The need to have skin in the game: Sebi's new rule for AMCs

Securities market regulator, the Securities & Exchange Board of India (SEBI), has been taking many initiatives to protect the interests of investors. One such initiative that it took in recent months is the new guideline which mandates Asset Management Companies (AMCs) or fund houses to align their interests with that of unit-holders or investors — also called beneficiaries.

The SEBI vide its circular dated April 28, 2021, conveyed that with effect from July 1, 2021, “it has been decided that a part of the compensation of the Key Employees of the AMCs shall be paid in the form of units of the schemes. A minimum of 20% of the salary/perks/bonus/non-cash compensation net of income tax and any statutory contributions (i.e., PF and NPS) of the Key Employees of the AMCs shall be paid in the form of units of Mutual Fund schemes in which they have a role/oversight”.

After deliberations with stakeholders, the SEBI said that this rule to ensure “skin in the game” would be implemented from October 1, 2021. While the SEBI defines who the key employees will be, their compensation by way of MF units will be subject to a lock-in of three years. Currently, many AMCs on their own could be giving ESOPs to their key employees to ensure that they have skin in the game, but SEBI’s order has made it mandatory for fund houses to pay a part of the CTC in the form of units. So unlike stock options, the employees will not have any “option” regarding receiving compensation in kind.

It is a moot point whether the new rules were introduced as a fallout of the Franklin Templeton Mutual Fund saga which incurred the wrath of investors when it decided to shut down six of its debt schemes in April 2020. There were also allegations that some employees of Franklin Templeton AMC had redeemed their personal investments in these schemes before they were wound up. Way back in 2014, the SEBI had introduced the concept of seed capital by which all AMCs had to invest a minimum of 1% of the amount raised in their own schemes subject to a ceiling of Rs 50 lakh. The rationale was that when the fund house itself had a stake in its schemes it would feel the pain of investors when the fund didn’t do well and a stake in the schemes ensured that fund managers would manage the funds more responsibly. Subsequently, in August 2021, the SEBI asked fund houses to invest amounts ranging from 0.03% to 0.13% in their own schemes depending on the risk level removing the ceiling of Rs 50 lakh, which meant that AMCs had to increase the net worth beyond the requirement of Rs 50 crore. Though analysts and other players feel that the new rules may result in a flight of talent from AMCs to insurance companies or broking houses where these rules don’t apply, SEBI’s move should be lauded as it aims to protect the interests of investors.

The phrase “skin in the game” is the title of a book by Lebanese American writer Nassim Nicholas Taleb, the gist of which says there should be symmetry between action and consequences. Taleb argues that fund managers must bear a cost when they fail the public. He contends that “A fund manager that gets a percentage on wins, but no penalty for losing is incentivised to gamble with the funds of clients.” Bearing no downside for one’s actions means that one has no “skin in the game” — which is like saying the age-old cliché “heads I win and tails you lose”.

Nassim Taleb, who also authored books like ‘Fooled by Randomness’, had warned about an impending financial crisis in his book ‘The Black Swan’ which was published in 2007. The book focuses on the extreme impact of rare and unpredictable events and suggests building robust financial models to face them. Taleb mentions Robert Rubin who served as the US Treasury Secretary under Bill Clinton and received nearly $120 million in cash and stock during his stint as an advisor and also briefly as the chairman at Citi Bank during the decade preceding the crash of 2008-09. Due to the decisions and policies of Rubin, Citibank became insolvent and had to be bailed out by the US Treasury. Rubin neither paid any penalty nor returned the humongous bonuses that he had received.

Taleb, who was also an options trader, calls this type of trade a “Bob Rubin trade”. Here in India, megastar Rajinikanth refunded a part of the losses to distributors when his movie ‘Lingaa’ flopped at the box office in 2014, owning responsibility for the failure of the movie. Extending the skin in the game rule beyond MF industry, say for example to banks — which make huge profits while lending but transfer the risks to thousands of depositors — would mean that employees are paid a part of their salary in fixed deposits. If they don’t perform and the bank fails, their FDs would be worthless except of course the DICGC cover up to Rs 5 lakh.

(The writer is a chartered financial analyst and a former banker and currently teaches at Manipal Academy of Banking, Bengaluru)