The Securities Exchange Board of India (“SEBI”) had floated a series of consultation papers in 2016, 2017, 2018, followed by another recent consultation paper released on January 15, 2020, where it had proposed some changes in the regulatory framework of the Investment Advisors (“IA”) and had sought public comments on the changes proposed. In the backdrop of these consultation papers, SEBI has recently notified the amendment to SEBI (Investment Advisers) Regulations, 2013 (“IA Regulations”) on July 3, 2020. These changes will come into force on the ninetieth day from the date of their publication in the Official Gazette. The amendment aims to infuse transparency in the functioning of the advisory industry. It mainly segregates the advisory and distribution services at the client level to avoid conflict of interest which acts as detrimental to the clients seeking such services. The amendment has also enhanced the eligibility criterion for the registration of the IA to improve the quality of these advisors in the advisory industry. Although the amendment, by segregating the role of advisory and distribution services, is the right step in making a robust framework, it fails to provide any rationale for enhancing the eligibility conditions for the advisors. In this article, the author tries to critically analyse these amendments, particularly the enhancement of the eligibility criterion, and study the possible legal implications of such change in the advisory industry.
IA Regulations was enacted in 2013 to lay down a robust framework for the investment advisors who provide advice relating to investing, purchasing, selling, or otherwise dealing in securities or investment products, etc to their clients. Investment advisor shall act in a fiduciary capacity towards its clients and shall disclose all conflicts of interests, whether actual or potential, as and when they arise. However, a potential threat of conflict of interest arises due to the dual role played by them as advisers and distributors of financial products. The lack of segregation between the dual roles of advisory and distribution services often leads to a situation where a client’s interest would be compromised by an adviser who would advise the client with the products which would fetch him better profits through commission. Additionally, the regulation did not provide any guidelines to ensure the quality of the investment advisors and prevent fraud play by the advisors who charge an exorbitant fee for their advice. In light of these issues, several complaints were brought before the SEBI against the IA regarding their lack of experience and qualification, unprofessional conduct and charging of the unreasonable and unfair fees to their clients. To devise a solution to these problems and make a more robust regulatory framework for the investment advisors, SEBI has notified the amendments in the IA regulations.
Analysis of the key regulatory changes
Segregation of Advisory & Distribution Activities
One of the major proposals suggested by the SEBI in its consultation released from time to time has finally been adopted by making clear segregation between the advisory service and distribution service provided to the client by an investment advisor. According to the IA Regulations, 2013 individuals and partnership firms were not allowed to provide advisory and distribution services simultaneously. However, the non-individual entities were allowed to do so through a subsidiary or separate identifiable department or division (“SIDD”). This would mean that if a corporate entity wishes to provide both kinds of services to its clients, it can do so by setting up a separate subsidiary that would provide one of the services to its clients. Hence, SIDD does not ensure the segregation of both the services at the client level. Thus, it poses a great difficulty in safeguarding the best interest of the clients since the intermix of advisory and distribution role of non-individual entities incentivizes them to advise their clients regarding such products and goods which are motivated by their ulterior motives of earning commission and hence result into a product biased advise. The amendment has provided the individual investors with the option to register as an investment adviser or as a distributor. It also provides that a non-individual investment adviser such as body corporate, partnership firm and limited liability partnership shall have client level segregation at a group level. This means that they cannot accept the same client for offering both advisory and distribution services. They are also required to maintain an arm’s length relationship between its activities by providing advisory services through a separately identifiable department or division.
No consideration for implementation services
As suggested by various consultation paper released by the SEBI, the amendment has clarified that the investment advisors may provide implementation services but are not allowed to receive any consideration whether directly or indirectly. Implementation services mean offering services to help implement or execute the advice so given. Since it is highly likely that that the entity registered as IA while providing implementation services, would find it difficult to maintain segregation between its advisory and distribution roles and often result in a conflict of interest. Additionally, it has been highlighted in the consultation paper released in January, 2020 that most of the clients find their advisors as a “one-stop shop” and a result the IAs exploit the clients by giving them auto implementation services. This deprives the clients with the choice of availing the implementation services from the IAs. Therefore, the amendment is a positive step which would provide the clients with the choice to avail implementation services from anywhere and would not be under a compulsion to avail it from the IAs. Importantly, it would eliminate the possibility of breach of fiduciary duty by the IAs towards its clients and ensure transparency and fairness in the market as IAs would not have any ulterior motive of earning a commission by rendering implementation services to their clients.
Mandatory agreement between Investment Adviser and client
SEBI has introduced a mandatory agreement between Investment Adviser and client, as suggested by all the SEBI’s consultation paper, so as to ensure enforceability and incorporate all the terms and conditions between them in the form of an agreement. Under the erstwhile regulations, there was no requirement for having a mandatory advisory agreement. In the absence of a written contract, most of the terms and conditions between the clients and IAs remained under the veil. This has led to a slew of complaints from the clients against the IAs regarding the unreasonable and exorbitant fee charged by them. Since there was no written agreement between them, the clients found it quite difficult to prove their claims about the unreasonable fee charged and thus had to enforce the contract with unjust terms. The mandatory advisory agreement would infuse transparency and fairness between the IAs and clients. This would also prevent IAs from making false promises and getting away with their claims. Since the terms and conditions would be reduced to a written contract, the enforceability of such a contract would be ensured with fairness.
