Governance of Mutual Funds and the Institution of Trustee

Author(s): G. Sethu
Source: Economic and Political Weekly , Apr. 15-21, 2006, Vol. 41, No. 15 (Apr. 15-21,
2006), pp. 1413-1416
Published by: Economic and Political Weekly

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 H T PIarekh finance forum

Governance of Mutual
lower middle class people to invest their
savings, whatever they may be - their
savings may be small or meagre - in any

Funds and the Institution

industrial enterprise or commercial under-
taking. In other words, they do not get any
benefit from the increasing prosperity of

of rustee
the country. They could do that only if two
conditions are satisfied, namely, that the
value of the shares of the industrial unit
is very low so that they can buy them with
The Securities and Exchange Board of India has in the recent past
their meagre savings and, secondly, they
taken big steps in fostering good governance in the mutualfund are prepared to take risk about the fortunes
of that individual unit. In order to diversify
industry, which provides an opportunity to move towards further
the risk, in order to reduce the risk to the
strengthening the governance structures and institutions in the minimum - the risk of investment - and
industry. This article examines afew alternative approaches to also give them a chance to invest any
strengthening mutual find governance through strengthening the amount, even as small as Rs 10, this Unit
institution of the trustee. Trust is being set up." The economic policy-
makers were convinced that mutual funds
G SETHU could offer a safe conduit for household
responding to the needs and circumstances
over the years. The Asian Development participation in equity markets.
Jnvestrment trusts1 had been in ex- Bank (2004) notes with satisfaction that Mutual funds have different kinds of
istence in India since 1869. Notable "unlike many developing markets... investors
the participating.5 While many would
among them were the IndustrialIndian mutual funds market broadly beisquite aware of what is happening to their
Investment Trust establ i shed by Premchand money, there are retail investors who are
able to function effectively, and has a legal
Roychand in 1933 and the Investment and regulatory framework that is farunawarein of the risks associated with invest-
Corporation of India organised by the Tatas advance of many markets, though some ing in the securities markets.6 The latter
in 1936. Though the government of India improvements can be made in both areas." pass the responsibility of managing the
deliberated the setting up of a mutual fund money to the fund houses. This delegation
in 1931, the fund industry, as we know Need for Mutual Funds is more of a fiduciary responsibility rather
it today, came to India in 1963 when Unit than a contractual responsibility. Consider-
Trust of India was established.2 UTI made When the economy is in a growth phase,
able regulatory oversight is required to
several pioneering efforts3 in the industry firms require considerable external financ-
ensure effective exercise of such fiduciary
and secured a strong place in the Indian ing. Unless significant equity capital is
responsibi lity. The power of a robust mutual
investmenet universe. In 1987, nationalised forthcoming, it would be difficult to foster
fund regulatory framework and the result-
banks and public sector insurance compa- innovation and enterprise, the twining
en-investor confidence to augment the
supply of equity capital seems substantial.
nies were allowed entry to the fund indus- gines of economic growth. Consequently,
try followed by the private sector and lack of equity capital might result in nations
international players in 1993. The indus- forfeiting high growth rates. Households
Mutual Fund: A Unique Concept
try has grown in terms of its size, number in poor economies do not have the ability
The mutual fund is a special case of a
of players, assets under management and to assume high levels of risk. Hence, the
the management processes. supply of risk capital in developingcollective
na- investment scheme. In a business
The erstwhile Unit Trust of India was tions would be limited. Any mechanism firm, the customer is different from the
governed by the UTI Act, 1963. The SEBI shareholder. In a collective investment
that mitigates risk would add to the avail-
(Mutual Fund) Regulations, 1996 govern scheme, the shareholder himself is the
ability of equity capital at the margin.
the entire industry at present. The regu- It is worth recalling the words of customer. When a customer wishes to
byT Krishnamachary when he introduceddisengage from a company, he merely
lation is continuously being fine-tuned T
way of amendmlents and circulars. the
TheUTI bill in Parliament in November stops buying things from that company.
regulatory process in the fund industry1963.
is He said "The Unit Trust provides In customer-centric markets, companies
marked by the active involvement of an theopportunity for the middle and lower even accept the returns and compensate
income groups to acquire without much
industry body, the Association of Mutual
Funds in India (AMFI)4 in the consultative
difficulty property in the form of shares..."The H T Ptarekh Finance Forum is
Morarka, a member of Parliament, whileedited and managed by Errol D'Souza,
process. It is acknowledged generally that
participating in the debate pointed out,
much has been done by SEBI in this domain Shubhashis Gangopadhyay, Subir Gokarn.,
"At the present moment there is no Ajay Shah and Praveen Mohanty.
in the past decade and that Indian mutual
fund regulation has been fairly dynamic,
opportunity for the middle class and the

