Date: 7 March 2019

Ajay Tyagi
Chairman,
Securities & Exchange Board of India (SEBI)
SEBI Bhawan,
Mumbai – 400 051

Subject: Reckless Lending By Mutual Funds

Dear Mr Tyagi,

We are writing to you on behalf of millions of Indian investors, including

more than 1 lakh members of Moneylife Foundation out of concern for their
investment in mutual funds, who have been drawn into various MF schemes
based on the AMFI’s message of "Mutual Funds Sahi Hai" bombarded across
different media.

In your tenure as chairman, you have taken several initiatives to protect

investors, including the major action of forcing fund houses to consolidate
similar schemes. We hope that this issue too will see bold and timely action
on your part to protect investor interest.

The exponential growth in mutual fund investment, especially after

demonetisation, presents a unique situation in India’s economic history. After
years of being limited to sidelines, mutual funds have now become part of the
mainstream, to channel the savings and investments of masses. While this is
commendable and desirable we must also remember that a large number of
ordinary people, who have no knowledge of the working of companies, funds
or capital markets, will be directly affected by any untoward occurrence,
fraud or egregious risk-taking behavior of mutual funds.

However, thanks to precisely such behaviour, this is the first time that
pension fund investments have affected the savings of Indians, in the
Infrastructure Leasing & Financial Services (IL&FS) debacle. In a country,
which has no social security or pension for a majority of Indians who are
outside government service, any such losses have serious implications for
their future security.

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It is in this context that we would like to draw your attention to certain
specific issues about the behavior of debt funds and urge strict action to
protect investor interest.

1. Promoter Funding: For some reason, instead of only focusing on investing

in marketable securities backed by cash flow, debt mutual funds have
taken the remarkable risk of funding promoters and thereby loading
unnecessary risk on retail investors who have been drawn in by Mutual
Funds According to one estimate promoter funding is as high as Rs50,000
crore. The quality of this lending and the checks and balances if any, as
well as the risks involved when stock prices collapse are unknown to most
investors.

MLF Suggestion: We request SEBI to ask for detailed disclosures of

promoter funding, by each mutual fund scheme, including the extent to
which they are protected with adequate marketable collateral. The
disclosure should not hide behind artificial structures and instruments
created to avoid public disclosure about shares pledged. This data is
entirely in public interest. And hence, it should be disclosed in a
searchable manner either on the SEBI website or AMFI website within the
next four weeks. Such disclosure is important for investors to make correct
investment decisions. Today they do not have this information.

2. Illegal Standstill Deals: In both Zee/Essel Group as well as Reliance

ADAG, Mutual Funds have joined hands with lenders to put a spin on
their private arrangements with corporate promoters. The standstill
agreements are being spun as being done to benefit investors. A standstill
agreement without any disclosure of the details or security on which it is
based, is a like restructuring and ever-greening of loans, which we believe
is illegal under the mandates of most funds. Standstill agreements
committing not to sell shares based on their market prices are justified as
being in investor interest, details of which are not disclosed to investors.
We would like to know what is the accountability of these funds if the
standstill agreement only increases the losses to investors.

MLF Suggestion: We request SEBI to order funds to disclose the

agreement and put in in the public domain so that we are clear about the
safeguards, if any, that have been put in place to protect unit holders’
interest. SEBI should specifically bar promoters funding in future because
it is against the very architecture of the mutual fund industry.

3. Wrongful Practices. Promoters of Dewan Housing Finance Ltd (DHFL)

structured a deal that has allowed them to borrow from two mutual funds
and indirectly inject the money into DHFL, which boosted its net worth. A
higher net worth of DHFL, in turn, has increased its borrowing and
lending capacity and also boosted its valuation. In the process, the

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 publicly held DHFL has underwritten a put option for the promoters the
details of which have been kept a secret. But this put option has not been
disclosed as a contingent liability.

