The US-64 Controversy

Biwesh Neupane, 10106, MBA Fall 2010

Case Synopsis

Unit Trust of India (UTI), a mutual fund, introduced the Unit Scheme-1964, (US-64), which was an open
ended scheme that in its early days mobilized huge sum of money and paid dividend higher than the
bank's deposit rate. This created trust among average Indian investors to invest in this scheme.
However, later the trust turned into distrust, once it was found that the fund was mismanaged. The
equity component of US-64 increased to 70% of the portfolio in 1990s which was around 30% in 1980s.
UTI invested in those scrips whose market value was falling. Due this the reserve of UTI turned negative
in 1998. Few restoring movements were done such as restricting of US-64's portfolio, launch of new
scheme called SUS-99, injection of fresh funds of Rs. 500 crore, tax free dividend, and creation of
trustees. Restoring movements showed the color and helped to gain the fading trust of investors, and
soon was declared as one of the best alternative investments. However, with involvement in K-10
investment (list of Ketan Parekh infamous stock), UTI was involved in yet another scam, which raised
doubts as to US-64 being an inherently weak scheme.

Question 1: Explain in detail the reasons behind the problems faced by US-64 in the mid 1990s.
Were these problems the sole responsibility of UTI?

In 1998, the reserves of US-64 had turned negative by Rs. 1098 crore. Because of which the SENSEX
dropped heavily and increased selling pressures from Foreign Institutional Investors (FII). This
resulted in decline in trust among investors and few nervous investors redeemed US-64 units worth Rs.
580 crore. The reasons behind these problems were:

a) High investment in Equity Stock:

As a disinvestment plan of the union government, UTI invested huge sum of money in public
sector unit (PSU) such as MTNL, ONGC, IOC, HPCL and SAIL. The portion of equity in the
portfolio of US-64 was around 30% in 1980s which increased to around 70% in 1990s. US-64
did not take account the requirement of the small investors who wanted fixed, regular returns
which is generally achieved through investment in debt instrument.
b) Mismanagement of funds
The investment made on those stocks did not yield high return because market value of the
stock declined sharply and they did not off load the equities when the market started declining.
More than that, the stock on which UTI invested was not growth stock rather they were
injecting money on the stock whose value was declining. This practice raised question about
further scam inside UIT.
c) Rules and regulation
The investment details of UTI were kept very secret and NAV figures were not revealed. These
gave huge opportunities to the management of US-64 to easily manipulate the funds to gain in
short term. All the management was very keen to show short term gain to US-64, which made
them mismanage the fund. The chairman of US-64 has an arbitrary power to personally decide
an investment up to a huge Rs. 40 crore. Such liberalization was tailor-made for frauds.

Yes, I think these problems are the sole responsibility of UTI, because the improper fund management
was the major issue regarding this problem. UTI invested largely in equity market instead of debt
market, to offer high dividend to the investors. And even during the crisis period, UTI kept on giving
dividends from its reserves, yearly income and sale of appreciated stocks. UTI had kept the sale and
purchase price artificially inflated by injecting more and more money into its equity based portfolio. It
was UTI's responsibility to make sure that US-64 invested primarily in debt instruments to give
adequate and fixed return to its investors rather than invest heavily on highly volatile stock market,
that too, in non-growth stocks.

Question 2: Analyze the steps taken by UTI to restore investor confidence in US-64. Comment
briefly on the efficacy of these steps.

Following steps were taken to restore investor confidence in US-64:

Formation of Review Committee:

When the UTI reserves became negative, UTI realized that it was high time to rethink about the
US-64. At this point of time, a committee under the chairmanship of Deepak Parekh was formed
who review the scheme and recommend measures to strengthen the position of US-64. This was
a very strategic step which proved to be very efficient as majority of recommendations helped
US-64 to bounce back. But still its efficacy can be doubted because some of the measures
forwarded by the committee were not implemented properly like the more involvement of
retail investors and the step to make divided tax free was also doubted by investors.

Introduction of SUS-99
The Special Unit Scheme -1999 was aimed as a bailout package by the government. In 1999, UTI
issued to the government special units of SUS-99 worth the book value and in turn government
issued dated securities worth Rs. 3,300 crore to take over the scrips of PSUs from the US-64
scheme. This bail out helped the US-64 to reduce its risky portfolio by getting rid of the non-
growing stocks which helped them to increase their NAV but it also highlighted the inherent
problems of UTI such as political interventions in the investment decisions of UTI and a total
lack of accountability.

Injection of fresh fund by core promoters

Core promoters injected further Rs. 500 crore which strengthen the capital base of the scheme.
This effort helped UTI to reduce its reserve deficit and also purchase some growth stocks in the
portfolio.

Portfolio Restructuring:
The portfolio of UTI was restricted by including growth stocks such as Satyam and Infosys and
selling underperforming PSU such as Indian Ryano, Tosco and Hindalco. This was the most
important step as it helped UTI to quickly reap the benefits of stock market. As a result, the
growth stock had outperformed the Sensex.

Tax free dividend and concentration on retail investors

The income distributed under US-64 was made tax free for three years to encourage retail
investors to invest but it did not increase the investors' confidence because most of the
investors were very small and aged, and thus could not reap benefit of tax redemption, rather it
encouraged big corporate investors to invest in lieu to tax exemption.

