Winding up waterfall

When a mutual fund scheme is wound up, its assets are sold and turned into cash. That cash does not go straight to the unit-holders.

It flows down in a fixed order, like water filling one bucket before it spills into the next. That order is the waterfall.

1. First, the scheme pays the liabilities that are due and payable under the scheme.
2. Next, it sets aside an appropriate provision for the expenses connected with the winding up.
3. Only what is left, the balance, goes to the unit-holders.

The balance is shared in proportion to each unit-holder's interest in the assets of the scheme. And that interest is fixed as on the date when the decision for winding up was taken, not on the day the money is paid.

So a unit-holder is always last in the queue. What he gets is the residue, not the gross sale value of the portfolio.

Where the rule comes from. Chapter 13 reproduces the SEBI (Mutual Funds) Regulations, 1996 on winding up. The waterfall is clause (2)(b) of the "Procedure and manner of winding up". In the workbook's words: "The proceeds of sale realised under clause (a), shall be first utilised towards discharge of such liabilities as are due and payable under the scheme and after making appropriate provision for meeting the expenses connected with such winding up, the balance shall be paid to the unitholders in proportion to their respective interest in the assets of the scheme as on the date when the decision for winding up was taken."

Where it sits in the whole procedure.

Why the freeze matters to the waterfall. Because units can no longer be created, cancelled, issued or redeemed once the notice is published, the set of unit-holders stops moving. That is what lets the balance be divided by each holder's interest as on one fixed date.

What the workbook does not give. It states no percentage or ceiling for the expense provision. It says only that the provision must be appropriate. Nor does it say what happens if the provision later proves larger than the actual expenses. There is no figure to learn here beyond the order itself.

And the tax that follows. The waterfall decides how much a unit-holder receives. Section 13.10 then says the amount received on winding up "will be treated like normal redemption amount". See taxation of winding-up proceeds.

Sale proceeds of the scheme's assets
  less  Liabilities due and payable under the scheme
  less  Appropriate provision for winding-up expenses
  ------------------------------------------------------
  = Balance available to unit-holders

One unit-holder's payout
  = Balance x (his interest in the scheme's assets
              / total interest of all unit-holders),
    both measured as on the date the winding-up
    decision was taken

Illustrative figures. The order of payment is the workbook's; the amounts are assumed.

The trustees of a debt scheme decide to wind it up. On the decision date there are 1,00,00,000 units outstanding. Mrs Deshpande holds 50,000 of them, which is 0.5% of the scheme.

The assets are sold for Rs 12,40,00,000.

Mrs Deshpande's share. 0.5% of Rs 12,00,00,000 = Rs 6,00,000. That is Rs 12 a unit.

The tempting wrong answer. Dividing the gross sale proceeds gives 0.5% of Rs 12,40,00,000 = Rs 6,20,000. It skips two steps of the waterfall and overstates her payout by Rs 20,000.

Why the decision date matters. Mrs Deshpande cannot raise her share by buying more units after the notice appears, and she cannot step out of the waterfall by redeeming. Once the notice is published, units can be neither issued nor redeemed, and her share is fixed by the interest she held as on the date the decision for winding up was taken.

Chapter 13 (Tax provisions for Special Cases), section 13.10, Taxation in case of winding up of Mutual Funds, sets out the SEBI (Mutual Funds) Regulations, 1996 procedure before giving its one-line tax rule. The waterfall is clause (2)(b) of the "Procedure and manner of winding up". A question can ask what the sale proceeds are used for first, what comes before the unit-holders' balance, or the date on which each unit-holder's proportion is fixed. It is a short passage, and the order is the whole of it.

• Liabilities first, not unit-holders first. The proceeds are "first utilised towards discharge of such liabilities as are due and payable under the scheme".
• The expense provision also comes before the unit-holders. The workbook's own plain-English summary on the next page says only that the trustees "pay off all liabilities" and pay the balance to unit-holders. It leaves out the expense provision. The regulation it summarises includes it, so answer with all three steps.
• The proportion is fixed on the date the decision was taken, not on the date of the notice's publication and not on the date of payment.
• Unit-holders share in proportion to their interest, not equally per head and not by the price each one paid.
• 75% and simple majority are different steps. A resolution by 75% of unit-holders is one ground for winding up. A simple majority at the unit-holders' meeting approves the procedure and authorises the persons who carry it out, including the waterfall.
• The report goes to SEBI and the unit-holders after the waterfall, and the scheme ceases to exist only once SEBI is satisfied.
• The waterfall does not change the tax. Whatever balance reaches the unit-holder is taxed like a normal redemption amount.