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Commentary

Mutual Fund Mis-Selling is now Fraud: SEBI

SEBI has made misselling a fraudulent practice by adding a clause into the "Prevention of Fraudulent and Unfair Trade Practices" Regulations, via a notification:

(s)  mis-selling of units of a mutual fund scheme;
Explanation.- For the purpose of this clause, "mis-selling" means sale of units of a        
mutual fund scheme by any person, directly or indirectly, byโ”€ 
(i) making a false or misleading statement, or 
(ii) concealing or omitting material facts of the scheme, or
(iii)concealing the associated risk factors of the scheme, or
(iv) not taking reasonable care to ensure suitability of the scheme to the buyer.

At first glance this appears to be a far reaching addition because you can hardly prove (or disprove) such an allegation when it occurs. Did the agent conceal a material aspect of a scheme? How can you prove it if he said he did reveal it?

The last bit (ensuring suitability of the buyer) seems even more subjective, but I suppose it could be on a "reasonable effort" basis where you can only get rapped in a very extreme case.

Having gone through the rest of the "fraudulent" practices, it seems we do have a framework of subjectivity. For example:

(b) dealing in a security not intended to effect transfer of beneficial ownership but
intended to operate only as a device to inflate, depress or cause fluctuations in
the price of such security for wrongful gain or avoidance of loss;

You could easily state that most intraday "strategies" of a large size will qualify. However I believe the framework is subjective because it needs to be so: given the range of appeals available (SAT, courts) it is better to have a law that is broad and subjective, rather than create a tight and restricted rule which the big and bad jokers will easily find a way around.

So overall, I don’t find it such a bad deal to not have a strict definition of what misselling is. What I would like to see, however, is that SEBI investigates cases, and has HUGE penalties on extreme forms of fraud of any sort, including jail time.

Today, fraudsters get away with small fines and a small period of a ban on trading. That should not be the case. If we want to deter other people from a crime, the punishment should be huge and visible. That means when they catch the big frauds, those people need to go to prison. We need to see people banned for life from the markets. We need to see fines that are so heavy they will leave the fraudsters with nothing – I mean, for a fraud of Rs. 100 cr. we should see fines of Rs. 500 cr. as punitive damages.

In this respect, if a bank is found to be selling equity mutual funds to old women who come in looking for a deposit, I think the bank should be fined a minimum of Rs. 10 cr. as a deterrent. Banks seem to have the most serious offences of misselling agents who pose as "relationship managers".

Misselling may be provable only in an extreme case, and with respect to mutual fund selling I think it’s difficult to prove either side. Online players need to be careful; they must provide all information available (risk factors etc.) and have some defence available to state that they tried to provide "suitable" products for a buyer. For others, agents have to be careful to reveal such information pro-actively.

I don’t believe this regulation changes much: misselling in mutual funds has been cut down since SEBI removed entry loads and the new offer frenzy died. But I would welcome something similar in insurance and banking.

  • Srikanth says:

    //So overall, I don’t find it such a bad deal to not have a strict definition of what misselling is. What I would like to see, however, is that SEBI investigates cases, and has HUGE penalties on extreme forms of fraud of any sort, including jail time.//
    Deepak,
    This sounds fine in theory. But an imprecise definition is a recipe for potential abuse. Things like 66A are warnings that broad prosecutorial authority enabled by loose wordings in law/regulation are dangerous. If not today, then in future. If not by the people who wrote the regulation, then by the people who will interpret it later.
    Srikanth

    • Srikanth,
      I’ve found that precise definitions lend themselves to even more abuse because they invariably create loopholes people work around with. In this respect, in the financial industry specifically where you have the most evil people working in my opinion who can apply a lot of money/brains to fraud people of their money (alongside very good people, undoubtedly) you have to have imprecise definitions as a deterrent. Satyajit Das makes this argument very well in his books, with examples of where precision was abused.
      In fact much of the abuse of precision in rules is evident in recent examples, like you have to say “Mutual fund investments are subject to market risk, please read the offer document before investing”. TV ads have to run this statement for 10 seconds. The font size of this in print ads is regulated. These are very precise definitions that had done exactly nothing for the cause.
      However, I think the best deal would be to have an imprecise guideline of a general principle with precise examples of what constitutes abuse. Even if those examples were of a hundred or thousand cases, each of which specifies one or more aspects of misselling, that would be better than just a broad guideline, I agree. The 66A argument fails in its application to everyone versus financial selling; in the former, you find that the abusers are tiny outliers compared to people who use free speech well, so much that it is ludicrous to try to deter a few outliers with a law. In the latter, I find financial misselling a very substantial part of all financial product sales, and it has been so in about 1 in 2 cases, at least some part of it, and in nearly 90% of cases in insurance, all in my personal experience. In this case, having a law is appropriate, because it’s a rabid problem, not an outlier.
      I understand the fear is that a court or a SEBI official will abuse this rule. For that we have appeals. We have to, at some level, trust our courts to take the right decision. And they’ve proved capable in the recent past.

