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Governance of Mutual Funds and the Institution of Trustee

The Securities and Exchange Board of India has in the recent past taken big steps in fostering good governance in the mutual fund industry, which provides an opportunity to move towards further strengthening the governance structures and institutions in the industry. This article examines a few alternative approaches to strengthening mutual fund governance through strengthening the institution of the trustee.

HT Parekh finance forum

Governance of Mutual Funds and the Institution of Trustee

The Securities and Exchange Board of India has in the recent past taken big steps in fostering good governance in the mutual fund industry, which provides an opportunity to move towards further strengthening the governance structures and institutions in the industry. This article examines a few alternative approaches to strengthening mutual fund governance through strengthening the

institution of the trustee.


nvestment trusts1 had been in existence in India since 1869. Notable among them were the Industrial Investment Trust established by Premchand Roychand in 1933 and the Investment Corporation of India organised by the Tatas in 1936. Though the government of India deliberated the setting up of a mutual fund in 1931, the fund industry, as we know it today, came to India in 1963 when Unit Trust of India was established.2 UTI made several pioneering efforts3 in the industry and secured a strong place in the Indian investment universe. In 1987, nationalised banks and public sector insurance companies were allowed entry to the fund industry followed by the private sector and international players in 1993. The industry has grown in terms of its size, number of players, assets under management and the management processes.

The erstwhile Unit Trust of India was governed by the UTI Act, 1963. The SEBI (Mutual Fund) Regulations, 1996 govern the entire industry at present. The regulation is continuously being fine-tuned by way of amendments and circulars. The regulatory process in the fund industry is marked by the active involvement of the industry body, the Association of Mutual Funds in India (AMFI)4 in the consultative process. It is acknowledged generally that much has been done by SEBI in this domain in the past decade and that Indian mutual fund regulation has been fairly dynamic, responding to the needs and circumstances over the years. The Asian Development Bank (2004) notes with satisfaction that “unlike many developing markets…the Indian mutual funds market broadly is able to function effectively, and has a legal and regulatory framework that is far in advance of many markets, though some improvements can be made in both areas.”

Need for Mutual Funds

When the economy is in a growth phase, firms require considerable external financing. Unless significant equity capital is forthcoming, it would be difficult to foster innovation and enterprise, the twin engines of economic growth. Consequently, lack of equity capital might result in nations forfeiting high growth rates. Households in poor economies do not have the ability to assume high levels of risk. Hence, the supply of risk capital in developing nations would be limited. Any mechanism that mitigates risk would add to the availability of equity capital at the margin.

It is worth recalling the words of T T Krishnamachary when he introduced the UTI Bill in Parliament in November 1963. He said “The Unit Trust provides an opportunity for the middle and lower income groups to acquire without much difficulty property in the form of shares…” Morarka, a member of Parliament, while participating in the debate pointed out, “At the present moment there is no opportunity for the middle class and the lower middle class people to invest their savings, whatever they may be – their savings may be small or meagre – in any industrial enterprise or commercial undertaking. In other words, they do not get any benefit from the increasing prosperity of the country. They could do that only if two conditions are satisfied, namely, that the value of the shares of the industrial unit is very low so that they can buy them with their meagre savings and, secondly, they are prepared to take risk about the fortunes of that individual unit. In order to diversify the risk, in order to reduce the risk to the minimum – the risk of investment – and also give them a chance to invest any amount, even as small as Rs 10, this Unit Trust is being set up.” The economic policymakers were convinced that mutual funds could offer a safe conduit for household participation in equity markets.

Mutual funds have different kinds of investors participating.5While many would be quite aware of what is happening to their money, there are retail investors who are unaware of the risks associated with investing in the securities markets.6 The latter pass the responsibility of managing the money to the fund houses. This delegation is more of a fiduciary responsibility rather than a contractual responsibility. Considerable regulatory oversight is required to ensure effective exercise of such fiduciary responsibility. The power of a robust mutual fund regulatory framework and the resulting investor confidence to augment the supply of equity capital seems substantial.

Mutual Fund: A Unique Concept

The mutual fund is a special case of a collective investment scheme. In a business firm, the customer is different from the shareholder. In a collective investment scheme, the shareholder himself is the customer. When a customer wishes to disengage from a company, he merely stops buying things from that company. In customer-centric markets, companies even accept the returns and compensate

The H T Parekh Finance Forum is edited and managed by Errol D’Souza, Shubhashis Gangopadhyay, Subir Gokarn, Ajay Shah and Praveen Mohanty.

Economic and Political Weekly April 15, 2006 the customer adequately. But it is unusual to find a similar treatment offered to an equity shareholder. In fact, equity is considered permanent capital.

In a collective investment scheme, should the shareholder-customer have a free exit or should he/she be asked to find another to replace him/her as shareholder-customer? The answer depends on which of the two roles – shareholder and customer – assumes primacy. If the shareholder-customer were treated as a customer, she would be offered free exit. This would mean the company should be prepared to redeem her shares at all points in time through an over-the-counter operation. On the other hand, if she were treated as a shareholder, she would be asked to seek exit through a stock exchange. For example, in a close-ended mutual fund, the shareholder-customer is treated primarily as a shareholder. In an open-ended mutual fund he is treated more as a customer.

