How does one navigate the legal landscape of mutual funds in India?

Introduction

Mutual Funds play an important role in the development of the economy by pooling money from many investors and investing in stocks, bonds, short-term money market instruments, and other securities. There is a cycle, in which investors pool their money, and fund managers invest it in securities; after investment, securities generate returns, and finally returns pass back to the investors. In the context of the legal framework, the Securities and Exchange Board of India (SEBI) regulates the funds as per the SEBI (Mutual Funds) Regulations, 1996[1], which define the term “mutual fund” as a fund established in the form of a trust to raise money through the sale of units to the public for investing in securities. Thus, understanding the legal regime governing mutual funds is essential for both investors and industry participants.

The historical background of the mutual fund industry in India began in the year 1963 with the formation of the Unit Trust of India (UTI) as an initiative of the Government and the Reserve Bank of India; in 1987, the SBI Mutual Fund became the first non-UTI mutual fund in India; subsequently, the year 1993 heralded a new era in the mutual fund industry in private sector companies.

Meaning of Mutual Fund

• As per the term “mutual fund,” the word mutual connotes getting together, and the word fund connotes money.
• It means an investment vehicle where individuals pool their money to achieve a shared financial goal.
• A mutual fund collects funds from investors and invests in various asset classes, providing lower trading costs and professional management.
• Key benefits include diversification, expert selection of stocks and bonds, and greater convenience and flexibility in investing.

Classification of Mutual Funds

Mutual Funds are designed to meet investor needs through various schemes:

• Income-oriented schemes focus on fixed-income securities like bonds and government securities.
• Growth-oriented schemes target capital appreciation by investing in quality equities.
• Hybrid schemes balance investments between fixed income and equities, often called “balanced funds.”
• High-growth schemes seek high returns through volatile investments.
• Capital Protection Oriented Schemes aim to safeguard the principal investment.
• Tax Saving Schemes offer tax rebates, including Equity-Linked Saving Schemes (ELSS).
• Special schemes encompass index funds and sector-specific investments.
• Real Estate Funds invest in properties, while offshore funds target foreign securities.
• Leverage funds use borrowed capital for speculative trading, and hedge funds engage in high-risk trading strategies.
• Funds of Funds invest in other mutual funds. Although less common, they are available in India.
• New Direction Funds focus on companies in scientific research.
• Exchange Traded Funds (ETFs) provide tax efficiency and liquidity, while Money Market Mutual Funds invest in short-term debt instruments.
• Finally, infrastructure debt funds primarily invest in the debt of infrastructure companies, supporting sector development.
• Mutual funds are also classified into open-ended and close-ended.
  • Open-ended mutual funds can be purchased and redeemed on any transaction day, except for Equity-Linked Saving Scheme (ELSS) funds, which may have specific lock-in periods, making them less liquid.
  • On the other hand, closed-ended mutual funds can be purchased only during New Fund Offer (NFO), and they can be redeemed only at maturity, hence they are low on liquidity.   

Structure of a Mutual Fund

A mutual fund is set up in the form of a trust, which has a sponsor, trustees, an asset management company (AMC), and a custodian. The Securities Exchange Board of India (SEBI) set up guidelines for the functioning of a mutual fund through the SEBI (Mutual Funds) Regulations, 1996. These regulations specify that a mutual fund must consist of the following important entities:

• Sponsor: The sponsor means a person or entity who brings the capital to start a mutual fund according to SEBI’s guidelines.
• Trust and Trustees: A trust is created by a sponsor and trustees to manage the operation or functioning of a trust. The duty of trustees is to ensure that all funds are managed and the investor’s interests are protected as per the guidelines prescribed by the SEBI.
• Asset Management Company (AMC): The trustee appoints the asset management company (AMC) to manage funds of investors and, in return, receives the fee to manage the fund.
• Custodian: The duty of the custodian is to ensure the safekeeping of investors’ funds and securities and also to ensure that they are used for intended purposes only.
• Registrar and Transfer Agent (RTA): The registrar and transfer agent (RTA) is to manage the backend operations of the mutual fund and also manage investors’ transaction requests and other related services.