Economic and Political Weekly April 15, 2006 1413

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 MANO HAR
the customer adequately. But it is unusual freedom - that of voting with his/her feet.
to find a similar treatment offered to an The shareholder is given the facility to exit
equity shareholder. In fact, equity is con-from the mutual fund at any time he/she
sidered permanent capital. pleases. This liquidity avenue, as discussed
In a collective investment scheme, should earlier, is offered as an over-the-counter REPORTING THE PARTITION
the shareholder-customerl have a fiee exitfacility by the mutual fund itself. As the OF PUNJAB 1947
or should he/she be asked to find another shareholder in an open-ended mutual fund Press, Public and other Opinions
has the right to exit, she must have ad- Raghuvendra Tanvar
to replace him/her as shareholder-customer?
81-7304-674-3, 2006, 622p. Rs. 1195
The answer depends on which of the twoequate information about the happenings
roles - shareholder and customer - assumes in the investment to time the exit decision.
PUNJAB POLITICS,
primacy. If the shareholder-customer wereThis calls for high levels of disclosure in 1 JANUARY 1944-3 MARCH 1947
a mutual fund. At the time of exit, the
treated as a customer, she would be offered Last Years of the Ministries
free exit. This would mean the company shareholder must also receive a fair price.9 Governers' Fortnightly Reports and
should be prepared to redeem her shares at The foregoing discussion underscores other Key Documents
five features of a mutual fund: Lionel Carter (ed)
all points in time through an over-the-counter
81-7304-662-X, 2006, 392p. Rs. 950
operation. On the other hand, if she were (a) Economies of scale (through pooling)
treated as a shareholder, she would be asked
to participation in the equity market. PUNJAB POLITICS, 1940-1943:
to seek exit through a stock exchange. For (b) Delegation of (fiduciary) responsibility. Strains of War
(c) Right to "vote with the feet".
example, in a close-ende( mutual fund, the Governors' Fortnightly Reports and
shareholder-customer is treated primarily(d) High level of information disclosure. other Key Documents
as a shareholder. In an open-ended mutual(e) Fair. exit price through an over-the- Lionel Carter (ed)
fund he is treated more as a customer. counter redemption mechanism. 81-7304-626-3, 2005, 427p. Rs. 995
In a general collective investment vehicle,
PUNJAB POLITICS, 1936-1939:
the relationship between the shareholdersFiduciary Responsibility The Start of Provincial Autonomy
and the manager is one of contractual
Governors' Fortnightly Reports and
arrangement. The shareholder is the prin- The trustee has a fiduciary responsibility other Key Documents
cipal and the manager is their agent. The vis-ai-vis the investors. Legally, a unit trust Lionel Carter (ed)
relationship is contractual. Efficient enforce- is, as the name implies, a trust fund. The 81-7304-568-2, 2004, 443p. Rs. 995
ment of contract depends on completenesstrustee on behalf of the beneficiaries, the
PAKISTAN
of the contract, capacity of the principal unitholders, holds the assets. The trustee's
Nationalism without a Nation?
to monitor the contractual deliverables, principal role is to act as the custodian of the
Christophe Jaffrelot (ed)
and the efficacy of the legal system in actual securities in which the fund invests
81-7304-407-4, 2004 (2002),352p. Rs. 650,
enforcing contracts. When the principal is and to oversee the operations of the fund Rs. 450 (Pb)
not up to this task, she delegates this manager.i0 The trustee ensures that the
responsibility to another. The relationship fund sticks to its investment objective set PATHWAY TO INDIA'S PARTITION
between the principal and the entity that out in the trust deed. It is also the duty of Bimal Prasad
Vol. I: The Foundations of Muslim
assumes this responsibility is a fiduciary the trustee to ensure that no one group of
Nationalism
arrangement. The mutual fund structure unitholders is treated preferentially. In
assumes that the unitholders neither have 81-7304-248-9, 1999, 319p. Rs. 600
administrative terms, the assets of the fund
Vol. II: A Nation within a
are held in the trustee's name. It is the
the time nor the skills to monitor the agent's Nation 1877-1937
performance. In the trust structure, thetrustee who issues the unit certificates when 81-7304-249-7, 2000, 469p. Rs. 800
individuals buy units. Besides creating and
trustee assumes the fiduciary responsibility. 81-7304-248-9 (Set)
Mutual funds in India have, therefore, liquidating units, the trustee supervises the
decided to follow the trustee structure.7 register of unitholders, settles all invest- PANGS OF PARTITION
In a mutual fund there are two kinds of ment transactions, collects the income of S. Settar and Indira Beptista Gupta (eds)
Vol. I: The Parting of Ways
ownerships. First, the shareholders8 arethe trust in the form of dividends on the
the beneficial owners: second, the trustee shares held, and distributes it to the share- 81-7304-306-X, 2002, 368p. Rs. 700
Vol. II: The Human Dimension
is the registered (and controlling) ownerholders. The two parts of fiduciary obli-
81-7304-307-8, 2002, 358p. Rs. 700
of the assets of the mutual fund. While the gation are duty of loyalty and duty of 81-7304-305-1 (Set)
benefits arising out of investments go tocompetence. Absence of either renders thefor our complete catalogue please write to us at:
the shareholders, the management controlfiduciary role ineffective. The first prin-
~' 0 ' * " :'K
of the investment manaager vests with theciple of mutual fund governance is the
trustee. As shareholders are ill-equippedfiduciary role played by the trustee.
to monitor the investment function, they are
unlikely to be able to assess the perfor-Role and Position of Trustees B "S

