Give us a smash, not a lob, Mr Damodaran

Now SEBI chief M. Damodaran plans to bring Mutual Funds distributors under regulation. But when the commodity being regulated is an abstraction called ‘advice’, the case for recognising, leave alone punishing, a breach becomes a challenge that AMCs, distributors and potential regulators can easily hide behind. And the hand-in-glove nature of the industry, where all but investors are winners, ensures a smooth flow of funds from millions of investors to 29 AMCs through 41,000 distributors, right under SEBI’s nose. But Damodaran is about to end these practices — and to SEBI’s credit, it is not the first time this attempt is being made.

In 2004, SEBI floated the idea of Amfi (Association of Mutual Funds in India) turning itself into an SRO (self-regulatory organisation). The latter rejected the idea, saying it was not in anyone’s interest to have another regulator — a fair argument. The real story, as top-level sources in the industry point out, is because Amfi did not want a representative from SEBI, the finance ministry or the general public to sit on its board and watch the goings on or influence policy.

If that is the case, it moots the question why an ‘association’ whose real mandate is to promote the interests of AMCs and agents has been given powers to certify (incidentally, the exam is a sham — the question bank is accessible to many AMCs, and is partially based on wrong and outdated information). If the multiple-regulatory argument is to be accepted, this outsourced and stretched legitimacy to Amfi must end. It should be SEBI that certifies agents, not Amfi — just as it is SEBI that has registered 9,128 brokers, 685 FIIs, 128 merchant bankers, 84 portfolio managers and so on. What makes mutual fund agents any different?

Globally, the regulatory landscape for financial products is as varied as cultures (see table). New Zealand is shown to have the most investor-friendly regulations — a “dishonest” agent faces conviction. As far as “quality of advice” goes, just six out of 17 countries have managed to regulate it.

India may have started late, but is not a laggard yet. It took the US Securities and Exchange Commission as late as 1976 to set up competency standards for investment advisors, long after the birth and maturity of mutual funds. Looking at the state of regulation in the intermediation business, India today has the opportunity to show regulatory leadership.

Essentially, there are five deliverables in regulating distributors :

• DEFINITION: According to the Financial Planning Standards Board, advice can be defined as: “Any recommendation, guidance or proposal of a financial nature furnished, by any means or medium, to any client or group of clients.” This applies to purchase or sale of any financial product. Definition is indeed the key that opens the doors of distributor regulation.

• RECORDKEEPING: Once advice has been defined, it should be recorded in all transactions between an agent and an investor. Which means, for instance, adding a few rows on the application form that tell the investor (and the regulator, therefore) why this particular scheme is being recommended. If a risk-averse investor insists on buying a sector fund, the markings of the agent recommending otherwise should be clearly marked out.

• DISCLOSURES: Fees and commission structures are the rule across the world, but disclosures on conflicts of interest, ties to firms if any, revenue sources and suchlike, though rarer, are needed.

• PENALTIES: If a distributor breaches any code of conduct, the investor should know where to seek, and how to get, redress. That redress should, apart from suspension and termination of the distributor’s license, ensure the investor gets adequately compensated and, like in the case of New Zealand, involve convictions.

• RESTRAIN: Good regulation walks a thin line: it must ensure efficiency and justice without increasing costs or bureaucracy. In a bid to end a malpractice, SEBI must not hugely increase expenses or paperwork. The pin-striped suits in Sydney, for instance, complain about how over-regulation in the industry has raised costs to prohibitive highs. Simplicity, investor protection and clear communication going hand in hand with the threat of a watchdog whose bite can hurt for many years, financially and physically (jail terms) are the keywords to success here.

Finally, regulating distributors is not merely regulating mutual fund distributors. Many distributors sell funds, insurance, stocks, post office instruments. Tomorrow, most of them will sell pension products. Sellers of advice in the entire spectrum of finance, including the newest and most sophisticated breed of financial planners, need to be brought under one umbrella, one regulator. For which we need to invest in time, as Parliament needs to enact a full-fledged legislation.

Until then, individual regulators — SEBI, IRDA, RBI, PFRDA — will have to have separate cells governing them. Since the three regulators regularly talk to one another through an informal coordination committee, this process can be formalised and expanded to include the last mile of their respective but largely common constituencies of agents. Processes must be set up to share distributor information (if an agent, for instance, has been reprimanded for mis-selling mutual funds, the other three regulators should put him on a watch list immediately, if he figures in their databases) and best practices (tracking fraud).

The ball today is in Sebi’s court and Damodaran is about to hit. Whether it’s a high lob or a hard smash remains to be seen.

gautam.c@expressindia.com