distinction matters — the accounts team keeps the AMC's own books; the fund accounting team keeps each scheme's books and computes NAV.

There is an Administration Department that takes care of various facilities, offices, and other infrastructure. In many AMCs, the administration reports to the finance function.

The HRD department is responsible for attracting, nurturing and retaining talent within the firm.

The Information Technology department also referred as the Technology team, takes care of the IT infrastructure required by various functions and departments. This may also include the AMC website, as well as many facilities offered to investors and distributors with the help of technology.

3.4 The service providers

Fund Accountant

The fund accountant performs the role of calculating the NAV, by collecting information about the assets and liabilities of each scheme.

The AMC can either handle this activity in-house or engage a service provider. There is no need for registration with SEBI to perform this function.

No SEBI registration for the fund accountant. Contrast the RTA, which must register.

Registrars and Transfer Agents

The Registrars and Transfer Agents (RTAs) maintain investor records. Their offices in various centers serve as Investor Service Centers (ISCs), which perform a useful role in handling the documentation of investors.

Their functions: processing of purchase and redemption transactions of the investor and dealing with the financial transactions of receiving funds for purchases and making payments for redemptions, updating the unit capital of the scheme to reflect these transactions, updating the information in the individual records of the investor, called folios, keeping the investor updated about the status of their investment account.

And the appointment rules: the appointment of RTA is done by the AMC. It is not compulsory to appoint an RTA. The AMC can choose to handle this activity in-house. All RTAs need to register with SEBI.

Three facts: appointed by the AMC, not compulsory, but must register with SEBI if appointed.

Auditors

Auditors are responsible for the audit of accounts.

And the separation rule: accounts of the mutual fund schemes need to be maintained independently of the accounts of the AMC. The auditor appointed to audit the mutual fund scheme accounts needs to be different from the auditor of the AMC.

Who appoints which: while the scheme auditor is appointed by the Trustees, the AMC auditor is appointed by the AMC.

Two auditors, two appointing authorities. The scheme auditor answers to the trustees, because the schemes belong to the unitholders.

Distributors

Distributors have a key role in selling suitable types of mutual fund schemes to their clients/investors. A distributor can be empaneled with more than one AMCs. Distributors can be individuals or institutions such as distribution companies, broking companies and banks.

The qualification: distributors need to pass the NISM Certification Examination (NISM-Series-V-A: Mutual Fund Distributors (MFD) Certification Examination) and register with AMFI.

And the route this examination belongs to: SEBI has also allowed provisions for empanelment of a new cadre of mutual fund distributors, who are allowed to sell a certain limited set of schemes. This new cadre of distributors can be empaneled if they clear the NISM-Series-V-B: Mutual Fund Foundation Certification Examination and register with AMFI under the particular category of distributors.

Collecting Bankers and Payment Aggregators

The investors' money goes into the bank account of the scheme they have invested in. These bank accounts are maintained with collection bankers who are appointed by the AMC.

Payment instruments against applications handed over to branches of the AMC or the RTA need to be banked with the collecting bankers so that the money is available for investment by the scheme. Thus, the banks enable the collection and payment of funds for the schemes.

The newer entrants: a new category of players have made an entry – the payment aggregators. There are some payment gateway providers, digital wallets, and payment banks. All these players facilitate the transactions by allowing investors to buy mutual fund units.

KYC Registration Agencies

It is mandatory for all investors in the securities market, including the mutual fund investors, to be KYC (Know Your Customer) compliant under the provisions of the Prevention of Money Laundering Act.

Why KRAs exist: if the investor has to go through the KYC process with each mutual fund, then it would become a repetitive process. SEBI issued regulations for registration of central KYC Registry Agencies (KRAs) in 2011. This introduced a common KYC for investors investing in securities markets.

KYC registration firms are registered with SEBI.

How they work: KRAs process various details and documents to establish the identity of the investor and assign a number through a letter. A copy of this letter can be submitted to any SEBI registered intermediary with whom the investor wants to transact.

And two safeguards: since the KRAs deal with sensitive investor information, they are mandated to have enough checks and balances in place to ensure that confidentiality is maintained. The regulations mandate KRAs to have computerised connectivity to share data with one another.

