THE FRANKLIN TEMPLETON COLLAPSE AND LESSONS FOR MUTUAL FUND COMPANIES
Updated: Aug 12, 2020
This post is authored by Pranay Bhattacharya, a fourth-year student of B.A. LL.B. at the Maharashtra National Law University, Aurangabad.
Introduction: What is Franklin Templeton Fiasco?
The sustained fall in liquidity and the net value of assets (NAV) in the securities market due to Covid-19 crisis has hit the mutual funds (MFs) market badly. Amidst this fall, global investment giant Franklin Templeton Mutual Fund (Franklin Templeton), one of India’s largest Asset Management Company (AMC or Company) announced voluntary winding-up (on April 23rd) of 6 debt funds schemes with an erosion of approx. Rs 25,856/- crore, as a last resort to preserve the value of unitholders and enable equitable exit for all investors.
The Franklin Templeton trustees have decided that no business activity shall be allowed to “create/ cancel/ issue or redeem” of any unit within the scheme. In this view, the article will focus on Franklin Templeton crisis and fall in liquidity faced by AMCs in the MFs market due to the economic slowdown.
Winding-up Mutual Funds Scheme under SEBI Regulations
For a successful winding-up scheme, an AMC is required to get 3 levels of approval under SEBI (Mutual Funds) Regulations, 1996,[i] i.e. 1) Trustees, 2) consent of 75% unitholders of the mutual fund scheme, and 3) finally SEBI (to exit the market).
In view of the above procedures, Section 39(2)(a) of Mutual Funds Regulation allows the trustees “on the happening of any event which, in the opinion of the trustees, requires the scheme to be wound up” to preserve unitholders value and equitable exit mechanism for all investors.
Hence, the trustees are required to give a notice disclosing the circumstances leading to the winding up, and shall ask the AMC to cease to carry on all business activities of such schemes as underlined in Regulation 40 of Mutual Funds Regulation.
Potential Reasons for failed Mutual Funds Schemes
The conscious strategy of investment in high-risk schemes and low-credit rating funds worked over the years for Franklin Templeton. However, the liquidity crunch due to economic slowdown and Covid-19 effect made things out of control for the company.
Franklin Templeton citing Covid-19 impact coupled with rising redemption requests from investors, the spike in yields (higher yield indicates higher risk) and lower trading volumes of its securities reduced the company’s liquidity to a bare minimum.[ii]
However, it is to be noted that market slowdown may not be the sole criteria for Franklin’s rising illiquidity. Other possible reason for such failure can be analysed below:
Wrong Investment choices by Franklin Templeton: High Risk means High Returns?
“Despite the regulations being clear, some mutual fund schemes seem to have chosen to have high concentrations of high risk, unlisted, opaque, bespoke, structured debt securities with low credit ratings and seem to have chosen not to rebalance their portfolios even during the almost 12 months available to them so far.”
– SEBI’s statement on Franklin Templeton dated May 7, 2020
The main reason for fallout of illiquidity can be analysed from the wrong investment choices made by Franklin in highly volatile and low-rated bonds, i.e., below the AAA category (considered as non-investment grade) having exposure category of high risk to moderately high risk against returns (Refer Image).[iii]
Since low-grade rated bond offers less security and more profit potential, Franklin continued to invest in such bonds even after SEBI 2019 framework,[iv] which warned AMCs not to invest in such schemes due to the risks involved. Further, most of Franklin’s investments were concentrated with risky schemes such as Yes Bank, Piramal-Shriram, Vodafone Idea debt, etc., which made it prone to market volatility.
The image represents the risk factor for unit holders on investment schemes decided by an AMC. [v]
Exiting the market due to stricter SEBI Norms
The second possible reason for such exit can be due to stricter SEBI disclosure norms[vi] for AMCs to compulsorily disclose schemes, investments, and profits in unlisted bonds. Additionally, SEBI has also directed such companies to lower the investment in unlisted non-convertible debentures (NCDs) to not more than 10%[vii] by June 30, 2020 (now extended to 31 December in view of Covid-19),[viii] which ultimately reduces the liquidity in unlisted bonds. Therefore, the stricter disclosure and capping investments in unlisted NCDs could be another possible reason for Franklin Templeton’s scheme closures.[ix]
What Winding-up means for Investors?
Firstly, all the 6 schemes will be restricted in terms of subscription/ redemption or trading until the winding up takes place, which will ultimately stop the investors to purchase/ sell/ dispose off their shares/debentures where the company has invested. This means that inventors shall face the burden and continue remain invested in such schemes without any exit opportunity.
Secondly, the schemes would be in a lock-in period until the date of maturity and the amount to existing investors will be paid in a staggered manner as per the maturity dates of the schemes, coupon, and pre-payments. As per Regulation 41(2), the following order will be followed for liquidation proceeds:
Outstanding dues > Investors with shorter maturity period > Existing investors
It means that investors will have to wait until their portfolio maturity period to receive their dues out of the investments made by the company.
Thirdly, in case of any gains or profits on redemption of debentures, such amount shall be taxed as capital gain from the investors. Therefore, even if the investors gain from the winding up scheme, whatever meager amount of profit or gain, shall be taxed at the time of redemption or closing of the schemes.