Client level segregation

An adviser paid by the client wants the client to do well. A distributor paid by the manufacturer wants the client to buy. Housing both roles in one firm and pointing them at the same client puts those two incentives in direct conflict over the same rupee.

SEBI's answer is not disclosure. It is separation, applied client by client.

An individual investment adviser may not provide distribution services at all. A non-individual adviser may run both businesses, but must keep them apart at the level of each client: whoever is an advisory client of the group cannot be a distribution client of the group, and vice versa.

For an individual adviser — a prohibition, extended to the family.

• An individual investment adviser shall not provide distribution services.
• The family of an individual investment adviser shall not provide distribution services to the client advised by that adviser.
• No individual investment adviser shall provide advice to a client who is receiving distribution services from other family members.

For this purpose the family of an individual investment adviser includes the adviser, spouse, children and parents. (Separately, the family of a client includes the individual client, dependent spouse, dependent children and dependent parents.)

For a non-individual adviser — segregation at group level. A non-individual investment adviser shall have client level segregation at group level for investment advisory and distribution services. The regulation explains it in two limbs:

• the same client cannot be offered both advisory and distribution services within the group of the non-individual entity; and
• a client can be either an advisory client, where no distributor consideration is received at the group level, or a distribution client, where no advisory fee is collected from the client at the group level.

"Group" means a holding company, subsidiary, associate, a subsidiary of a holding company to which it is also a subsidiary, or an investing company or venturer of the company under the Companies Act, 2013 where the adviser is a company; in any other case, an entity which has a controlling interest in, or is subject to the controlling interest of, the non-individual investment adviser.

Plus a structural requirement. The non-individual adviser must maintain an arm's-length relationship between its activities as investment adviser and as distributor by providing advisory services through a separately identifiable department or division. Compliance and monitoring of client segregation at group or family level must follow the guidelines specified by SEBI.

Northfield Financial Services Pvt Ltd is a SEBI-registered non-individual investment adviser. Its wholly-owned subsidiary, Northfield Distribution Pvt Ltd, is a mutual fund distributor. They are one group.

A client, Mr Rao, has Rs 80,00,000 to deploy. The group must choose a lane, once, for him.

Assume a trail of 0.75% and an advisory fee of 0.60% of assets. The group's revenue is Rs 60,000 a year either way. What differs is who pays it — and therefore whose interest the group serves when a scheme has to be chosen.

What the group may not do is split him: advise on the Rs 50 lakh equity portion for a fee and distribute the Rs 30 lakh debt portion for commission. The same client cannot be offered both services within the group, and if he is an advisory client, no distributor consideration may be received at group level on him at all.

The individual-adviser version is stricter still. Suppose Ms Iyer is an individual registered investment adviser and her spouse runs a mutual fund distribution business. She may not distribute at all; her spouse may not distribute to her advisory clients; and she may not advise anyone already receiving distribution services from her spouse. If Mr Rao is already her spouse's distribution client, she must decline him as an advisory client — even though the two businesses are separately owned.

Chapter 18 (Key Regulations), section 18.6.15, is the operative text, and Chapter 1 previews it when describing how SEBI separated advice from distribution. Section 18.6.1 supplies the definitions of "family of client" and "family of an individual investment adviser". Expect questions on whether an individual adviser may distribute, on whether a group may serve one client both ways, and on what "group" and "family" include.

• Individual advisers cannot distribute at all. Only non-individual advisers get the segregation route; for individuals it is an outright prohibition.
• The segregation is per client, not per department. A group may run both businesses and may serve thousands of each — it simply cannot serve the same client both ways.
• The bar runs in both directions. No distributor consideration at group level for an advisory client; no advisory fee at group level from a distribution client.
• Family is defined differently on each side. Family of an individual adviser = adviser, spouse, children, parents. Family of a client = the client, dependent spouse, dependent children, dependent parents. Note the word "dependent" appears only on the client side.
• "Group" is a statutory definition, running through holding, subsidiary, associate and controlling-interest relationships under the Companies Act, 2013 — not just entities sharing a brand.
• Segregation and arm's length are two separate requirements. Client-level segregation decides who may be served; the separately identifiable department or division is the structural obligation on top of it.
• Implementation services are a third thing. An adviser may provide them to advisory clients, but no consideration — commission, referral fee, embedded or indirect, by whatever name — may be received at group or family level for that service.