According to the erstwhile IA Regulations, an IAs could charge fee which is fair and reasonable from its clients. However, the term ‘fair and reasonable’ is quite vague and subjective and leaves for the IA to determine what constitute a fair and reasonable fee. The amendment does not give much clarity on the advisory fee charged by the IA from its clients. It states that the fee shall be in the manner as specified by SEBI. The SEBI in its consultation paper released in January, 2020 has highlighted the need for a regulatory stipulation on the fee charged by the IA and suggested two models for the determination of the fee. The first model stipulated a cap on fixed fee enhanced from INR 75,000 to INR 1, 25,000 per annum per “family of client” across all schemes/ products/ services offered by IA. “Family of client” shall include individual client, dependent spouse, dependent children and dependent parents. The second model also stipulated that the maximum fees that can be charged under the assets-under-advice (“AUA”) mechanism shall be 2.5 per cent of AUA per annum per “family of client” across all schemes/ products/ services offered by IA.
However, it is worth noting that the first model does not solve the problem of unreasonable fee charged to a great extent. Model one, which stipulates a fixed cap from INR 75,000 to INR 1,25,000 per annum, fails to take into consideration that there are different customers who need customized services from the IA. Thus, it is highly unjust for the advisors who, even after putting his best of effort and giving quality advise for complex and valuable assets, could charge only INR 1,25,000. On the other hand, the second model is a more reasonable method of determining the fee since it takes into account the AuA and charge 2.5% of it as the advisory fee. Hence, the fee charged is determined by evaluating the assets for which the advice was rendered.
SEBI is expected to shortly come out with the press release, notifying the guidelines dealing with the modes of charging fees and other terms and conditions. The author, however, suggests that the possible ramifications of both the models should be closely looked into and accordingly changes should be incorporated in the next amendment relating to the modes of charging a fee to ensure a balance between the interest of IAs and their clients.
Eligibility criterion for the Investment Advisor:-
The net worth criteria for registration of an individual entity and the non-individual entity as an investment advisor has been increased from 1 lakh and 25 lakh to 5 lakh and 50 lakh respectively in accordance with the consultation paper released in January 2020. This, however, would create unnecessary impediments for the new and small advisors to step in the market. It would also result in the influx of deep-pocketed companies into the advisory markets and force small scale advisors out of the market since they would not be able to compete with the deep pockets corporate. Importantly, the hike in the net worth from 1 lakh to 10 lakh is ten times the earlier net worth for individual entity, while the raise from 25 lakh to 50 lakh is only two times for a non-individual entity. Therefore, the enhancement is more onerous and unbalanced for the individual entity and thus seems very problematic and unreasonable for an advisory industry. Moreover, neither the amendment nor the consultation papers released from time to time provide any strong rationale behind the enhancement of the net worth criteria. A consultation paper issued in 2020 merely states that the financial capability is an important factor while assessing the capabilities of an IAs, however, it does not explain how enhancement in the financial abilities of an entity adds value to the services rendered and make the advisory industry more robust and effective. Additionally, unlike the change in the enhancement of educational qualifications, where SEBI has expressly exempted the existing IA from the compliances, the amendment with respect to the increment in the net worth criteria does not clarify whether this condition applies to the existing investment advisors. If it does, it would drive a large chunk of small scale advisors out of the advisory industry. Thus, the surrounding ambiguity around the retrospective application of the enhanced eligibility conditions of IAs should also be clarified and the existing IAs shall be exempted from such changes
Enhanced educational qualifications:-
The amendment requires that the individual investment adviser or a principal officer of a non-individual investment adviser should have an enhanced professional or post-graduate qualification in relevant subjects and relevant experience of five years. The amendment is in line with the suggestion made in a consultation paper released from time to time. The amendment, however, has exempted such existing IAs which is specified by the SEBI from the compliance of the enhanced educational qualification. This implies that the SEBI has intended to apply these changes retrospectively to all the IAs. While this is a laudable change made to improve the quality of advice rendered to the clients, the retrospective application of such a change would also force many existing IAs out of the advisory industry.
The recent amendment in the IA regulation is a positive step to bolster the regulatory framework of the investment advisors in the market and ensure that the interests of the clients are not compromised due to the surrounding dust and ambiguity in the advisory and distribution services of the IAs. While most of the changes bought are expected to improve the quality and effectiveness of the advice rendered to the clients without being driven by the advisor’s self-interest, the increment in the net worth criteria for the IA seems unreasonable and creates an entry barrier for many small scale advisors. Therefore, it is pertinent that the SEBI should reconsider some of its stringent compliances rules which create unnecessary impediments for the advisors and are likely to drive them out of the advisory industry due to their failure to meet the onerous net worth compliance.
[i] Suvam is a fourth-year student at National Law University, Jodhpur. He has a keen interest in corporate laws. For any discussion related to this article, he can be contacted via firstname.lastname@example.org.