      • Srikanth says:

        Deepak,
        Agree with the broad points that you make. However, when you say,
        ”In the latter, I find financial misselling a very substantial part of all financial product sales, and it has been so in about 1 in 2 cases, at least some part of it, and in nearly 90% of cases in insurance, all in my personal experience. In this case, having a law is appropriate, because itโ€™s a rabid problem, not an outlier.//
        If you look at specifically MF sales, which this addendum/amendment addresses, this assessment of misselling being a “very substantial part” will very likely not hold good. Especially in the last 2-3 years (since entry load ban). And, if you add to it Manoj’s observation regarding banks not being within the ambit of this provision, I see no potential for valid use of this provision in the present scenario, and only potential for abuse.
        Srikanth

        • I think you’re right now in that mutual fund misselling is a lot lesser than it used to be, since the commissions structures have been cut to size. However there have been demands to expand the types of MF products available (to say, things like covered call schemes etc. which are specifically not allowed). Adding complexity to MF products should perhaps add in a layer of customer protection against misselling as well.
          Banks are in within the ambit, no? They are also agents and will be held accountable as SEBI registered entities.

      • Manoj Nagpal says:

        I would tend to agree with Deepak on this.
        Also as a stated policy, SEBI’s stance has been to move from “Rule” based regulations towards “Principles” based regulations.
        This is a step in that direction and I understand lot of Regulators across the globe follow “Principles” based regulations rather than specifying the type of font and size of font. ๐Ÿ™‚

  • Manoj Nagpal says:

    One critical thing is that Banks will NOT be covered by SEBI regulations as they are governed by RBI and not by SEBI. Hence these regulations will be applicable to the IFAs and National Distributors only (this is my interpretation and not stated in the regulations).
    For Insurance, as a corporate agent, Banks are explicitly registered with IRDA and hence IRDA guidelines are applicable. Even there, except for the case of IndusInd Bank, IRDA has not really been able to take any action on Banks for Insurance mis-selling inspite of thousand of complaints registered with IRDA. The best case scenario has been that the Banks refund the premium back to these complainants. No penalties are passed by IRDA, leave alone punitive damages. RBI, clearly, keeps a hands-off approach on mis-selling giving a free run to Banks.
    These regulations, though, surely a step in the right direction will put the fear of God in Banks and more teeth to aggrieved investors – but they can’t bite. ๐Ÿ™‚

    • Oh Banks are covered by SEBI also, in their role as MF agents. (RBI doesn’t have much of a role here) SEBI can cancel their MF agent license and they can’t sell funds anymore for commission.
      IRDA has a problem – the max fine it can give is Rs. 5 lakh per incident. They do put that kind of fine often.

      • Manoj Nagpal says:

        Any specific example of even the Rs. 5 lakh fine on any Bank except IndusInd Bank by IRDA. None, to my knowledge. IRDA has fined other Corporate Agents and Insurance Companies but no other Bank. Please check. ๐Ÿ™‚
        Also SEBI has no power to suspend anyone’s ARN and nor has it done it in the past. ARN suspensions/cancellations is the domain of AMFI and even they have not suspended/cancelled or even given a warning to a single bank toward’s mis-selling. They have also done it only for IFAs. Please check. ๐Ÿ™‚

        • IRDA – you’re right, they haven’t hit any bank with that fine (only have hit hte life insurance companies). That’s a very good point!
          Didn’t realize SEBI has no control over mutual fund advisors – in which case this regulation shouldn’t apply in any case to anyone? If not, then this regulation will apply to banks as well.
          But great point again on the fact that SEBI has never rapped banks for misselling!

  • Raghavendra Shenoy says:

    India has always been a place where you could have your own interpretation of the law and get away with it. The best example is an industrial house ( now two), that has always operated on the ‘fringe’ of the law and has managed to get away with it till now..IMO, Regulation for the heck of it is not going to help.
    A financial planner ‘cum’ ‘financial products seller’ called me a couple of days ago and offered to do the FP for me, and asked some questions post which he said – “Sir, let us meet this Saturday – i will also get some product brochures of some ULIPs for your son and a pension policy for you”. Given our ‘excellent literacy rate’ and ‘ability/willingness to fall for conmen’, agents easily convince us that if you want pension, buy a pension policy..:D Sounds idiotic, doesn’t it? But sadly, most of their prospective clients fall for it.

  • statspotting says:

    “In this respect, if a bank is found to be selling equity mutual funds to old women who come in looking for a deposit, I think the bank should be fined a minimum of Rs. 10 cr. as a deterrent. Banks seem to have the most serious offences of misselling agents who pose as “relationship managers”. ”
    couldnt stop laughing on that one ๐Ÿ™‚