Role and Functions of Key Players in Mutual Funds

A mutual fund is a professionally managed investment scheme, usually managed by an asset management company (AMC) that brings together a group of investors and invests their money in stocks, bonds and other securities. There are five principal players and three market intermediaries in the functioning of mutual funds, which are the following:

1. Principal Players

• Sponsor: A sponsor is an influential investor who creates demand for securities because of their positive outlook on it. The sponsor brings in capital, creates a mutual fund trust, and sets up the AMC. The sponsor makes an application for the registration of the mutual fund and contributes at least 40% of the net worth[2] of the AMC. For example, IDBI Bank Ltd. acts as a sponsor of mutual funds.
• Asset Management Company: An asset management company is a company that invests its clients’ money into the securities as per the client’s needs. The AMC provides investors with more diversification and investing options, such as mutual funds, hedge funds, and pension plans. These companies charge service fees or commissions to their clients for services. For example, IDBI Asset Management Ltd.
• Trustee: A trustee is a person or firm that holds and administers property or assets for the benefit of a third party. A trustee may be appointed for a wide variety of purposes, such as in the case of bankruptcy, for a charity, for a trust fund, or for certain types of retirement plans or pensions.
• Unit Holders: A unit holder is an investor who owns the units issued by a trust, like a real estate investment trust. The securities issued by the trust are called units, and the investors in the units are called unit holders.
• Mutual Fund: A mutual fund established under the Indian Trust Act to raise money through the sale of units to the public for investing in the capital market. The funds were thus collected as per the direction of the Asset Management Company.

2. Market Intermediaries

• Custodian: A custodian is a person who carries on the business of providing custodial services to the client, keeping the custody of securities of the client and also maintains accounts of securities of the clients. The roles and responsibilities of custodians as per the SEBI (Custodian of Securities) Regulations, 1996[3], prescribe that every custodian is to administrate and protect the assets of the client and also to  a separate custody account and deposit account in the name of each client.
• Transfer Agent: A transfer agent is a person who has been granted a certificate of registration to conduct the business of a transfer agent under the SEBI (Registrar to an Issue and Share Transfer Agents) Regulations, 1993. The Transfer Agent manages the transfer of mutual funds between the buyer and seller and prepares transfer documents, maintains updated investment records, and provides customized reports of investment to the clients.
• Depository: A Depository holds mutual funds in electronic form, ensuring their safety and reducing the risk of loss or theft associated with a physical certificate, and it helps to reduce paperwork and processing time.

Conclusion

The legal regime governing mutual funds in India, primarily framed by the Securities and Exchange Board of India (SEBI) through the SEBI (Mutual Funds) Regulations, 1996, play a pivotal role in ensuring a transparent, regulated, and efficient framework for mutual fund operations. The structure of mutual funds is built upon a trust model, encompassing various key players such as sponsors, trustees, and asset management companies (AMCs), custodians, and unit holders, each with defined roles and responsibilities.

Understanding the interrelationships among these players, where sponsors initiate the fund, trustees safeguard investor interests, AMCs manage investments, custodians ensure asset security, and transfer agents facilitate transactions, is crucial for both investors and industry participants. This collaborative ecosystem fosters investor confidence and encourages participation in the capital markets.

[1] SEBI Act, 1992, India, available at: https://www.sebi.gov.in/legal/regulations/jan-2022/securities-and-exchange-board-of-india-mutual-funds-regulations-1996 (last visited on January 25, 2022).

[2] ICSI Capital Market & Securities Laws 474.

[3] SEBI Act, 1992, India, available at: https://www.sebi.gov.in/legal/regulations/jul-2023/securities-and-exchange-board-of-india-custodian-regulations-1996 (last visited on July 4, 2023).