The Securities and Exchange Board of India has taken note of mis-selling in the financial sector and is planning to regulate the distributors, the only unregulated part of the industry. Sebi Chairman M Damodaran, in an exclusive interview, to Monika Halan talks of his plans of getting the mutual fund agents in line.

The Sebi order on mutual fund amortisation has come very late. The NFO game has been on for two years. Why did it take so long?

First, we need to see AMFI (Association of Mutual Funds in India) as an industry organisation. Industry interests cannot, on a long-term basis, be different from those of the investing community. I thought AMFI would be able to come out with satisfactory solutions to the problems that existed.

It discussed the problems, but there was no clear view, so AMFI asked us to take some steps. So we did. We changed the fee structure, asked MFs not to use the term IPO and 'at par', and also pulled up fund houses on specific misleading advertisements.

One of our major concerns now is with the distribution industry. The AMCs are regulated and investors are coming in. And then you have distributors who are not regulated, who are driving the churn because there is enough money to be pulled in and are also encouraging fund houses to indulge in questionable practices.

We wanted AMFI to address this. Here, as expected, there was no unanimity; some fund houses are happy and some are not, depending upon the value systems they subscribe to. So we gave them time, we thought they would come up with alternatives. But they are no closer to a solution today. So we thought it best that we announce our intention of regulating distributors.

How do you plan to do this?

One of the ways we thought of is to involve the trustees more. Trustees exist today as representatives of the investor and ensuring that the asset management compnay (AMC) does a reasonable job. So, we thought, why not ask the trustees to see whether there are distribution practices that are against the interest of the investor.

In some sense, we haven't used the trustees well enough. I also think the trustees have not asserted themselves adequately. But maybe they do not have a clear understanding of their role.

It could also be because trustees are appointed by those who set up the fund. If you have the sponsor, the chairman of the sponsor company, heading the AMC and you have his number two as the associate member of the trustee company, what role can the trustee play? Do you expect this number two or three to question the practices of an AMC headed by his own chairman?

But more than how many trustees are independent -- a majority need to be independent -- it is really who they are that is important. Just as companies have independent directors, it depends on who these people are and to whom they owe their allegiance.

Right now the role of trustees is only on paper, it has not been activated.

Exactly. They may be meeting with the prescribed periodicity, but what do they do during the meeting? They also get the prescribed agenda (in terms of what Sebi requires them to comment on) from the AMC, since they have no independent source. We want to get trustees activated.

Of course, there is another model, which has been adopted in Europe -- some countries have a professional trustee company to whom you contract out the function of trusteeship.

Isn't that in the Cadogan Report?

Yes, that report has said that Sebi should look into this. But I really don't think this gets the kind of acceptance we are looking at.

That is one model. To have a few trustee companies, who understand the role and responsibilities of the job better and do this for a fee. You can argue that to continue the business relationship they might drop their guard. But, really you won't get a perfect solution. Even without going in for that, Sebi could engage with the trustees a little more because they are first-level regulators of this industry at the fund level. To consider them to be batting for us is something we have to do.

Can you do that without changing the 1996 Regulations?

Yes, we can do that. This is on the cards, in fact, even as I speak to you today, half the papers here are details of the trustees. (Patting the papers to his left).

Funds say that they are unable to control the distributors. Can Sebi regulate just by activating the trustees or is there a need to get the distributors to register with you?

Ultimately, that is where we are headed. We are headed to a situation where the distributors will be registered with us, as in the US.

But in the US, if you notice, it is not the SEC (Securities Exchange Commission) that regulates them but the NASD (National Association of Securities Dealers). We don't have a strong SRO (self-regulatory organisation) tradition as yet. Why I said we'll involve the trustees is because of the kind of problems we are facing.

Let us take a situation, of say, one distributor and five asset management companies. This distributor is looking at who is giving more commission. In the interest of fairness, let's say he's looking at the top five funds that are performing. But in that top five or six, what is it that is driving him to push one fund against the other? If an investor says, "I believe this is the best performing fund and I want it," the distributor sometimes says, "Why do you want that one, take this one. . ."

