Consent Of Majority Shareholders Needed for Winding Up the Debt Funds

Winding up of a mutual fund is always bad news for the investors, as it involves the sale of all the fund’s assets and the distribution of the proceeds received to the unitholders.

INTRODUCTION

The economy is going through a volatile situation, and the credit goes to the pandemic that the world is currently facing. The COVID-19 pandemic, which knocked the doors of the Indian economy in the later days of March 2020 has left several industries scrambling for making even. The share market, though has seen tremendous growth, has also seen great falls during the past year, which makes the situation riskier than ever.

For investments in share market, several people are looking only at the risk factor, because as they say, higher the risk, higher the return. However, the common people with a limited earning are eager to invest in low risk, fixed-return schemes which are linked to the share market. Debt funds are one such scheme. However, the debt funds might not be sailing through as one of India’s largest mutual fund houses, Franklin Templeton lately decided to wind up its six debt mutual funds. The six fund that are liquidated by the firm are Franklin Low Duration, Franklin Dynamic Accurate, Franklin Credit Risk fund, Franklin Short Term Income, Franklin Ultra Short Bond, Franklin Income Opportunities Fund. Cumulatively, these six funds manage assets of over Rs. 26,000 crores.

Considering the situation and the regulations for winding up of the mutual funds, the Supreme Court of India intervened and gave a landmark decision in favour of shareholders. Let us take a look at it.

DEBT FUNDS IN INDIA

For understanding the entire situation, we need to understand what a debt fund is. Investing money in a debt fund is equivalent to lending money to the entity issuing such an instrument. A debt fund, once created, invests the money in fixed-interest generating securities like corporate bonds, government securities, commercial papers, treasury bills and other market instruments which garner a fixed rate of interest over the amount invested. The basic aim behind investing in debt funds is to earn a steady income through interest and capital appreciation. Before buying the debt fund, the issuer decides and communicates the rate of interest that would be received by the buyer at the end of the maturity period. Hence, these debt funds are also known as fixed-income securities.

The instrument in which the debt funds invest is based on the credit rating of the said instrument or security. The security’s credit rating signifies the risk of default involved in disbursing the returns that the debt instrument issuer has promised. To ensure that the fixed rate of interest that has been promised to the buyer is available, the fund manager of the debt fund invests in only high rated credit instruments.

A higher rating in terms of credit ensures the entity timely and regular payment of the interest on the debt security as well as the payback of principal amount upon maturity. Volatility is also a factor considered while investing. Debt funds investing in higher rated securities are less volatile as compared to those investing in low rated securities.

Also, maturity of the debt fund depends on the investment strategy of the fund manager of the debt fund and the overall interest rate regime in the economy. A falling rate of interest in economic regime encourages the fund manager to invest in long term instruments. However, when there is a rising rate of interest in the regime, the fund manager is encouraged to invest in short term securities.

The aim behind debt funds is to optimize returns by investing across all classes of securities available in the market. This allows the debt fund to earn decent returns without much expenditure. However, there is a greater risk if the returns are not guaranteed.

Debt funds often fall in a predictable range of interest and this makes them safer avenues for conservative investors who invest for future gain rather than for risk taking. Debt funds are also suitable for people with short term and medium-term investment horizons rather than long term investment horizon. Short term investments range from 3 months to one year while medium-term investments range within the period of 3 years to five years.

For short term investments people like to keep their money in savings accounts, however the returns received in short term investments in debt funds like liquid funds gives greater returns and interests, proving themselves to be ideal investments as compared to savings bank accounts. Liquid fund offer a greater return in the range of 7% to 9% along with safety of liquidity to meet emergency requirements which might not be available in terms of returns in a Savings Bank account.

As for medium term investments, debt funds like dynamic bond funds are ideal for riding the interest rate volatility. As against a five-year FD, debt bonds offer greater returns and greater interest rates. For people looking for regular income through investment, there is a scheme for monthly income plans under the debt funds like dynamic bonds.

Debt funds work best for those investors who are averse to risk and want a regular income. The interest in such securities is higher and predefined, the investment is secured and the return of the principal amount investment upon maturity happens in full.

