The strength of a regulation lies in the clarity that it provides to the common man. How does SEBI’s regulation on mis-selling of mutual funds score on this count?

There is good news for mutual fund investors. The Securities and Exchange Board of India (SEBI) has brought mis-selling of mutual funds under the ambit of fraudulent trade practices. But there is a bad news as well. Mis-selling as a concept probably still requires as many clarifications as it did before SEBI decided to make mis-selling as a part of fraudulent trade practices. SEBI has defined mis-selling as the sale of units of a mutual fund scheme by any person, directly or indirectly, by
 

 (i) making a false or misleading statement, or 
 

(ii) concealing or omitting material facts of the scheme, or
 

(iii) concealing the associated risk factors of the scheme, or
 

(iv) not taking reasonable care to ensure suitability of the scheme to the buyer
 

Let us try to understand and interpret all the four scenarios of mis-selling as defined by SEBI.
 

The first clause says that making a false or misleading statement to an investor is a fraudulent trade practice. Let us take an example to analyse the scope of the statement.  If a mutual fund scheme has given an average return of 15% during last five years with as high as 40% return in one single year and the agent selling mutual fund says that the scheme can give 40% return to the investor, will it be interpreted as mis-selling? Is the statement false or misleading?  On the face of it, the agent is making statement based on the past performance but he is also creating an impression which may not be right, as past performances cannot be repeated in future. This statement may lure an investor to invest into the scheme.
 

Similarly if a mutual fund scheme has given positive returns during the last five years when the benchmark index, Sensex, gave negative return and the mutual fund distributor says that the scheme gives positive return irrespective of performance of Sensex, will it be interpreted as mis-selling based on false or mis-leading statement? Logically the distributor sounds correct but is it not again mis-selling? If this is mis-selling then how can a distributor pitch such good schemes of mutual funds?
 

Wanted: Financial Literacy for Regulators. Click here
 

As regards the second clause to identify mis-selling, the meaning of the word “material facts” need to be interpreted first. Material fact is generally defined as, “A fact that would be important to a reasonable person in deciding whether to engage or not to engage in a particular transaction; an important fact as distinguished from some unimportant or trivial detail”.  What is material in context of a mutual fund schemes? An equity mutual fund is a mutual fund which should have invested more 65% of total corpus in equity shares of companies. An investor asking for a equity mutual fund is suggested a mutual fund which has invested 65.5% of its corpus in equity shares of companies and 33% in debt. Will 33% of debt be considered as material and can the investor claim that he was offered a scheme which has a sizeable corpus invested in debt contrary to what he was looking for and he has made investment in the scheme based on recommendations of the distributor?
 

Similarly, associated risk factors of the scheme are very broad and varied and in absence of clear-cut distinction it will be difficult to identify what will be classify as the associated risk factor. However, the most important aspect of the regulation which says that not taking reasonable care to ensure suitability of the scheme to the buyer is a fraud indeed requires elaboration. Can selling an equity scheme to a risk averse customer be treated as mis-selling as equity schemes are not suitable for customers who wish to avoid risk?
 

Read about mis-buying, a bigger problem than mis-selling: Buying Blindly
 

It is true that all regulations are ultimately subject to judicial interpretations but strength of a regulation lies in the clarity that it provides to the common man. We will have to wait and watch to see how things unfold in future with respect to this regulation. Also will mis-selling stop or will this regulation again be an example of a half empty glass which is also a half full glass as far as interpretation goes.
 

To read more from Vivek Sharma, click here.
 

(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)