Valuation agencies

SEBI has issued guidelines for the purpose of arriving at fair valuation of debt securities that are non-traded or thinly traded. According to these guidelines, there have to be at least two valuation agencies that provide valuation matrix. The AMCs have to make use of this matrix to arrive at fair valuation of these investments.

AMFI has appointed CRISIL Ltd. and ICRA Ltd. for the purpose.

Credit Rating Agencies

Credit rating agencies rate debt securities issued by various issuers. Fund managers consider such ratings as an initial input while taking investment decisions, prior to doing their own due diligence.

Where ratings do more than inform: certain categories of debt funds such as corporate bond funds, credit risk funds are defined on the basis of credit rating. Even capital protection-oriented schemes need to carry a credit rating assigned by the rating agency.

And for FMPs: in case of Fixed Maturity Plans (FMPs), the AMC is allowed to disclose the proposed rating profile of the scheme before the portfolio is constructed. It is then mandatory to invest in debt securities only within the proposed rating profile, or less risky papers (higher credit rating than proposed).

Note the direction of the permitted deviation — safer is allowed, riskier is not.

Depositories and Depository Participants

A depository is an institution, which holds the securities in dematerialised or electronic form on behalf of the investors.

Investors have the option of holding their mutual fund units in dematerialised form through a depository participant. If not held in dematerialized form, the units are tracked in the form of Account Statements.

One exception to the option: the units of ETFs are compulsorily held in demat form as only demat securities are allowed to be traded on stock exchanges.

The analogy the workbook offers: one can consider the depositories as the head office of a bank and the depository participants akin to the branches of the bank. Like a bank account holder does not transact directly with the head office of the bank, but only with the branch; an investor does not deal with the depository, but with the depository participant.

There are two depositories in India, viz., National Securities Depository Limited (NSDL), and Central Depository Services Limited (CDSL).

Stock exchanges and transaction platforms

Investors can now transact in mutual fund units through the stock exchanges. The units of close-ended funds and ETFs are compulsorily listed on at least one stock exchange. At the same time, units of open-ended funds are also available through special segments on the stock exchanges.

The two exchange platforms: at the Bombay Stock Exchange (BSE), this segment is known as BSE-Star MF; while at the National Stock Exchange of India (NSE), it is called NSE Mutual Fund II Platform (NMF-II).

And the industry's own: MF Utilities India is another transaction platform for units of mutual funds. This is an initiative by the mutual fund industry under the Association of Mutual Funds in India (AMFI). This platform allows for the aggregation of transactions for a mutual fund investor... Investors are able to complete their required transactions across multiple mutual funds using a single platform.

3.5 AMFI

Association of Mutual Funds in India (AMFI) is the association of all the registered Asset Management Companies.

Its objectives:

• To define and maintain high professional and ethical standards in all areas of operation of the mutual fund industry
• To recommend and promote best business practices and code of conduct to be followed by members and others engaged in the activities of mutual fund and asset management
• To interact with SEBI and to represent to SEBI on all matters concerning the mutual fund industry
• To represent to the Government, Reserve Bank of India and other bodies on all matters relating to the mutual fund Industry
• To undertake a nationwide investor awareness programme to promote proper understanding of the concept and working of mutual funds
• To disseminate information on the mutual fund industry and to undertake studies and research directly and/or in association with other bodies
• To regulate the conduct of distributors including disciplinary actions (cancellation of ARN) for violations of Code of Conduct
• To protect the interest of investors/unitholders

Its most visible function: a major role of AMFI involves the registration of mutual fund distributors, by allotting them AMFI Registration Number (ARN), which is mandatory for becoming a mutual fund distributor.

And the point the exam asks about: an important point to note here is that AMFI is neither a regulatory body nor a Self-Regulatory Organisation (SRO).

An association of AMCs — not a regulator, not an SRO, and not an association of distributors.

Cyber Security and Cyber Resilience

SEBI has issued detailed Cyber Security and Cyber Resilience Framework (CSCRF) with the objectives to address evolving cyber threats, to align with the industry standards, to encourage efficient audits, and to ensure compliance by SEBI Registered Entities (REs).

The CSCRF is standards based and broadly covers the five cyber resiliency goals adopted from Cyber Crisis Management Plan (CCMP) of Indian Computer Emergency Response Team (CERT-In):

1. Anticipate · 2. Withstand · 3. Contain · 4. Recover · 5. Evolve