Aditya Birla Mutual Fund and Templeton Mutual Fund have subscribed
to non-convertible debentures (NCDs) issued by Wadhawan Global
Capital (WGC) which holds the promoters’ shares in DHFL. These fund
houses bought debentures of the holding company, which is covered by
its own debt covenant; the fund houses have no recourse to DHFL’s shares
held by WGC; hence, these shares are free.
https://www.moneylife.in/article/how-loans-to-promoters-and-poor-dis
closure-was-used-to-boost-net-worth-loan-book-and-valuation-of-dhfl/55
885.html.

A report from Bloomberg states that various schemes of Reliance Mutual

Fund bought the entire Rs1,160 crore bond issue raised by Morgan Credits
Private, a holding vehicle of the Yes Bank’s promoter Rana Kapoor while
Franklin Templeton Mutual Fund bought bonds worth Rs630 crore from
Yes Capital India Pvt Ltd, another of Mr Kapoor’s vehicles that holds
3.27% of Yes Bank’s stake.
(https://www.bloomberg.com/opinion/articles/2018-11-25/lessons-from
-il-fs-group-bankruptcy-go-unheeded-in-india)

MLF Suggestion: Lending on a structured financial product against

promoter shares by mutual funds is wrong and anti-investor. These
should be banned.

4. Role of Trustees: In each of the above cases, mutual funds have not been
prudent in fulfilling their fiduciary duty and the trustees have failed in
their oversight. Debt funds pool the money of tens of thousands of
investors and act on their behalf. These investors have trusted the funds
with their money to make high quality investment decisions and not to
offer unsecured loans to promoters for risky projects. The Essel group debt
papers are rated below AA. Rating below AA reflects risky paper not fit
for mutual fund investments. Investing in them reflects poor judgement of
mutual funds who have taken unnecessary risks with public money. It
reflects a lack of fiduciary responsibility on part of the rating agencies.

MLF Suggestion: The trustees of these specific funds need be pulled up,
and the role of trustees need to be subjected to greater scrutiny in the light
of the way some debt funds have acted. SEBI needs to ask for a change in
the board of Trustees of mutual funds involved in such deals.

5. What is the true NAV?: NAV is a sacred number. It reflects the

performance of a fund that mutual fund investors rely on. It determines
the return an investor gets. We all know that a confirmed default in a

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 Mutual Fund means that its NAV (Net Asset Value) takes a huge knock.
But the standstill agreements conceal the true NAV.

MLF Suggestion: The mutual fund trustees should be held to account and
the sponsor should pick up debt papers in question at par if the issue is
not resolved in the next six months.

6. Role of rating agencies: Most of these investments, including the one in

Dewan Housing Finance Companies’ (DHFL), the promoter entities were
given AAA rating by ratings agencies. CARE Ratings gave AAA to
debentures issued by Wadhawan Global Capital (WGC), the promoter of
DHFL. Morgan Credits, which holds 3.04% of Yes Bank has raised Rs1,160
crore through issue of non-convertible debentures, which mature in 2021.
These debentures are rated “A- Stable” by CARE Ratings.

In the case of IL&FS Financial Services Ltd (IFIN), before August 2018, all
three major credit rating agencies, ICRA, CARE Ratings and India Ratings,
had given high ratings for the company’s short-term commercial paper
(CP). For IFIN's Rs4000 crore short-term CP, August 2018, both ICRA and
CARE Rating, had given a rating of A1+, which was downgraded later.
For IFIN's Rs700 crore short-term CP, Ind-Ra gave it A1+ rating on 24
August 2018. Above examples, clearly, shows how rating agencies have
failed to do their due diligence.

MLF Suggestion: Ratings are the cornerstone of debt market. Unless the
market regulator cracks down on such compromised rating, the behaviour
of rating agencies will get worse to the detriment of the retail investors
since fund managers can also get away and absolve themselves of any
responsibility, citing the ratings.

7. High Exposures to HFCs: We believe what has aggravated this situation is

the excessive leeway to mutual funds for investment in Housing Finance
Companies (HFCs). Mutual funds are allowed an exposure of as much as
15% of their corpus in finance companies and their exposure to housing
finance sector can be as high as 25%. In contrast, exposure limits are
capped at 10% for other sectors. It is surprising that mutual funds are
allowed to have such a high exposure to such a high-risk sector.