mance of the trustee too. For this reason, in

a trust structure, the beneficial owner has In India, mutual funds seem to combine
no control on the business judgment exer-practices from the US and UK. The trust
cised by the trustee. Given this loss of controlstructure came from the UK. While tle
B{
on the way his/her money is managed, theregulation offers the choice of forming a
shareholder is given a compensating trustee company or a board of trustees.

1414 Economic and Political Weekly April 15. 2006

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almost all mutual funds in India follow the high level of mutual fund expertise. This
A possible method of improving mutual
trustee company model. A company is situation is not conducive to the exercise fund governance in India would be to
consider entrusting the trusteeship to cor-
formed and the sole duty of the company of competence. The directors of the trustee
is to function as the trustee of a mutual company receive sitting fees when theyporations whose business is to provide
fund. The board of the trustee company attend the board meetings. This amount is trustee services. 14 Such practice is prevalent
is required to have a minimum number (at moderatet2 and perhaps not commensuratein the debt markets of India where deben-
ture trustees intercede between the lenders
least two-thirds) of independent directors.with the level of responsibilities expected
In theory, the members of the board of the to be discharged by them. Inadequate and borrowers. This mitigates the credit
trustee company are identified by the compensation may result in a superficialrisk and helps in monitoring the debenture
sponsor. For all practical purposes, thistrusteeship function. covenants and terms more effectively.
task is left to the asset management com- Under Indian mutual fund regulations, There are three specific advantages. First,
pany. These names have to be approveda minimum of 40 per cent of shareholding inthe trustee company could be large15 and
by the Securities and Exchange Board of the asset management company is requiredindependent. Second, the specialist trustee
India. Whether the independent directors to be held by the sponsor. The trustee iscompany would be able to discharge the
would act independently is predicated uponappointed by the sponsor. The assettrusteeship duty more professionally. Third,
the directors identified. the regulator would be able to specify the
management company is appointed either
preconditions for an entity to be registered
The responsibilities of the trustee com- by the sponsor or the trustee. It is not clear
pany resemble the responsibilities placedif it is possible for the trustee to terminate with it as a specialist trustee company.
on the directors of mutual funds in the US. the asset management contract. It appears Among other conditions, it would be
The first level regulation of mutual funds in that the sponsor, the asset management possible for assessing the risk of the trustee-
India rests with the trustee. The actions company and the trustee are tied to one ship business and prescribing adequate risk
taken by the trustee are deemed to be the another in a gridlock. Unless clear inde- mitigating mechanisms through a possible
actions of the mutual fund. The trustee is pendence is established between the assetcapital adequacy norm for the trustee
charged with many duties. It is the dutymanagement company and trustee, con- company.
of the trustee to approve the appointmentflict of interest13 is unavoidable. Such
of directors of the asset manacgement conflict of interest dilutes the loyalty of
Institutionalising Better
company, obtain periodic reports from the the trustee to the unitholder. Thus, the two
Governance
asset management company about the fund parts of fiduciary obligation, Inamely, duty
