AN OVERVIEW ON AUDIT OF PORTFOLIO MANAGEMENT SERVICES By CA Gautam Mota and Vivek Gala Introduction: The Indian Capital Market is flourishing since 1990s post liberalization of economy with a large participation from corporates, FII and others. However, over the years it has been felt that the retail participation in the equity market was low primarily due to the fact that retail investors found itdifficult to comprehend, analyze and invest in the capital markets without professional help. To ensure that retail investors also benefit from growing capital markets, Securities Exchange Board of India (SEBI) introduced the concept of Mutual Funds. However, over a period of time Mutual Fund industrycould not give the desired result primarily due to the fact that products were not customized as per the requirements of clients and were general in nature.this gave upsurge to Portfolio Management Service (PMS) in India.The said article discusses the various regulations and factors that need to be considered while conducting the PMS audit. Types of PMS: Portfolio Management Service is a special kind of investment product which can potentially be tailoredto meet specific investment objectives. The PMS services can be of different types such as either discretionary, non-discretionary or a hybrid of the two as the situation demands. Discretionary PMS The portfolio manager individually and independently manages the funds of each client i.e. fund manager has been given general powers to make investment / redemption decisions on behalf of client. Non-discretionary PMS The portfolio manager manages the funds in accordance with the directions of the client i.e. fund manager role would be restricted only to advising the client for a particular decision; however final decision would rest with the client. Governance/ Law Applicable:
The Portfolio Managers are governed by following regulations. SEBI (Portfolio Managers) Regulations, 1993 Circulars issued by SEBI from time to time Guidelines / Schemes if any issued by SEBI Primarily, the SEBI governs the functioning of Portfolio manager through (Portfolio Managers) regulations, circulars and schemes. Portfolio Manager: As per clause 2(cb) of SEBI (Portfolio Managers) Regulations, 1993, portfolio manager means any person who pursuant to a contract or arrangement with a client, advises or directs or undertakes on behalf of the client (whether as a discretionary portfolio manager or otherwise) the management or administration of a portfolio of securities or the funds of the client, as the case may be. Thus what is essential is Portfolio Manager shall before taking up an assignment of management of funds or portfolio of securities on behalf of the client, shall enter into an agreement in writing with the client, clearly defining the inter se relationship and setting out their mutual rights, liabilities and obligations relating to the management of funds or portfolio of securities in form as specified in Schedule IV of the SEBI (Portfolio Managers) Regulations, 1993. The agreement so entered should cover the minimum details as specified in Schedule IV of the Regulations. However, additional requirements can be specified by the Portfolio Manager in the agreement with the client. Disclosure Document Disclosure document is record of various facts relating to Portfolio Manager. All portfolio managersare required to provide the disclosure document to their prospective clients at least two days prior to entering into an agreement. The disclosure document ought to contain the following minimum details (illustrative): - Quantum and manner of payment of fees - Portfolio risks - Disclosures in respect of related parties as per AS 18
- Performance of the portfolio manager - Audited financial statements for the immediately preceding 3 years This document is neither approved nor disapproved by SEBI nor does SEBI certify the accuracy or adequacy of the contents of the Documents. However, Rule 14 (2) of the Regulations requires the Chartered Accountant to certify the contents of the Disclosure Document. This Document is to be filed with the SEBI within 30 days from the end of six months or from the date of change along with the Certificate in Form C mentioned in Schedule I of the Regulations. Annual Accounts The SEBI (Portfolio Managers) Regulations, 1993 prescribe the Portfolio Manager to maintain proper books of accounts. The Auditor has to ensure that the Portfolio Manager has followed proper accounting methods and procedures and that he has performed his duties in accordance with the law. A certificate to this effect should be submitted to the Board within six months of close of Portfolio Manager's accounting period. Audit Requirement: The regulatory changes impacting the financial services industry require increased governance and reporting obligations from asset managers. Investors are now more cautious about where to invest funds and expect more from their asset managers for things like greater transparency, stronger risk management, coherent governance, cost-effective management and incentive fees all while producing high performance returns. This is specifically the reason why clause 20 of SEBI (Portfolio Managers) Regulations, 1993, requires the portfolio manager to get his accounts audited. Any person who is eligible to be appointed as auditor in terms of section 226 of the Companies Act, 1956, shall be eligible to be appointed as auditor of portfolio manager. The Audit prescribed under the PMS Regulations is more of an internal nature and has a different scope and purpose as compared to that of the statutory audit. While conducting the PMS Audit, following are key areas which need to be properly verified by Auditor during the course of audit and are to be included in the audit report to be issued to the management: 1) Capital Adequacy Requirement (CAR) The portfolio manager is required to have a minimum net-worth of Two Crore rupees at any given point of time.