Our Suggestions: SEBI should reduce the exposures to the financial sector
to 10% and housing finance companies to 5%. There is an urgent need to
reduce exposure to housing finance companies since the basic assumption
that housing finance is a safe business is false in reality. Housing finance
companies have not just been selling home loans but funding real estate
developers, which is high-risk activity.

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 Exposure to investment companies: Debt paper issued by ‘investment
companies’ form a significant part of the portfolio of many MFs. In a way,
these investments are banking more on faith rather than cash flows. The
rise in promoters pledging their core holding, shows how the lines
between promoters’ personal wealth and shareholders’ wealth in
promoters’ listed companies is blurring. This is a worrying trend from the
standpoint of governance standards within corporate India.
(https://www.business-standard.com/article/markets/rise-in-pledged-s
hares-by-promoters-puts-dalal-street-on-the-edge-119021900015_1.html )

Many of the investment companies are in the nature of holding companies,

which have no cash flows other than dividends received. In such cases,
repayment is possible only if i) the investment company sells some shares
in order to repay the debt or ii) it keeps replacing one debt with another.
In the real world, the first of the possibilities is a rare happening and when
it is forced upon by the lenders, it leaves behind a wave of destruction of
value.

MLF Suggestion: Mutual Funds should be prohibited from investing in

debt papers issued by promoters’ companies. In general, these borrowers
are unlisted, have limited access to capital markets and there is no control
or transparency in end-use. They are used for various ‘corporate’ purposes
through a maze of onward lending.

Banks are lenders. Debt mutual funds are investors. Their functions and
skillsets are different. However, mutual funds have stepped into the shoes of
lenders and have done reckless bilateral deals. As a result, they are now at the
mercy of a bunch of promoters who are defaulting. Retail investors who have
invested in these funds had no clue about the extensive and reckless pledging
of securities and promoter funding done by mutual funds.

To handle the crisis, mutual funds have used nomenclature similar to that of
the Insolvency and Bankruptcy Code (IBC) such as a “creditors’ committee”
to lull investors into believing that these are safe arrangements permitted by
the regulator.

In the bull market that followed demonetisation, the coffers of mutual funds
coffers were overflowing with money, when investors were lured with a
campaign assuring them that Mutual Funds Sahi Hai. But while the
investments of equity funds are fairly transparent, debt funds had a lot of
leeway to hide their more irregular investments from the eyes of the regulator,
fund analysts and retail investors. They decided to become lenders without
the legal backing to secure themselves, or the skillset to assess lending risk.

If SEBI does not crack down on mutual funds using cooked up credit ratings
to hide behind promoter funding, this is bound to grow into a systemic

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menace. We don’t know how widespread it is even today. The least SEBI
should do is to punish rating agencies and fund companies involved in such
lending by barring them from accepting new business for one year. It can
make this a direct punishment or ‘advise’ them to voluntarily punish
themselves.

We trust you will take our issues and concerns on board and ensure that
safeguarding of investor interest is the first priority, in line with the preamble
to the SEBI Act.

With Best Regards,

Sucheta Dalal Debashis Basu

Founder Trustee Founder Trustee
Moneylife Foundation Moneylife Foundation

Encl.
1. The Zee/Essl Deal: Mutual Funds on a Hope and a Prayer
(https://www.moneylife.in/article/the-zee-essel-deal-mutual-funds-on-a-ho
pe-and-a-prayer/56287.html )
2. Mutual Funds as lenders? Sahi nahin hain
(https://www.business-standard.com/article/opinion/mutual-funds-as-len
ders-sahi-nahin-hain-119021800013_1.html )
3. India’s Sleepwalking to Trouble on Builder Debt
(https://www.bloomberg.com/opinion/articles/2019-02-17/india-builder-lo
ans-face-stress-on-shadow-bank-squeeze )
4. Rise in pledged shares by promoters puts Dalal Street on the edge
(https://www.business-standard.com/article/markets/rise-in-pledged-share
s-by-promoters-puts-dalal-street-on-the-edge-119021900015_1.html )

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