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This article is written by Aparna Jayakumar, from Guru Gobind Singh Indraprastha University. This article analyses the famous scam-ridden mutual fund schemes in the Franklin Templeton matter.

The Franklin Templeton Mutual Funds

Franklin Templeton Investments, established in 1947, provides “exceptional wealth management” to clients in more than 165 countries. It employs over 1,300 investment professionals in more than 30 countries. Franklin Templeton Investments is the world’s largest cross-border asset management firm.

These investments are a well-known multinational management company with approximately $1.5 trillion in assets as of December 31, 2020. On July 31, 2020, Franklin Templeton acquired Legg Mason. Individuals, institutions, pension funds, trusts, and alliances will benefit from its investment management strategies and integrated risk management solutions.

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Government bonds, corporate bonds, municipal bonds, securitized securities, bank loans, and currencies are among the income-producing funds offered by Franklin Templeton, each with its unique characteristics and level of risk. 

Overview of the Franklin Templeton case

From various news sources, we know that the Karnataka High Court (HC) gave a preliminary hearing on the matter of the winding-up of schemes in May 2020 in the Securities Exchange Board of India v. Franklin Templeton Trustees case, and said that the matter would be heard on a priority basis to complete the hearing within three months. In July 2020, the Supreme Court (SC) ordered that a case relating to Franklin Templeton Mutual Fund’s decision to wind up six of its yield-oriented schemes be heard in the Karnataka High Court. The Supreme Court did not interfere in the Gujarat High Court’s stay order on the e-voting process, which was expected to move the wind-up process forward.

The Supreme Court of India has authorized SBI Mutual Fund’s distribution plan to distribute Rs 9,122 crore to unitholders in the Franklin case. After consulting with the Securities and Exchange Board of India (SEBI) and Franklin Templeton Mutual Fund, SBI Mutual Fund submitted their distribution process.

After experiencing unprecedented redemptions, Franklin Templeton Mutual Fund’s six debt schemes with assets of around 26,000 crores were frozen on April 23, 2020. The schemes were notorious for investing in high-risk debt to generate high returns. When India’s covid-19 crisis strike, a flood of mutual fund redemptions came through, as investors feared defaults seeing the economic conditions changing drastically. To reach redemptions, the schemes initially lent money, but this proved insufficient. As a result, the fund house agreed to put the debt schemes on hold before they could be wound down.

What does it mean to “wind up” and what will happen to the money invested

To begin, it is critical to recognize that these are debt schemes. They do not invest in stocks, but rather in instruments such as corporate bonds and shares. Schemes that invest directly in stocks are classified as “equity” and are unlikely to be impacted at this time. 

In this situation, “winding up” means that investors who invested their money into those six Franklin Templeton schemes will no longer be able to withdraw their money depending on the underlying assets’ value. Instead, the funds have been frozen.

Franklin Templeton will now try to recoup its investment in such schemes by selling the underlying properties, such as corporate bonds, or by waiting for them to mature. They would then be obliged to refund the money owed to them. In the face of mutual funds’ huge public relations campaign over the last decade, this serves as a stark reminder to investors of the oft-mocked statutory disclaimer that “mutual fund investments are subject to market risks. Before investing, please read the offer document carefully.”

Facts 

  1. Franklin Templeton Trustee Services Private Limited has decided to wind up their six Franklin Templeton Mutual Fund schemes by the provisions of SEBI (Mutual Funds) Regulations, 1996, Regulation 39(2)(a) (Mutual Fund Regulations). Because of the Covid-19 emergency and the resulting lock-down of the Indian economy, there has been a continued decline in liquidity in particular segments of the corporate securities market. Simultaneously, mutual funds, especially those in the fixed-income category, are seeing a surge in redemptions. 
  2. After careful investigation and review of the proposals proposed by Franklin Templeton Asset Management (India) Private Limited (the AMC) and consultation with the speculation community, the Trustees of Franklin Templeton Mutual Fund in India are of the considered opinion that a situation has occurred, which necessitates the twisting of these schemes and that this is the only viable option for saving an opportunity for unitholders and enabling a methodical and unbiased exit for all investors in these extraordinary circumstances. Some investors, disappointed by the decision, filed a lawsuit.
  3. Franklin Templeton is the ninth-largest mutual fund company in the United States. Franklin India’s low-duration fund, dynamic accrual fund, credit risk fund, short-term income strategy, ultra-short bond fund, and income opportunities fund were all shut down on Friday, April 24, 2020. The Reserve Bank of India declared in April 2020 that it will open a special liquidity window for mutual fund institutions worth Rs 50,000 crore.
  4. The step, which was similar to what India’s central bank did in 2009, was made to assuage investor concerns, after Franklin Templeton closed six of its debt schemes, locking up nearly Rs 30,000 crore in investor funds. 
  5. Franklin Templeton declared the closure of six schemes because the securities they owned at the time were insufficient to repay the investors who had approached them for redemption and that the payments would be made as soon as the security prices of the investee entities improved. In consideration of the interests of the investors, the management realized that their last and the best choice was to begin winding up these schemes. They requested more time to pay back investors who are preparing or trying to get their investments redeemed. 
  6. Following an appreciation of the fair rate, the management is willing to pay a portion of the cash/duty in various amounts for the offer of securities retained in the investee organizations.
  7. Many investors believe that the management’s hasty decision is a questionable demonstration that should have been thoroughly investigated to determine how this situation arose and whether the equivalent could not have been identified earlier by the SEBI, which deals with massive exposures daily as far as the SEBI MF Regulations are concerned. 
  8. A few investors filed petitions in various High Courts, requesting the transfer of funds, at least in part to meet their liquidity needs. Following consideration of each of these cases and a small number of other petitions filed under its watchful eye, the Supreme Court ordered that all of the cases be heard by the Karnataka High Court.