For different and diverse investors, there are different types of debt mutual funds. The primary basis of differentiating between the debt funds is the maturity period for which they are invested in. On this basis these are the following types of debt funds:-
  1. Dynamic bond funds
Dynamic bond funds, as the name suggests, are dynamic funds. The fund managers in these debt funds keep changing the portfolio composition time to time as per the fluctuating interest rate prevailing in the market. Dynamic funds have different average maturity periods as these funds take interest rate calls in investing instruments for longer as well as short term maturity page.
  1. Income funds
Income funds take call on the interest rates and invest predominantly in debt securities with extended maturity periods. This factor makes them more stable than dynamic bond funds as their average maturity stands between five to six years.
  1. Short term and ultra-short term debt funds
These debt funds are those in which the investment instruments are done for shorter maturity periods ranging between one year to three years. Short term funds are ideal for conservative investors who are do not want to be affected by the interest rate movements.
  1. Liquid funds
Liquid funds are those debt instruments where by the maturity period does not exceed 91 days. This factor makes them almost risk free and they rarely see negative returns. These funds are better alternatives to saving bank accounts as they provide similar liquidity with higher rates of return and interest. Many mutual fund companies offer instant redemption on liquid fund investments through unique debit cards as well.
  1. Gilt Funds
Gilt funds are those debt instruments that invest only in government securities which are high rated and involve very low credit risk. Since government seldom defaults on loan repayments that it takes in the form of debt instruments, gilt funds are an ideal choice for non-risk-taking fixed income investors.
  1. Credit Opportunities Funds
Credit Opportunities Fund are newly debt funds and unlike others, credit opportunities fund does not invest as per the maturity of the debt investments. These funds try to earn higher returns by taking a call on credit risk or by holding lower rated bonds that come with higher interest rates and are relatively riskier than other debt funds.
  1. Fixed Maturity Plans
These debt funds are closed-ended funds which invest in fixed income securities like government securities and corporate bonds. The money invested in these plans have a fixed horizon as the funds are locked-in. This period can be a few months or can run into years, However, the investment can be done only during the initial offer period and not later. The structure of a fixed maturity plan is similar to a fixed deposit as it delivers superior and tax effective returns. However, it does not guarantee high returns against the investment.

Gains and incomes arising out of debt funds are taxable in nature. The dividends offered by all classes of mutual funds, including debt funds are taxed in a classical manner. They are added to the overall income of the taxpayer and are taxed at a rate of income tax slab within which the taxpayer’s taxable income falls.

Earlier, the dividends of up to Rs. 10 Lakhs a year were made tax free in the hands of the investor, however, post the Budget of 2020, the rate of taxation on capital gains of debt funds was made dependent on the holding period. If the holding period of the instrument is more than three years, then the same would be termed as long-term capital gains while, if the holding period of the security is less than three years, it is termed as short-term capital gains.

The short-term gains are taxed at the investor’s tax slab while long-term gains are taxed at a rate of 20% after indexation.
 
WINDING UP OF A MUTUAL FUND

Winding up of a mutual fund is always bad news for the investors, as it involves the sale of all the fund’s assets and the distribution of the proceeds received to the unitholders. The entire exercise comes across more of a forceful sale from the point of the view of the investors, and in the worst case, the investor might have to suffer a loss while paying the capital gains tax as well.

A mutual fund can be wound up in the following situations:-
  1. Failure of asset management company in managing the scheme.
  2. Poor performance ranking leading to reduced asset flow and low track record of fund house.
  3. Failure to meet the requirement of minimum assets for open-ended debt-oriented schemes (Rs. 20 Crore at all times as per SEBI).
  4. Close ended scheme shall be wound up after expiry of its fixed duration unless it is rolled over for further.
  5. Under happening of any event, where in the opinion of the trustees, scheme is required to be wound up or 75% of the unitholders of a scheme approve in a resolution that the scheme should be wound up or the board decides so in the interest of the unitholders, after repaying the amount due to the unitholders.
When is scheme is decided to be wound up, the trustees given notice to the board, in two daily newspapers that have circulation in whole India, and in one vernacular newspaper that is circulated at the place where the mutual fund is formed, disclosing the circumstances and all the particulars of the circumstances that led to the winding up.

The following are the steps that need to be followed while winding up:-
  1. A meeting is called by the trustees whereby the unitholders authorize trustees or anyone carrying out the winding up process, by voting at the meeting, and approve the resolution by a simple majority. However, if the scheme is wound up at the end of the majority period of the scheme, the meeting of the unitholders is not necessary.
  2. The trustee or any authorized person appointed by unitholders shall dispose of the assets of the scheme in the best interest of the scheme unitholders.
  3. The process of sale is completed and the proceeds realized shall be first utilize towards the discharge of outstanding and payable liabilities under the scheme.
  4. An appropriate provision is made to meet the expenses connected with the winding up.
  5. The balance amount shall be paid to the unitholders in proportion, with respect to their interest in holdings of the scheme as on the date of the decision of winding up.
Once the process of winding up is completed, the trustees shall forward the report of the entire process to the board and the unitholders containing the following particulars:-
  1. The details of the circumstances leading to the winding up
  2. Steps taken for disposal of fund’s assets before winding up
  3. Expenses incurred by the fund for scheme’s winding up
  4. Available net assets for distribution to the unitholders
  5. A certificate from fund’s auditors
Once the report is received by the board and it satisfies the board that all the measures taken for winding up of the scheme are at par with the compliance, the scheme seizes to exist.

