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Commentary

Decoding the hefty 512 Cr SEBI fine on Franklin Templeton

FranklinFine-scaled.jpg

SEBI has finally dinged Franklin Templeton a huge fine for what they did last year. (Read the order) Remember in April 2020, Franklin shuttered 6 debt mutual funds, refusing to let any investor encash any money until they saw an “orderly liquidation”. While the money is slowly being repaid, there is still a considerable amount stuck in these funds even a year later.

Read our post: The Franklin Debacle, Six Funds Shuttered [April 2020]

We had recommended one of these funds earlier, the Franklin Ultra Short Bond fund, the only one we thought was a stable performer without insane amounts of risk. But in March 2020, took a call to sell even that one, because of the carnage in the debt markets and the fact that it was losing AUM considerably quickly.

Also read: How debt funds bluff regulations and what SEBI can do to fix it [April 2020]

In the end of April, the funds had to borrow money to repay investors since the bonds they held were illiquid. It became too much to manage, and Franklin shut down redemptions. This is not legal as per SEBI rules, but the fund house decided it was in the best interests of the investors.

SEBI has investigated in detail and found a few problems in the entire exercise. We will explain. But first, the action SEBI has taken:

  • Franklin has to pay 2 years of fees, of Rs. 512.5 cr. including 12% interest
  • Franklin cannot have new debt funds in the shuttered categories for two more years
  • Certain executives, who sold their own holdings in these shuttered funds, have been dinged with a fine and more.

What follows is a more detailed analysis.

First, thanks for listening, SEBI!

Let’s highlight a few tweets from us on this topic in 2020.  We mentioned some of these remedies in a detailed tweet thread. (Read tweet thread)

Tweet on Franklin to dock feesFranklin tweet impact Capitalmind

It’s turned out that all our grouses were addressed in the SEBI order – the modified duration abuse too has been cut in a separate circular. We also requested that the payout be handled by a different AMC (not Franklin) to ensure fairness, and that has also happened, with SBI Mutual fund taking over the redemption process. At this point, we must thank SEBI for acting strongly.

The Apparent Misuse of “Macaulay Duration”

The idea of a Macaulay Duration is to find out the interest rate risk of a bond in a portfolio. But Franklin had put many longer term bonds (that is, bonds that mature many years away) into short term debt funds, by using a strategy of “interest rate resets”. They would introduce a term in which the issuer and Franklin *could* choose to change the interest rate, and thus, a 9 year bond could become a 6 month duration bond when seen in the formula of Macaulay duration. We noted this in our post (read) and also you can see how the Franklin Ultra Short Bond had all these elements:

Franklin maturity

The fact that an ultra short bond had a 2029 bond itself is laughable, but they fund’s response, even on a phone call conference that I was on, was that the 2029 bond had unlimited interest rate resets (no floor, no cap).

I asked the CEO a further question: “Can you not increase those rates at the reset dates so that you get paid back for sure?” and his reply was: “Oh, if we increase rates unreasonably then we will be charged with usury so we can’t do that.”. This was strange, because the idea of an unlimited rate reset is that you are literally able to get the issuer to pay you in full, or pay a very high interest rate (why else would you not put a cap).

It turns out that SEBI has found, that not only is the Macaulay Duration being abused in such cases, but also the concept of the interest resets were not kosher.

  • In three cases : The issuer (not Franklin) chose the rate at which the reset happens. And Franklin did not have the right to ask for the bond to be repaid – if the issuer wanted, they could choose to not repay.
  • In the rest too : With an upper and lower cap on the resets, the issuer could choose not to repay and Franklin had no legal right to make them.

This is one of the key areas that needed reform in the debt fund space.

The concept of a “Commercial Understanding” that’s not legally enforceable

Franklin’s management has said that such clauses are in the nature of a commercial understanding that is normal. Such understandings aren’t legally exercisable in court, and are usually verbal. We all know how that works.

There were also mentions of a “letter of comfort” by some borrowers (or their parent firms). A letter of comfort is the legal equivalent of saying: “We aren’t legally liable to pay this money back, but maybe if we feel very nice about you, we will”. I wish we could do things like this for home loans, but apparently it’s ok if you wear the right suit? SEBI doesn’t agree.

Did not exercise exit option

Oh remember those interest rate resets? There were also other bonds with explicit exit options. Some of these bonds were illiquid and unlisted, and unlisted bonds had no buyers in the market due to another SEBI rules. And SEBI notes that Franklin, in its own letters, says that they were seeing big redemptions after October 2019.

And yet, they chose not to exit even when they had, in some cases, the legal right to do so. SEBI finds that distasteful.

Keeping Future Group bonds fully valued despite default

The Future group promoter entities, who had issued bonds to Franklin, had apparently come to a deal before April 18, to defer their payment. A deferring of a payment is a default, and if noted on April 18 itself, the NAV of the funds would have fallen. But Franklin chose to not reveal this deal saying that it was valid only after the 27th of May.

(Note that between April 18 and April 27, they shuttered the funds and didn’t allow further withdrawals)

SEBI says that if you make a deal, the re-valuation of the underlying bonds should happen immediately. I don’t think I disagree.

The calculation of the fine: 512.5 cr

There were other things – procedural lapses, allowing a banned entity to withdraw money, allowing a bondholder to defer a put option by paying a penalty etc. So SEBI found the whole thing problematic and decided to fine Franklin two years of fees. They calculate it as below:

Franklin Fine on Fees

This is a lot of money but is designed to be distributed to all unitholders. SEBI won’t keep the money.

Does Franklin have the money to pay?

Of course it does. From it’s latest balance sheet:

Franklin AMC financials

There’s around 900 cr. of cash which can be used to pay out such a fine.

No one in India pays fines without appeals. And in appeals, the courts tend to reduce such fines substantially. We expect Franklin to appeal, first to SAT and if that doesn’t work, to the Supreme Court.

Note that the parent (Franklin Resources, or $BEN) is listed in the US, and has still not disclosed this as a material item. Maybe it’s too small, but US investors might throw a fit.

SEBI says company President Vivek Kudva sold personal units to exit early

In another order, SEBI has found that the president and director of Franklin Templeton India, Mr. Vivek Kudva, “had redeemed units in the impugned debt schemes during the period” i.e. between 1st March and 23rd April 2020. (Read order) In essence, SEBI’s points based on the report of the auditors and the response filed by the AMC and the Trustees:

  • Kudva asked the Franklin team for the liquidity profile and other non-public information about the debt funds
  • According to SEBI, this was not public information and clearly showed that Franklin needed to borrow to pay back for redemptions
  • Between 20th March and 3rd April, Kudva redeemed Rs. 40 cr. of investments in his and his family’s name, in the struggling debt funds of Franklin
  • Kudva and his wife (ex-CEO of CRISIL and a senior exec at Omidyar networks) are fined ₹ 7 Crores
  • They must also transfer back about ₹ 22 crores back to an escrow account to SEBI
  • SEBI will release money back to them in the same proportion, when money is released from the underlying funds which are going through liquidations.

This is also likely to get appealed. The rules here aren’t the most exacting, since mutual fund units can be redeemed by management when they like. The timing of the redemptions, clearly has not gone down well with SEBI.

Overall, the Franklin judgement is comprehensive, but it gives you an idea of a few things that have happened in the mutual fund industry. While Franklin takes the entire hit this time, some such practices have been common in other fund houses too. SEBI’s recent changes to regulation should take care of further transgressions.

SEBI’s action in the Franklin case should serve as a deterrant to other AMCs playing fast and loose with the rules.

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