How new SEBI norms may impact investment advisory business
Rohan Priyadarshi (left) and Vivaik Sharma

Investment advisers, who chalk out for a fee a financial plan for clients based on their risk profile and goals, are fiduciaries regulated by the capital markets regulator Securities and Exchange Board of India (SEBI).

These advisers are separate and distinct from other advisers operating in the financial ecosystem, such as portfolio managers and fund managers of mutual funds or alternative investment funds.

The investment adviser registration has been considered ‘a light touch licence’ in comparison to the alternative regulatory platforms in the financial services space.

However, a recent set of changes to the regulations by SEBI is set to have a major impact on the way investment advisers have been operating. Implemented after due public consultation, the changes aim at protecting investor interest and fostering a healthy regulated environment where the interests of all stakeholders are aligned.

Advisory vis-à-vis distribution verticals

An investment adviser can now either act as an adviser or a ‘distributor’ of investment products for a particular client or their family/group, and not both. A distributor is an additional intermediary in the financial ecosystem who earns a fee by recommending products such as mutual funds and unit-linked plans (ULIPs).

Importantly, unlike an investment adviser, a distributor does not earn a fee from the client. It is the manufacturer of the product (the asset management company in case of mutual fund or the insurance company in case of ULIPs) that pays a commission on every product sold by the distributors.

Moreover, entities operating as distributors are not permitted to have words like ‘wealth advisers’ or ‘financial advisers’ in their nomenclature, unless they are registered with SEBI as investment advisers.

Such client-level segregation between the investment advisory arm and the distribution arm, at the level of the entire group of an investment adviser, mitigates the inherent conflict in serving the same clients as both a distributor and an adviser. Hence, the change is welcome and could go a long way in establishing credibility and mutual trust between clients and their advisers.

It is imperative for financial services groups and multi-family offices to take note of this change as they would be required to implement standard operating procedures, clearly identifying whether a potential advisory client has been booked under its distribution arm and vice versa, such that the expected client-level segregation is maintained.

Service fee caps

The amendments have introduced a cap on the maximum fee that advisers can charged from clients for the advisory services rendered. Advisers can either choose a ‘fixed-fee model’, wherein the annual fee per client would be capped at Rs 1,25,000, or a model linked to the ‘assets under advice’ (AUA), wherein the fee would be capped at 2.5% of the AUA per annum per client. The rules also specify the exit load and the upfront fee that can be charged from clients.

In our view, investment advisers should have been allowed the option of adopting a combination of the fixed and variable fee models vis-à-vis their clients in view of commercial considerations.

Second, while the cap on fees has been introduced probably with a view to harmonise it with the caps applicable to the mutual fund industry, there is an astronomical disparity in the penetration and size of the two industries – both in terms of the number of players as well as assets under management.

Third, a hard cap on fee, especially where the cap is linked to the AUA, leaves no incentive for the adviser to formulate a portfolio that will generate stellar returns year after year.

From the client’s perspective, a performance-based incentive plan akin to the ‘high water mark principle’ prescribed by SEBI for portfolio managers, would have been more beneficial. This principle, which essentially requires portfolio managers to outperform the highest historic net asset value before charging any performance fees, has been in force for a complete decade and has become widely acceptable for portfolio management services.

Qualifications for team

SEBI has also introduced a critical change in the minimum qualification requirement. Investment advisers now must have a professional degree such as CFA, CA or a postgraduate qualification and a minimum experience in the field. This is moving away from the earlier position wherein either of the two conditions had to be satisfied.

Collectively, these requirements could create an entry barrier for seasoned professionals who have a considerable track record and experience but do not possess higher educational qualifications. While SEBI provides a breather to existing individual investment advisers above 50 years of age by exempting them from the requirement of having higher educational degrees, the qualification requirements would still be applicable to other professionals.

Client agreement

Advisers must compulsorily record their terms of engagement with the client by way of a written contract containing certain mandatory clauses and declarations. This practice was being undertaken long before this amendment. But SEBI now mandates a written contract codifying the adviser-client relationship with certain mandatory disclosures. SEBI has also prescribed the mandatory terms and conditions which an adviser must include in its client agreement.

Recordkeeping requirements

SEBI has clarified that investment advice rendered to a client or potential client must be recorded. This can be done by way of archiving recordings of telephonic conversations, e-mails, text messages or any other verifiable record.

This is an important compliance and advisers would now need to maintain client-wise files showing paper trail for every advice given. This would have to be disclosed during annual audit and in any potential inspection by SEBI.

Concluding Remarks

An area where SEBI could have provided more clarity is on the legal framework for robo-advisers. With fintech gaining momentum, new models are emerging where artificial intelligence is used to offer investment advice.

The legal sanctity of such robo-advisers is a grey area in the absence of any clear regulation in India. Developed markets such as Singapore have recognised this breed of advisers under their laws. Hopefully, SEBI would in future make specific rules dealing with the increased use of artificial intelligence in the financial services sector.

In terms of the amendments, the regulatory requirements of maintaining group-level segregation between clients of the investment advisory and the distribution arms, and the cap on fees could prompt industry players to operate as discretionary or non-discretionary portfolio managers. For this, a separate registration with SEBI is prescribed. However, in view of the higher net-worth requirements, restrictions on investments in unlisted securities and the minimum account size requirements prescribed for portfolio managers, the choice may not be easy.

SEBI has undertaken the responsibility of institutionalising a very under-penetrated market. Investment planning for many, even today, revolves around three asset classes – fixed deposit, real estate and gold.

Investment advisers, if adequately regulated and incentivised, could play a pivotal role in reshaping financial plans for millions of Indians who lack financial literacy.

What remains to be seen is whether such tightening of the regulations by SEBI can lead to an uptick in the consumption of investment advisory services, or if the industry will find these regulatory prescriptions a bit too overwhelming.

Rohan Priyadarshi and Vivaik Sharma are Associate and Partner, respectively, at AZB & Partners. Views are personal.

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