operations, monitoring security dealings of loyalty and duty of competence, are Currently, the Securities and Exchang
of key personnel of the asset management likely to be vitiated. Board of India encourages the AMFI to
company, review of contracts, file As the trustee company in the currentbring industry inputs in framing better
periodic reports to the regulator, and tomutual fund regulations has low capitalregulations for the mutual fund industry.
discipline the asset nmanageiment coim- and a meagre revenue base, it does not The Mutual Fund Advisory Committee
pany.1l These duties are considerable inhave the capital adequacy to meet the deliberates on desirable changes in regu-
liabilities that could be faced by the trusteelatory practices and recommends them to
magnitude and call for significant exper-
tise and devotion of time. Trustees meet company in its cturrent form in India. Whilethe regulator. An interesting aspect of this
the trust laI does not provide for the unit-
six (or more) timles in a ycar to deliberate edifice is that the trustees are not institu-
on these matters. In addition, often deci- holder to sue the trustee company, tionally represented in the process. AMFI
sions are taken by circulation if deemedindividual mlemibers on the board of the is a body of asset management companies.
urgent. As all directors of the tlustee trustee company could be sued undercertainWhile all activities are undertaken by the
company are non-executive directols,circumstances.
it is Some mechlanisms have asset management companies, legally it
been
debatable how much oversight is feasible. evolved in terms of director's insur- would be difficult to assume that asset
ance but that seems inadequate when assets management companies represent the
Unlike the practice in the US, regulations
in India do not mandate that the trustee under maniaagement are large. A more robust unitholders. In fact, the legal position points
alternative is required to deal with this risk. to considerable conflict of interest. It is
colnpany (and its directors) be provided
with adequate administrative support for only the trustees that can be considered to
discharging their responsibilities. LTrustee represent the unitholder interest.
Specialist Trustee Company
companies have neither an otfice nor staff In the US, independent directors of
of their own. The only office- that has The a situation mentioned above seems mutual funds have established the Mutual
unique to India. In the US, the directors
direct reporting relationship with the t tustee Fund Directors Forum. It is a not-for-profit
company is the compliance officer. The organisation, whose mission is to improve
of the fund appoint all service providers.
fund governance by promoting the devel-
compliance officer is usually an officerInofthe UK, there is no concept of sponsor.
the asset management company. She The has trust deed is between the managementopment of vigilant and well-informed
compalny and the authorised corporate
a dual reporting relationship, one with the directors. This is accomplished by offering
asset management company and the other continuing education programmes to inde-
trustee. In the contractual pool formn preva-
with the trustee company. lent in continental Europe, the depository
pendent directors, providing opportunities
The mutual fund business has its own (which also functions as custodian) super-
for independent directors to discuss mat-
technology and businless complexities. vises the fund operations. In all these ters
threeof common interest, and serving as
When the directors of the trustee company advocates on behalf of independent direc-
cases, the entity that assumes the fiduciary
are drawn from diverse backgrounds, it would
responsibili t is 1sir"'. .. . i' capitalised,
tors.16 The forum is entirely independent
be unrealistic to expect them to possessanda specialised. of the mutual fund advisory industry.