Organizational Restructuring
Five new additional trustees were added and given emphasis on a proper system of
performance evaluation of all schemes, marked-to-market valuation of assets and evaluation of
performance benchmarked to a market index. Likewise, research teams were established to
 become more proactive in fund management, and sub-groups were created to manage the debt
and equity portion. The restructuring helped US-64 to compile with the regulations and
guidelines and norms of UTI and also review the scheme's performance and guide future
managers on the future course of action.

NAV driven Scheme and divestment of real estate

Initiative was taken to make US-64 Scheme NAV driven and to increase the spread between
sales and repurchase price. NAV based scheme means that per share price of a mutual fund is
based on NAV not based on the forces of demand and supply. This makes sure that NAV of the
mutual fund is based on the underlying securities it hold, not on the bidding of the fund's share.
Thus, NAV will reflect the true picture of the market. Previously, only the sale and purchase
price was disclosed by UTI which resulted in tendency of fraud. NAV driven mutual fund has less
chances of fraud.
Likewise, UTI also transferred its real estate investment to Development Reserve Find as it was
against guidelines for mutual funds.

Question 3: As a market analyst, would you term US-64 a safe mode of investment? Justify your
stand with reasons.

As a market analyst, I would not term US-64 as a safe mode of investment rather I would instruct
investors to sell their US-64 units at least enough to break even on his investment in the scheme.
Following are the reasons to support my stand:

They should sell the units enough to make them break even and hold on to left over units such
that if UTI sees any improvement in future the investors can make money out of it. UTI is
repurchasing its units at Rs. 14.25 where as its book value is worth only Rs. 9. Hence, the
investors should sell its units to UTI so that they can get Rs. 14.25 per unit.

At present, for every buy back, UTI is actually incurring loss of Rs. 5.25. In addition to this, to
pay the dividend of around 10 - 20 %, US-64 has to dip into its reserves. If the Sensex dips
down, then the whole reserve will deplete, which will put UTI again in crisis.

Provided the current scenario, UTI might skip paying dividends later year to preserve the
reserves, without the dividends there is no point in holding on to or purchasing units of US-64.

UTI has been very reluctant to become NAV driven Mutual Fund and also has not made public
its investment strategies and actual NAV. Due to this, there is high chance that the top
management may again involve in some fraud and government would again interfere and
introduce yet another bail-out package to save UTI.

There is high possibility that the repurchase price of US-64 units may not be same at current
level of 15.25 rather there is high chance that the repurchase price may fall in future.
Question 4: US-64 should have been NAV driven from the very beginning like other mutual
funds. Comment.

Truly, US-64 should have been NAV driven from the very beginning. NAV based scheme means that per
share price of a mutual fund is based on NAV not based on the forces of demand and supply. This makes
sure that NAV of the mutual fund is based on the underlying securities it hold, not on the bidding of the
fund's share.

The major reason why US-64 has not been made NAV based appears to be the fact that there is a
substantial gap between the repurchase price of the unit and it's NAV. This gap increases or decreases
depending upon the market price of US-64’s portfolio. Moreover, since US-64 has in its portfolio large
blocks of shares in individual companies, its ability to create liquidity immediately by selling the shares
in the market is restricted, as large sales would depress market prices and further widen the gap. Thus,
US-64 has been historically not basing its repurchase and sale price on NAV, where as it should have
been NAV driven from the very beginning like other mutual funds.

Most of the mutual funds are NAV driven. It is the price at which investors purchase units from a fund
company and sells them to a fund company. NAV is derived from the portfolio of securities it holds.
Thus, the mutual fund's unit price is based on the underlying stocks that it holds. However, US-64 never
disclosed its portfolio holdings and thus never disclosed it NAV. This was intended to protect small
investors as fall in NAV figures would have discouraged the investors. This lead to lack of transparency
as sale and purchase price was not related to NAV and also fueled the belief that UTI and US-64 was
immune to the volatility of the Sensex. The practice of non-disclosure of NAV and portfolio encouraged
the directors to immerse themselves in risky stock rather than debt and also engage in fraudulent
activities.

Had US-64 been based on NAV from the very beginning like other mutual funds, the management of the
fund would have been transparent and within the control of its unit holders as they would know where
their money has been invested. UTI would not have spent so much no stocks that were not growing in
terms of market value rather they would have stuck to their plan in investing in debt instruments more
so that they can provide regular income to its retail investors. Moreover, had it been NAV based US-64
could have reaped the benefits from bullish share market. Since, US-64 did not make itself NAV based
even after Parekh's recommendation, US-64 was not able to reap benefits from the bullish share
market.

Case Summary

To conclude the whole case, US-64 was a money attracter, as it was able to attract money from retail
investors as well as corporate investors since it was backed by government and was thought that
Sensex had less effect on the price of mutual fund schemes. But because of its non-transparent policies
and involvement of huge money, top directors were involved in scam such as investing too much on
non-growth stocks (directors were alleged of promoting those shares by taking bribes from those
scrips), and involvement in K-10 case. These scams made government to interfere on the management
of mutual funds and come up with bail-out packages to save the investors. It showed rays of hopes after
taking many restructuring efforts by the government but still the faith was shaken with involvement on
other high financial scams. At this point of time it was suggested that unit holders should sell its units to
fund at least to make break even on their investment. Had the US-64 been based on NAV from the
beginning, the situation would have come up in the surface at all.

This case was a perfect example of effect of dividend policies, mismanagement of portfolio, effect of
rules and regulations, and involvement of top directors in financial scam.