SEBI vide its order dated December 29, 2022, imposed a penalty of Rs. 1 Lakh on DSP Investment Managers Private Limited (AMC) for bearing expenses of the DSP Nifty 50 Exchange Traded Fund (DSP ETF) out of its own pockets.
SEBI noticed in one of the compliance test reports submitted by DSP that the actual Total Expense Ratio (TER) of the mutual fund was higher than what was being charged to the investors, thereby indicating that the excess amount was absorbed by the AMC. It was observed that the AMC charged investors for a TER value of only 0.07 per cent while the actual TER that should have been charged to the investors amounted to 0.16 per cent.
This led to the conclusion that the balance 0.09 per cent of the TER was absorbed by the AMC and paid from their own pockets. SEBI considered this activity of the AMC to be in violation of the SEBI Circular dated October 22, 2018.
Relevant laws on charging expenses to the Scheme
SEBI through a circular dated October 22, 2018, mandated that all the expenses related to a scheme should be within regulatory limits and be charged to the investors and not be borne by the AMC. Furthermore, Regulation 52(6)(b) of the SEBI (Mutual Funds) Regulations, 1996 provides that the regulatory limits, i.e., the maximum permissible TER for an ETF should not exceed 1 per cent of the daily net assets.
Defence taken by DSP
DSP in its response to SEBI highlighted that the law states that any expenses in excess should be absorbed by the AMC; apart from this, the law does not impose an express prohibition on the AMC from absorbing expenses. The AMC substantiated their defence by conveying that their intention behind undercharging the scheme for the expenses borne was to keep the TER attractive to investors and scale up the assets under management. The AMC explained that charging a higher TER will create a burden on the investors. This is because, the scheme was in the process of scaling up its assets under management thereby leading to the operating cost of the scheme as a percentage of the assets under management to be higher during this period. As a result of this, the TER would increase and would consequently discourage investors from investing in the scheme and parallelly would hinder the capability of the fund to increase the assets undermanagement. This action could potentially make the scheme “an outlier in terms of TER and tracking error”. For this reason, the AMC absorbed the expenses of the scheme. In arguendo, the AMC submitted that there is no breach of law as the TER that it incurred on managing the DSP ETF was at 0.16per cent which was still lower than the regulatory limit of 1 per cent.
In its order, SEBI opined that while the TER was within regulatory limits, the bigger concern was that the AMC had borne the cost of the scheme from its own pockets. SEBI laid down the intention of the circular dated October 22, 2018,was to limit the TER of schemes and ensure that AMCs do not absorb expenses on their own books. SEBI elaborated on this by stating that the practice of a mutual fund scheme to charge investors with a lower TER than what it actually incurs has the potential to mislead investors and create anomalies in the mutual fund industries.
SEBI reasoned that practice of AMC bearing scheme expenses can also be unfair as profitable or large AMCs would be able to afford the scheme’s expenses from their own books and this would not provide a level playing field for smaller AMCs who do not have the capacity to bear the expenses of the scheme on their own. Hence, SEBI found that the non-compliance of DSP “is not merely a technical violation but is deliberate one.” It is also pertinent to note that SEBI imposed a penalty of Rs. 1 Lakh on DSP Trustee Limited for not ensuring compliance of AMC with SEBI circular dated October 22, 2018.
Through this order, SEBI has made it categorically clear that it is not permissible for AMCs to absorb expenses pertaining to a particular mutual fund scheme, even if the TER is below the regulatory limits, i.e., 1 per cent. This order delivered by SEBI can act as a double-edged sword where the interests of smaller AMCs will be protected but at the same time may also be detrimental for index funds. Since index funds is a low TER product any AMC which is launching an index fund would not have sufficient AUM to cover its marketing and operational expenses and be competitive at the same time.
Therefore, we believe that a plausible solution would be for SEBI to prescribe a threshold of AUM, lets say Rs. 500 crores. If the AUM of an index fund scheme or an ETF is less than the threshold limit, the AMC can bear the scheme expenses and once the AUM crosses the threshold limit all expenses should be borne by the AMC.
Authored by Anil Choudhary (Partner) and Lipika Vinjamuri (Associate)