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Mutual Funds: Skin-in-the-game rule — In investors’ interest


The markets regulator, Securities and Exchange Board of India (Sebi), last week came out with a circular which is being termed as ‘skin in the game’. According to it, a part of the compensation of key employees such as board directors, fund managers, etc., of asset management companies (AMC) must be paid in the form of units of the schemes under their purview or managed directly by them.

Let us discuss in detail what is this compensation scheme all about and how it impacts investors as well as AMCs.

Skin in the game

The phrase refers to owning the risk by being involved in achieving a particular goal. Best known as ‘Hammurabi’s code’, it is named after King Hammurabi (Mesopotamia, 1972-1750 BC), who laid out this set of laws to manage risk. Three concepts associated with this code are reciprocity, accountability, and incentives. Conflicts of interest in mutual funds between managers, fund sponsors, and unit holders have recently attracted academic, political, and legal attention across the globe.

In this context, Sebi announced that a part of the compensation (20%) for key employees must be paid in the form of units of the scheme which they manage directly or are under their purview. The above unit based compensation will have a lock-in period of minimum three years or tenure of the scheme. If there is any code of conduct violation by the employee, it will be subject to claw back. The new rule is applicable with effect from July 1. The rationale given is that this will align the interest of key employees of the AMC with the unit holders of their scheme.

Positive impact on investors
This is not the first effort by Sebi; a few years back the regulator has mandated that an AMC invests in all schemes that it manages. This new Sebi rule comes in the wake of the recent debacle of Franklin Templeton Mutual Fund debt schemes. The follow-up forensic audit investigation revealed that ‘fund insiders’ redeemed a significant part just before the announcement on the schemes’ closure.

Thus, Sebi in the recent announcement included a lock-in period of three years. Further, this rule is aimed at accountability by the fund manager along with the concept of pay for performance thus reversing the agency problems.

Difficulties in operationalisation
Though this rule appears apt from the investors’ perspective, it may bring in certain peculiarities in its application within the AMCs. For instance, if this rule applies to all top-level executives, then it appears a bit harsh, as some of these top executives (like heads of IT, HR, sales) may not have played any significant role in the investment decision and performance of the said fund.

Further, for other members of the fund houses, the 20% figure might be burdensome as they would be forced to invest in a particular form and a stringent fixed amount. It might be burdensome, especially because it comes in with a lock-in period of three years. For an individual employee the rule may build in certain exceptions, as the lock-in period might refrain the person from using this savings (investments) when the fund house employee needs it desperately like buying a house, or medical treatment.

To conclude, ‘skin in the game’ rule is a necessary step keeping in mind the larger investing ecosystem which includes investors as major stakeholders. It will bring in increased ownership and discipline among fund managers as fines or monetary penalties should not replace personal accountability.

Source : Financial Express

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