Economic and Political Weekly April 15, 2006 1415

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 In India too a similar initiative could be Notes (ii) Compliance with representations made in
documents distributed to prospective
encouraged by the regulator. A forum of investors.
independent directors on the boards of trustee 1 It is said that the investment trust principle (iii) Performance of the fund portfolio.
companies could provide the necessary originated as a device to avoid the splitting (iv) Quality and cost of portfolio executions.
up of an estate, at the time of transfer to the (v) The manner and cost of distribution of
checks and balances in industry governance.
heirs. Instead of taking a portion of the estate, fund units.
each heir received his corresponding interest
(vi) The custody of fund securities.
Governance Reforms in the trust. The early investment trusts had (vii) Administration of individual investor
their origin. about the middle of the 19th accounts.
century, among certain Scotch lawyers engaged
The major heads of governance reforms 11 This is only an illustrative list.
in the administration of estates. This first
12 Mutual funds collect trustee fees. This fee
in the fund industry have been addressed
investment trust that sought public participation
would be about 0.05 percent of the assets under
by Ruder (2004). These are paraphrased
was the International Financial Society, management or may be even lesser. In all
as follows: London, 1863.
probability, this could be the smallest item of
2 The idea of starting a unit trust was before the
(i) Independence of directors on the board expense in a mutua! fund scheme in India.
governlnent of India since 1931 [Aney 13 See Erlichman (1993) for descriptions of
of the trustee company (three-fourths). 1963:3226]. conflicts of interest.
(ii) Independent chairman of the trustee 3 The original scheme of US-64 stipulated NAV-
14 See ADB Report TA 4010-IN.
company. based sale and repurchase prices. This was
15 The Securities and Exchange Commiission noted
amended in June 1965 allowing UTI to vary
(iii) Establishment of a nominating com- in 2003: Our concern is that in many fund
tile sale and repurchase prices from the NAV-groups the fund adviser exerts a dominant
mittee, an audit committee, a compliance based levels to the extent it deemed lit
influence over the boardc. Because of its mono-
committee and an investment committee, [Pendharkar 2003:2121. In addition to NAV-
poly over informattion about the fund and its
substantially composed of independent based pricing. UTI pioneered the reinvestment frequent ability to control the board's agenda,
directors. plan, voluntary savings plan, children'sthe
gilt
adviser is i in a positio to attempt to impede
plan, savings-cum-insurance plan, distribution
the directors from exercising their oversight
(iv) Facility to the trustee to hire indepen- through bank branches, distribution through
dent counsel and staff. role. In some cases, boards may have simply
post offices, multidimcnsional approach to
abdicated their responsibilities, or failed to ask
(v) Chief compliance officer reporting to marketing, creation of a strong agency network,
tough questions of advisers; in other cases,
use of vernacular language for communications
the trustee (in addition to reporting to the boards may have lacked the information or
with unitholders, etc lalso see Bhatt 19961.
asset management company). 4 Asset management companies are the memlbers
organisational structure necessary to play their
proper role (Investment Company Governance,
(vi) Written compliance policies and of AMFI.
Rel IC-26323. January 15, 2003, p 3).
procedures. 5 The corporate customers and high networth 16 In 2003. Securities and Exchange Commission
(vii) Certification of financial statements investors alve been able to take advantage of asked the forumi to develop guidelines and best
bond funds and short-termi liquid funds under practices in fIve areas where directors' oversight
by the chief executive officer and the chief certain circumlstances. Th valIue of the sche s lmes
financial officer. ,and decisions are critical for the protection of
