Review of provisions relating to close ended schemes 1.0 Introduction The current scenario in the market caused by the extreme liquidity crunch along with high redemption pressures has highlighted the need to review the existing provisions related to unlisted close end debt schemes. This Memorandum attempts to examine the current position regarding the regulatory provisions, issues highlighted by current liquidity situation, possible solutions to such issues including amendment to SEBI (Mutual Funds) Regulations & issuance of directions by way of circular relating to the close ended schemes. 2.0 Close ended scheme Close ended schemes are defined in Regulations as schemes in which the period of maturity is specified. In terms of current regulation re-purchase of units by Mutual Fund of a close ended scheme is allowed. Further, the current regulation also exempts close ended schemes from mandatory listing in case, inter-alia, the scheme provides for periodic re-purchase facility to all unit holders with restriction, if any, on the extent of such re-purchase or if the scheme opens for re-purchase within a period of 6 months from the closure of subscription. 3.0 Rationale for providing exit options in close ended schemes To understand the rationale for the relaxation to close ended scheme from mandatory listing, we have referred to the Mutual Fund 2000 Report of 1995-96 based on which the current Mutual Fund Regulations were drafted. As per the Report, Regulation 30 of the SEBI Mutual Fund Regulations (of 1993) provides that listing of the schemes shall be done immediately along with the launch of the scheme. SEBI has received representations from mutual funds requesting that the requirement for immediate listing may be Page 1 of 5
dispensed with. The argument advanced for this proposition is that as front end load closed ended mutual schemes invariably will have a NAV below par, they would begin trading. As the fund managers usually take time for schemes to be fully invested, NAV of the scheme will remain below par during this period, and at any time thereafter the market discounts will increase. The high discounts on NAV in turn adversely affect the investor perception and even if the NAV improves later, the poor perception lingers on. Mandatory listing was stipulated in the Regulations to provide investors with an exit route and it would therefore not be in the investors interest to dispense with this requirement completely. The report also said that close ended unlisted schemes must offer continuous repurchase facility; though there could be maximum and minimum limits of redemption per day and also for individual investors which must be disclosed in the prospectus. 4.0 Current Scenario in credit markets and its impact on the close ended debt schemes Since September 2008, money markets have witnessed very tight liquidity for various reasons. The primary reason was a complete freeze in developed country credit markets and other reasons included advance tax outflows, forex intervention by RBI to support rupee, Government borrowing etc. The debt schemes of mutual funds- initially the liquid schemes and later fixed maturity plans have been facing extreme redemption pressures. The redemption pressure in close ended debt schemes has highlighted the need to review the exit options in such schemes due to the following reasons: Page 2 of 5
(a) asset liability mismatch The scheme offer documents contain a disclosure that they would invest in securities whose maturity is normally in line with maturity of the schemes however, at the same time the provide facility for periodic (daily, weekly, monthly etc) repurchase to investors. This practice results in an inherent asset liability mismatch in the scheme. For example, the scheme which has 1 year maturity and offers daily redemption facility to investor s results in a scenario where the fund manager will invest in securities with maturities close to a year, however any redemption request would entail sale of securities held for maturity to meet the redemption pressure. In normal conditions securities would find buyers and redemption request could be met however, if the securities are not tradable, such asset liability mismatch result in fire sale at discounted prices. This problem gets aggravated in times of liquidity crunch when either there are no buyers even for quality papers or even if the investment paper finds buyer, the discounts are too steep. This results in sale of liquid securities to meet the emergent redemption and a portfolio of illiquid securities for the residual investors. (b) Impact on the residual investors In normal circumstances redemptions are met with cash/ cash equivalent assets with nominal impacts on NAV. However, in situations of substantial redemption requests prior to the scheme s maturity accompanied with fall in value of debt/money market securities, sale of these securities for meeting such redemption requests has an adverse bearing on the NAV and on the interests of the investors who continue to remain invested. Our present valuation norms do not require illiquid / non-traded debt securities of less than 182 days upto maturity and non traded money market instruments to be marked to market. In situations of extreme stress on liquidity in debt markets as observed in recent past accompanied with Page 3 of 5
huge redemption pressures, the funds were forced to sell the debt instruments which were liquid (certificate of deposits of public sector banks) despite having to book losses. Such a step leaves the balance investors holding the illiquid securities and allows the early exits to the benefit of higher NAV, which is higher than the realizable value due to valuation based on accrual concept. It is seen in recent past, the high exit loads imposed to dissuade the early exit loads were not a deterrent in containing the redemptions. 5.0 Exit option in Close ended Equity schemes In case, the main principle in close ended schemes is considered as one to give more certainty to fund manager to manage the funds, then irrespective of whether the scheme is equity or debt, the early exit facility should not be given prior to maturity except through the listing mechanism. 6.0 Recommendations While the valuation norms and other issues are being examined separately, the asset liability mismatch caused due to allowing redemptions prior to maturity need to be addressed. Accordingly, it is proposed to carry out changes in the SEBI (Mutual Funds) Regulations as detailed below: (a) Make listing of close end schemes mandatory and do away with the exemptions available. The time period within which the units need to be listed shall be in terms of requirements specified by SEBI. (b) Remove the provision available for repurchase and re-issue of units of close ended schemes and to provide that the units of close end schemes shall not be repurchased before maturity. (c) Provide for listing fees as a permissible expense as part of the recurring expenses chargeable to scheme. (d) Other consequential amendments to the Regulations Page 4 of 5
(e) In order to further strengthen the framework for such close end debt schemes it is proposed that the close ended debt schemes may be allowed to invest in securities of initial or residual maturities not exceeding the maturity of the scheme. The requirement for maturity of debt securities to not go beyond the maturity of the schemes may be specified by way of circular since at present there are no regulations or guidelines in this regard. This would come into effect for all schemes to be launched after the date of the circular (even if these have been cleared by SEBI earlier). The board may approve the above proposals and may authorize the Chairman to make such amendments to SEBI (Mutual Funds) Regulations, 1996 and issue such guidelines as may be necessary, consequential and appropriate to give effect to the above proposals. Submitted for approval of the Board. Page 5 of 5