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Side-pocketing of Illiquid Securities of Mutual Funds

Finsec Law Advisors

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In the last four years Indian debt market has seen four major defaults which have had a long-lasting impact on the mutual fund industry. One such event occurred in 2015 when Amtek Auto Limited defaulted on the repayment obligations of its non-convertible debentures. The Net Asset Value (NAV) of various mutual funds that had an exposure to the debt instruments of Amtek fell. Anxious unit-holders placed premature redemption requests to limit their losses. When the fund houses received numerous redemption requests at the same time, they were forced to sell their good assets.

Quite recently, the Infrastructure Leasing & Finance Company Limited (IL&FS) defaulted in its debt obligations amounting to Rs.5,000 crore (Rs.50 billion). After this, many fund houses requested SEBI to allow side-pocketing. Side-pocketing allows a fund to segregate its NPAs from other liquid assets. The unit-holders on the day of segregation will be provided with the units of side-pocketed fund on a pro rata basis. In other words, two units are created where one existed. Once illiquid securities are side-pocketed, the remaining fund can continue business as usual. Any proceeds from realization of illiquid securities will be distributed only among the unit-holders of the side-pocketed fund. Side-pocketing freezes the class of investors, so that investors on the day of default are not penalised and new investors do not gain a windfall if there is subsequent recovery.

Prima facie side-pocketing may seem like a solution. However, it is important that any framework permitting side-pocketing addresses basic issues, such as, selection of events that would trigger side-pocketing, securities and funds eligible to do side-pocketing, timing of creation of side-pockets, ways to achieve liquidity for side-pocketed fund (in case the unit-holders intend to exit), trading of units of side-pocketed funds on exchanges etc. Further, it is also important to determine the applicability of existing provisions pertaining to - calculation of NAV on a daily basis, restrictions on the quantum of expenses chargeable to the funds, compliance norms, and classification of the schemes in the categories prescribed by SEBI. Any policy permitting side-pocketing must answer each of these issues after a careful analysis of the financial markets, investor behaviour, and economic and legal policies of the country.

*Mr. Sandeep Parekh is a member of the Mutual Fund Advisory Committee of SEBI.