As an investor, in the event of winding up, the mutual fund pays a sum to the investor based on the NAV at the point after adjusting the expenses. Unitholders are entitled to receive a report as mentioned already on winding up from the mutual funds with all the necessary details as mentioned above.

If any complaints arise out into winding up, the mutual fund offer document contains the name of a contact person to whom the investor may approach. The names of the directors of AMC and trustees who monitor the activities of the mutual fund are also mentioned in the offer document who can also be approached. Investor can also approach the concern mutual fund or the investor service center with their complete.
Even after approaching the mutual fund, if the complaint remains unresolved, the investor can approach SEBI for regulating the grievance. After receiving a complaint, SEBI enquires the entire matter and give notice to the concern mutual fund and follows up with the regular regulations.
 
FRANKLIN TEMPLETON MUTUAL FUND CASE

On 23rd April 2020, the six debt schemes of Franklin Templeton Mutual Fund, holding assets worth Rs. 26,000 crore were frozen after they faced unprecedented redemptions. Before the COVID-19 crisis, the schemes were known for investing in riskier debts to garner higher returns, however, with the pandemic, the wave of redemptions hit the schemes as investors started getting worried about defaults with the falling economy. The schemes initially resorted to borrowing money to meet the redemptions, but once it wasn’t sufficient, the fund house decided to freeze the debt schemes with the eventual aim of winding them up.

Taking up the matter, the Supreme Court in its landmark decision provided some relief to the investors. The apex court ruled that the mutual fund trustees are required to seek the consent of the unitholders in the event of the winding up of a mutual fund scheme.

The SEBI regulations provide three instances in which a fund can be wound up, as mentioned above. Franklin Templeton chose the first option whereby the trustees decided to wind up the schemes. The reason behind the wound up was cited as the liquidity crunch arising out of the pandemic. Franklin Templeton mutual fund said the decision was taken in the best interest of the unitholders, however, contrary to belief, the decision left investors in the lurch as they could not access their own money.

The fund house has distributed Rs. 21,080 crores in five instalments till now however the full recovery is still a while away. SBI fund management is the official liquidator of the six debt funds liquidated by different house.

While holding in deciding the matter, the judges of the Supreme Court stated that denying unitholders say weakens their role in the entire scheme and their right to participate. Unitholders exercise informed choice and discretion when they invest in or redeem the units. Therefore, the trustees have a responsibility and should envision the investors as perceived and prudent and be transparent about the statements, reports etc. This enables the investors to make a conscious decision and continue their support or withdraw it from the mutual fund.

The judges further remarked that the unitholders should not be placid onlookers, impuissant and helpless when the trustees decide about the winding up of the scheme. Since they are the persons who have invested, they have the paramount right to decide if the winding up should be initiated. Subsequently, holders also have a right to veto and override decisions taken by the trustees. In addition to this, the court asserted that the stature and rights of the unitholders can co-exist with the expertise of the trustees as they are well versed with the market. However, the role of the trustees cannot be diluted because they owe a fiduciary duty to the investors.

While explaining regulation 39 to 42 of the SEBI act, the court said that the regulations pertain to the manner and procedure of mining out of the scheme. The court’s order stated that the trustees have to give a notice explaining the circumstances that led up to the winding up to the SEBI as it is regulatory authority. Furthermore, the trustees have a duty to publish the notice as per the regulations of SEBI for informing the investors about the winding up.

From the date of publication of notice, the trustees and the asset management company will cease to carry on the business of the scheme, create or cancel units of the scheme and issue or redeem the units of the scheme. Thereafter, the trustees are required to call a meeting with unit holders to appoint a person as per the votes of the unitholders, who would take steps for the winding up of the scheme and who would dispose off the assets accordingly.

The court prominently mentioned that the scheme should seek the consent of the unitholders after publication of the notice and disclosure of the reasons. The majority shareholders’ consent is necessary in winding up of a debt fund once the public notice is issued.
 
CONCLUSION

Closure of an open-ended mutual fund is a rare occurrence and it is unlikely that we will see a repeat of the liquidity crisis that arose in the debt market due to the pandemic that led to the winding up of the Franklin Templeton Debt Mutual Fund schemes.

However, the fiasco caused by the Franklin Templeton fund house is one which should be considered by the economic and financial experts, and lessons should be taken from it. There was a reason that the fund house decided to wind up, and it was because of lack of liquidity and lesser incentive from the Reserve Bank of India.

However, when this aspect came to light, an important question came forward regarding the consent of majority shareholders. The court cleared the air around the same question, introducing steps to make mutual fund houses and their key employees and trustees more accountable for their actions.

The opinion and consent of the majority shareholders is important, without a doubt, while making decision of winding up. This clarity in law is sure to reap fruits and show results in the future for the better economic growth of the country.