Net-worth means the aggregate value of paid up equity capital plus free reserves (excluding reserves created out of revaluation) reduced by the aggregate value of accumulated losses and deferred expenditure not written off, including miscellaneous expenses not written off. In case the net-worth of portfolio manager falls below the prescribed limit then the certification would be subject to cancellation. 2) Initial Contribution not less than 25 lakh rupees The portfolio manager can perform PMS service for his client only in cases where it has receivedinitial contribution equal to or in excess of twenty five lakh rupees. Initial contribution can be either in the form of actual funds or securities. In case where the securities are accepted as initial contribution, the same have to be valued at market rate as on the date of registration / activation of account. 3) Fee charged by Portfolio Manager As per the circular of SEBI 1, Portfolio Manager can charge fees to its clients only on the basis of high water mark principle i.e. the highest value that the portfolio / account has reached based on which the performance fees was charged. No other model can be adopted by portfolio manager for charging fees to clients. For eg: Consider that performance fee is charged on annual basis,initial contribution is 25 Lakhs and value of portfolio at end of each year is as follow. Then the amount on which performance fees can be charged is as follows: Year Portfolio (Rs) Performance chargeable on 0 25,00,000 Nil 1 30,00,000 5,00,000 2 28,00,000 Nil fee 1 Cir. /IMD/DF/13/2010 dated 5 October, 2010
3 33,00,000 3,00,000 Thus as per the new regulations the investor would be liable to pay fees to portfolio manager only in year 2 and year 4 based on the high water mark principle as against year2,3,4 in line with the practice followed earlier by portfolio manager. The auditor has to verify whether the fees charged by portfolio manager is in compliance with the SEBI circular and agreement entered between client and portfolio manager. However, it needs to be noted that the high water mark principle is not applicable incase where the Portfolio manager renders advisory services. 4) Discretionary or Non-discretionary PMS The auditor needs to verify whether portfolio manager is managing the funds of clients as per the agreement entered and directions of client. There are separate reporting requirements for clients who have opted for discretionary PMS and clients who have opted for no-discretionary PMS. 5) Funds to be used for specified purpose The auditor should verify whether the funds collected by the portfolio manager are strictly used as per the terms of agreement. Portfolio manager cannot use those funds in bill discounting, lending of funds or any other financial transaction which is not agreed between the parties to arrangement. 6) Bank and Demat operations The portfolio manager cannot possess any securities on behalf of the client. The auditor shall verify whether the securities traded have been transferred to the demat accounts of the clients. Further, auditor has to also ensure that portfolio manager has credited the benefit of corporate action such as dividend, bonus, split etc. to client account. Further, it needs to be properly verified whether the funds of one client are not used for another client. The portfolio manager is required to maintain separate client-wise data with regards to such operations undertaken by him.
7) Monthly 2 / Half yearly reports to SEBI As per the circular of SEBI, portfolio manager shall file monthly returns in the prescribed format with the Board. The auditor shall verify whether such returns have been filed within the appropriate time limit.monthly reports are to be uploaded on SEBI website within 5 days from the end of the month and half yearly report are to be submitted within 30 days from the end of half year along with networth and other certificates. 8) Other points for consideration Whether the portfolio manager has a valid certificate of registration. Normally, validity of PMS certificates is for a period of three years. Verify whether portfolio manager has undertaken proper Know Your Customer (KYC) Check before accepting funds / contribution from client. Ensure that power of attorney and other supporting documents are in place before accepting contribution from client. To ensure that portfolio manager abides by code of conduct (as specified in schedule III) while providing portfolio management services. To verify the sample periodic performance reports sent to the clients. To reconcile the demat accounts, funds held as on the reporting datewith the actual holding statement / bank statement. To ensure that portfolio manager does not make secret profit out of the said transaction. It also needs to be verified whether entire profits relating to purchase and sale of investments are accounted in client accounts or not. Conclusion Audit of portfolio manager is different from statutory audit as nature, purpose and function is totally different from our routine audit. PMS audit is conducted with the intent of safeguarding the interests of 2 Cir. /IMD/DF/14/2010 dated 8 October, 2010
investors and assuring them that portfolio manager has acted as per the guidelines laid down by SEBI. Further, the audit enables the investor to keep a check on portfolio manager from entering into any acts which are inconsistent with the terms of agreement. With increase participation of retail investors and high net-worth individuals in capital markets and the fact that PMS is niche segment of services it could provide a great platform for investors to use PMS as investment tool and could be a productive area of practice in coming years. ************