Issues involved

Whether it is possible for the trustees of a mutual fund to decide to wind up schemes on their own, or does the decision require the unitholders’ consent?

Analysis 

Critically, the court placed the ball in the court of the unit-holders by implying that any decision to close the schemes is contingent on their consent, which can be obtained through a simple majority. However, in this case, it would not interfere with the decision made by the FTMF trustees, as that is within the domain of industry experts. Regulation 39(2)(a) of the Mutual Funds Regulations states that a mutual fund plan may be terminated “on the occurrence of any function which, in the opinion of the trustees, requires the Scheme to be wound up.” The provision does not expressly state that investors must give their consent when trustees decide to close a scheme. Regulation 41 accommodates the system and method of winding up, which requires the trustees to convene an investor’s meeting to approve the method of winding up the plan by simple majority. 

A closer examination reveals that Regulation 41 allows unit holder intercession concerning the specific idea of the winding up and its substance rather than the inquiry into whether the plan should be ended up at all in any case; this was also the focus of the Karnataka High Court. Although Regulations 39 to 41 deal with the procedures for winding up a plan, the contention arose because of the presence of another provision, Regulation 18(15)(c), which states that the trustees will obtain the consent of the unitholders “when the majority of the trustees choose to wind up or rashly reclaim the schemes.”

This appeared to be a drafting error, and it gave rise to a prickly interpretational question. In this case, the Court was preoccupied with a purposeful translation of the Mutual Funds Regulations in light of its objectives and determined that the requirement of obtaining the assent of the unit holders under Regulation 18(15)(c) to choose whether to terminate a plan cannot be avoided by relying on the nonappearance of the unitholders. 

“When the majority of the trustees form an opinion as contemplated by sub-clause (a) of clause (2) of Regulation 39, the trustees are under a mandate to obtain the consent of the unitholders as contemplated by sub-clause (c) of clause (15) of Regulation 18. Only after such consent has been obtained it can be stated that the Scheme is to be wound up following clause (3) of Regulation 39. Thus the court ruled that the trustees needed to obtain the unit holders’ prior consent by a simple majority vote. 

Implications of the decision on other mutual fund investors 

The Court’s decision clarifies the procedure for winding up mutual fund schemes. The technique was previously just on paper, with no mutual fund currently relying on it. As a result, there was some confusion. The decision expands mutual fund unit holders’ rights to give or withhold consent to the winding up of mutual fund schemes. It also establishes a point of reference for investors to appeal a mutual fund’s decisions under the watchful eye of the courts if they violate the SEBI Act, 1992 or the regulator’s mutual fund rules.

The implication in terms of mutual funds as a whole

Many observers do not believe the suffering would be confined to Franklin Templeton. In general, investors have been withdrawing money from credit-risk funds, and the decision to wound down the schemes – leaving money frozen – would likely cause even more to do so. Other investment banks have worked hard to reassure investors that their debt funds are not invested in as risky instruments as Franklin Templeton’s, but it’s unclear how effective this strategy would be.

Systematic investment plans, in which institutional investors put fixed sums of money into mutual funds, have held India’s markets afloat for a long time, with a massive surge following demonetization. A significant portion of it has gone into equity, which does not face the same issues as debt funds in this case. However, if investors become wary of mutual funds in general, it could significantly affect investment in Indian firms, even as the economy suffers from the Covid-19 pandemic.

The outcome of Supreme Court’s decision

Due to a legal challenge by the Khambatta family, promoters of Rasna, who were investors in the debt schemes, the fund house’s decision to wind up the debt schemes was stayed by the Gujarat High Court in June 2020. All of the cases challenging the winding-up were eventually transferred to the Karnataka High Court, which ruled in October that the consent of investors was necessary.

Conclusion

This decision is likely to be closely scrutinized, given the scale of the funds involved, the number of aggrieved investors, the peculiar nature of the case, and the number of cases brought around the country (which were then combined in the current appeal). The Karnataka High Court recognized the importance of the legal issues and postponed the implementation of its orders for around a month and a half. The essence and gravity of the issues involved lead one to believe that this will be accepted by the Supreme Court and be vigorously challenged.

References

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