Portfolio Management: SEBI Curbs Ability To Invest In Related Parties

Prior consent will now be mandatory if a portfolio manager intends to invest a client’s funds in its related parties or associates. Clients should have complete and full disclosure of such investments, said the latest amendment to SEBI (Portfolio Managers) Regulation, 2020.

Related parties are parties who hold pre-existing relationships as specified by the regulations. It will also include "investing companies" that could be an associate of the portfolio manager.

"Associates" refers to a company in which the portfolio manager or his director/partner holds 20% ownership or those companies who hold such ownership in the portfolio manager entity.

To be clear, so far, if portfolio managers sought to invest in related parties or associates, they had to merely make a disclosure to clients. Now, the Securities and Exchange Board of India has mandated prior consent.

The amendment has been introduced to ensure complete transparency and prevent portfolio managers from appropriating the funds for the benefit of related parties, Yashojit Mitra, partner at Economic Law Practice, said.

The amendment attempts to define the concept of related party, makes prior consent mandatory, improves the disclosure regime and empowers SEBI to set prudential limits for investments in related parties by the portfolio manager, he said.

Obtaining client consent would be a one-time activity and can be done as part of the portfolio management agreement. For existing clients, a fresh agreement may be entered into.

This consent requirement will be applicable irrespective of whether it's a discretionary or non-discretionary portfolio manager entity, Mitra added. However, it’s going to be a practical challenge considering the objectives of each set-up, he said.

The regulations also provide for certain exemptions from the prior consent requirement. Co-investment portfolio management services, advisory portfolio management services and government-mandated funds fall in the exempted category.

Besides prior consent, the regulator has also prescribed investment limits in a related party entity.

Total investment in equity and debt instruments of related party cannot exceed 30% of the client's funds held with a portfolio manager. This includes a 15% cap on equity instruments and a 25% cap on debt instruments. Any breach in the limit should be balanced within 90 days, the circular states.

These limits would be set at a client level rather than at the portfolio manager level, Mitra said. "This is to ensure that clients are not overexposed to risks in such transactions more than they can handle."

Overall the amendment places limitations on investments by discretionary and non-discretionary portfolio managers in securities of their related parties or associates, which inherently involve a conflict of interest for portfolio managers, Vivaik Sharma, partner at Cyril Amarchand Mangaldas, said. Portfolio managers are required to put in place an alert based system to monitor compliance with prudential limits, he added.

Finally, portfolio managers are now also prohibited from deploying client funds in unrated securities of their related parties or associates. For discretionary managers, this bar is absolute. Non-discretionary managers have some leeway here—10% of the client's funds can be invested in unlisted, unrated securities as long as it does not belong to a related party or an associate.

Additionally, disclosure to clients will have to be made on future diversification policy of the manager—information on investments in related parties, credit rating, breach of limits and subsequent rectifications.

The new changes will become effective from Sept. 21.