Arm's length relationship

An investment adviser earns a fee from the client for advice. A distributor earns commission from a product company for selling that product. SEBI does not want the same firm to blur these two roles, because commission can tempt an adviser to recommend the product that pays more, not the one that suits the client.

The rule is called an arm's length relationship. It means the advisory work has to be kept separate from any other business the firm runs. If the firm does both advice and something else, such as distribution, the two must sit in different divisions, with a clear boundary between them, as if they were two different companies dealing with each other at arm's length.

SEBI's Investment Adviser Regulations, 2013, place this duty on both individual and non-individual advisers, and the workbook states it in two places.

Non-individual advisers (Chapter 18, general obligations): an investment adviser 'shall maintain an arms-length relationship between its activities as an investment adviser and other activities', and must ensure the advisory service is 'clearly segregated from all its other activities'.

Individual advisers offering execution (Chapter 1): an individual adviser cannot do both advice and distribution together. A non-individual adviser instead gets client-level segregation at the group level, and must run the advisory service through a separate division or department to maintain the arm's length relationship. No consideration for execution work may be received at the group or family level.

The point of both versions is the same: the fee a client pays for advice must not be mixed with income the firm earns from selling a product.

Meridian Wealth Advisors Pvt Ltd is registered with SEBI as a non-individual investment adviser. It also runs an insurance distribution business under the same corporate group.

To keep the arm's length relationship, Meridian sets up its advisory practice as a separate division, with its own staff, its own client agreements and its own systems, kept apart from the insurance distribution division. Ritu, a client, pays Meridian's advisory division a Rs 30,000 fee for a financial plan. She cannot also be sold insurance by the same division for a commission — that has to go through Meridian's separate distribution division, which might earn a 15% first-year commission on any policy Ritu buys there — and Meridian's own family or group cannot earn a fee for executing Ritu's transactions.

If Meridian instead let the same relationship manager both advise Ritu and earn insurance commission from her account, it would have broken the arm's length rule.

Chapter 1, section 1.6, uses the phrase for individual advisers who also want to offer execution services. Chapter 18 restates it as a general obligation for all advisers, individual and non-individual. Expect a question that asks what SEBI requires of an adviser who also distributes products — the answer is segregation through an arm's length relationship, not a ban on holding both businesses.

• An arm's length relationship does not ban a firm from doing both advice and distribution. SEBI requires segregation, not exclusivity, for non-individual advisers; only individual advisers must choose one or the other.
• The segregation has to be structural — a separate division or department — not just a policy on paper.
• No consideration for execution can flow to the adviser's own group or family, even where the advisory and execution arms are kept apart.