held by themi ranged from 60 per cent to 90 funid shareholders.
While some of these features are already per cent. See the report on ReJfor, ' o Muttlal
present in the Indian industry, others are Funds. ill Ilndi prepared by Cadogen Financial
and A F Ferguson and Co in November 2003. References
not. These ideas are worth considering 6 In 2001 tlhere were 11.8 million households
with a view to establishing true inde- investing in mIlIltual fitllds in India. This was
Asian Development Bank (2004): 'India:
pendence of the trustee. 6.7 per cent of all households. Middle to highReform of Mutual Funds', Final Report TA
income households dominai;ted. Retail 4010-IN.
investment iln mutual funds was mlostly froml
Ancy, M S (1963): 'Proceedings of Lok Sabha,
Conclusion ur.ban centres. See Stirve\ lf hllici Inivtestol-s,
Decemlber 5, 1963, Unit Trust of India Bill,
SEBI-NCAER, March 2003.
1963', p 3226.
If the nation has to fund its economic 7 There are other formis of legal structures Bhatt,
for R S ( 1996): 'Unit Trust of India and Mutual
growth internally, mobilising household nmutual funds. In the US,the legal structure is an Funds', UT1 Institute of Capital Markets, Navi
savings towards equity capital is inevi- investment company. In some parts of Europe, Mumhai.
mutual funds are contractual pools. In the Brown,
UK D A (2000): Towards Improved Fund
table. The mutual fund industry could play and Australia, mutual funds are unit trusts.
Governance: The Way Forward', (ntario
a vital role in this nation-building task.8 The terms shareholder aInd unitholder are used Securities Commission.
Small investors would be comfortable interchangeably by us in the context of mutual Erlichman, S I (1993): 'Managing Potential
funds. In India, the term unitholder is used; in Contlicts of Interest' in Mutual F,unds: NAew
entrusting their meagre savings to mutual
the US, the term shareholder is used. Productls, New Comlpetitors, Newv Ruiles, the
funds if they perceive good governance in parties should see the price as fair: the
9 Three Canadian Institute, Toronto.
the fund industry. The trustee of a mutualselling/buying shareholder, the other share- Pendharkar, V G (2003): 'Unit Trust of India-
holders who do not intend leaving the mutual
fund plays a crucial role in this regard. We Retrospect and Prospect', UBS Publishers'
have examined a few alternative approachesfund, and the asset manager. I fthc price deviates Distribution, New Delhi.
from the fair value, then the exiting shareholder Rucer, David S (2004): 'Mutual Fund Reform',
to strengthening mutual fund governance either gets subsidy or offers subsidy. Fair price Statement, Committee on Banking, Housing,
through strengthening the institutionmeans of the precise value of his share of the and Urban Affairs of the US Senate.
mutual fund trustees. The Securities and investments. Valuation of the investment is Stevens, David P (2002): Trust Law Implications of
Exchange Board of India has taken big likely to be a complex and contentious matter Proposed Regulatory Reform of Mutual Fund
under most circumstances. There is one notable Governance Structures', Goldman and Car- LLP.
strides in fostering good corporate gover- exception, however. If the asset has a The Law Commission (1993): 'Collective
nance in the recent past. There is an competitive market, the market price is likely Investments: Other People's Money', Report
opportunity to consider strengthening to be the fairest method to value the asset. For Number 65, the Companies and Securities
this reason, mutual funds are mandated to focus AdvisoryCommittee,Commonwealth ofAustralia.
governance in the mutual fund industry
investments on marketable securities. Thompson, J K and Sang-Mok Choi (2001):
and make it even better. fIs
10 The trustee's supervisory function includes: 'Governance Systems forCollective Investment
(i) Advisory fees and fees of other entities Schemes in OECD Countries', Financial Affairs
Email: gsethu@utiicm.com providing services. Division, Occasional Paper, Number 1, OECD.

1416 Economic and Political Weekly April '5, 2006

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