. . . They say this is 'cheaper' at Rs 10 against the one that is Rs 50.

Yes. But even otherwise, if they have the same NAV, he is not looking at fund performance alone but at his own returns. Clearly, that is something that AMCs can do very little about except through fund performance and investor education.

Equally, the worry is about payments that are not accounted for, apart from the legitimate commissions. Somebody says 'I will meet all your postage expenses', or 'I will send your workforce to Singapore'. All that is happening; we don't need to pretend it is not. Now, if only the trustees see it as part of their role to tell the AMC that they want no part of this, because, at the end of the day, the investors are paying for it. . .

In fact, some fund houses that are not doing this offer lower annual fees.

I know some are doing this. If the trustees said: "We know you are not obliged to charge the maximum that Sebi has permitted. But you are charging this because you are humouring the distributors; ultimately, we can decide if you will manage this fund or it is given to somebody else." Maybe over time some of the unhealthy practices will go away.

I am realistic enough to believe that it will not happen overnight. But I think this is the right direction. The other is that we are expanding. We will get CAs, lawyers and not just ordinary MBAs but those who are accountants and lawyers. And until such time, we have an SRO, or AMFI summons the courage to become an SRO maybe. . .

Won't happen!

(Laughs) There was one attempt my predecessor made in this direction. But until you see a credible SRO tradition, we will have to engage in this ourselves.

There are not too many of them in the business and you need to look at the top four or five in the business and the rest will fall in line.

Why would a person who gets trusteeship fees want to rock the boat by challenging the AMC?

That is the problem with all boards. That is why you need men and women who don't seek this as bread-and-butter but are there to add value. Trustees anyway don't earn a king's ransom.

But trustees have unlimited liability and can be sued by investors, can they not?

True. But how many times has this happened? We've had mutual funds for so long, and any number of AMCs with trustees, has any trustee company ever even told an AMC, forget threaten, either your fund performance is not good enough or your compliance is not good enough? Not even one threat has come.

How can you get the sponsor to hire trustees that you think are good enough?

I will start with the presumption that those who are in the position are good and capable people. But clearly there is need to understand the role of the trustees. Maybe many of those have not been told their true role or the sense of involvement is not there.

Part of our role will be to engage with them and tell them what their responsibilities are. AMFI is an industry body that represents the AMCs. It does not have trustees and it has nothing to do with the trustees. So we need to address these issues. And in 2006, mutual funds are definitely one of the things that Sebi will look into.

But there is a regulatory overlap in the industry. There are pure equity products from insurance companies, supposedly long-term ULIPs are sold for three years. Distributors push ULIPs even to those who may not need them. Shouldn't Sebi be regulating equity ULIPs under the mutual fund rules?

The ULIP product was originally offered by UTI. That is in Sebi's regulatory ambit. But now everybody has ULIPs and they come under Irda. To be fair, Irda has been looking at some of these issues. Prior to Irda, insurance was sold as a tax-saving product. Now it is being pushed as an investment product; someday hopefully it will be sold as an insurance product. That insurance is a subject matter of solicitation should not appear on the bottom of the ads. That should be the central message.

Yes, or like in the case of motor insurance, make a term plan mandatory. But what can we do here?

We are in touch with Irda, and we have a body where there is regulatory coordination among RBI, Irda and the others. But the agenda is usually taken up by issues that RBI and Sebi are interested in, and not so much by Irda issues. But there is really a case for Sebi and Irda to work closely together. For instance, we don't have a category of rounded investment advisors. So, a person who has an insurance product to sell convinces the investor to buy this due to the commission he gets. Allocation amongst asset classes is not taking place because it is driven by who reaches the investor first.

Do we need an umbrella regulator?

This by itself does not create a case. The FSA (Financial Services Authority) model itself is only a few years old. I don't know whether, in the Indian condition, this is the best model. It is not that we have a serious problem in regulatory co-ordination. There is no friction between regulators, but we have had regulatory gaps. I think we can address such issues in the present regulatory model.

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