In a general collective investment vehicle, the relationship between the shareholders and the manager is one of contractual arrangement. The shareholder is the principal and the manager is their agent. The relationship is contractual. Efficient enforcement of contract depends on completeness of the contract, capacity of the principal to monitor the contractual deliverables, and the efficacy of the legal system in enforcing contracts. When the principal is not up to this task, she delegates this responsibility to another. The relationship between the principal and the entity that assumes this responsibility is a fiduciary arrangement. The mutual fund structure assumes that the unitholders neither have the time nor the skills to monitor the agent’s performance. In the trust structure, the trustee assumes the fiduciary responsibility. Mutual funds in India have, therefore, decided to follow the trustee structure.7

In a mutual fund there are two kinds of ownerships. First, the shareholders8 are the beneficial owners; second, the trustee is the registered (and controlling) owner of the assets of the mutual fund. While the benefits arising out of investments go to the shareholders, the management control of the investment manager vests with the trustee. As shareholders are ill-equipped to monitor the investment function, they are unlikely to be able to assess the performance of the trustee too. For this reason, in a trust structure, the beneficial owner has no control on the business judgment exercised by the trustee. Given this loss of control on the way his/her money is managed, the shareholder is given a compensating freedom – that of voting with his/her feet. The shareholder is given the facility to exit from the mutual fund at any time he/she pleases. This liquidity avenue, as discussed earlier, is offered as an over-the-counter facility by the mutual fund itself. As the shareholder in an open-ended mutual fund has the right to exit, she must have adequate information about the happenings in the investment to time the exit decision. This calls for high levels of disclosure in a mutual fund. At the time of exit, the shareholder must also receive a fair price.9

The foregoing discussion underscores five features of a mutual fund:

  • (a) Economies of scale (through pooling) to participation in the equity market.
  • (b) Delegation of (fiduciary) responsibility.
  • (c) Right to “vote with the feet”.
  • (d) High level of information disclosure.
  • (e) Fair exit price through an over-thecounter redemption mechanism.
  • Fiduciary Responsibility

    The trustee has a fiduciary responsibility vis-à-vis the investors. Legally, a unit trust is, as the name implies, a trust fund. The trustee on behalf of the beneficiaries, the unitholders, holds the assets. The trustee’s principal role is to act as the custodian of the actual securities in which the fund invests and to oversee the operations of the fund manager.10 The trustee ensures that the fund sticks to its investment objective set out in the trust deed. It is also the duty of the trustee to ensure that no one group of unitholders is treated preferentially. In administrative terms, the assets of the fund are held in the trustee’s name. It is the trustee who issues the unit certificates when individuals buy units. Besides creating and liquidating units, the trustee supervises the register of unitholders, settles all investment transactions, collects the income of the trust in the form of dividends on the shares held, and distributes it to the shareholders. The two parts of fiduciary obligation are duty of loyalty and duty of competence. Absence of either renders the fiduciary role ineffective. The first principle of mutual fund governance is the fiduciary role played by the trustee.

    Role and Position of Trustees

    In India, mutual funds seem to combine practices from the US and UK. The trust structure came from the UK. While the regulation offers the choice of forming a trustee company or a board of trustees,

    Economic and Political Weekly April 15, 2006

    almost all mutual funds in India follow the trustee company model. A company is formed and the sole duty of the company is to function as the trustee of a mutual fund. The board of the trustee company is required to have a minimum number (at least two-thirds) of independent directors. In theory, the members of the board of the trustee company are identified by the sponsor. For all practical purposes, this task is left to the asset management company. These names have to be approved by the Securities and Exchange Board of India. Whether the independent directors would act independently is predicated upon the directors identified.

    The responsibilities of the trustee company resemble the responsibilities placed on the directors of mutual funds in the US. The first level regulation of mutual funds in India rests with the trustee. The actions taken by the trustee are deemed to be the actions of the mutual fund. The trustee is charged with many duties. It is the duty of the trustee to approve the appointment of directors of the asset management company, obtain periodic reports from the asset management company about the fund operations, monitoring security dealings of key personnel of the asset management company, review of contracts, file periodic reports to the regulator, and to discipline the asset management company.11 These duties are considerable in magnitude and call for significant expertise and devotion of time. Trustees meet six (or more) times in a year to deliberate on these matters. In addition, often decisions are taken by circulation if deemed urgent. As all directors of the trustee company are non-executive directors, it is debatable how much oversight is feasible.

    Unlike the practice in the US, regulations in India do not mandate that the trustee company (and its directors) be provided with adequate administrative support for discharging their responsibilities. Trustee companies have neither an office nor staff of their own. The only officer that has a direct reporting relationship with the trustee company is the compliance officer. The compliance officer is usually an officer of the asset management company. She has a dual reporting relationship, one with the asset management company and the other with the trustee company.

    The mutual fund business has its own technology and business complexities. When the directors of the trustee company are drawn from diverse backgrounds, it would be unrealistic to expect them to possess a high level of mutual fund expertise. This situation is not conducive to the exercise of competence. The directors of the trustee company receive sitting fees when they attend the board meetings. This amount is moderate12 and perhaps not commensurate with the level of responsibilities expected to be discharged by them. Inadequate compensation may result in a superficial trusteeship function.

    Under Indian mutual fund regulations, a minimum of 40 per cent of shareholding in the asset management company is required to be held by the sponsor. The trustee is appointed by the sponsor. The asset management company is appointed either by the sponsor or the trustee. It is not clear if it is possible for the trustee to terminate the asset management contract. It appears that the sponsor, the asset management company and the trustee are tied to one another in a gridlock. Unless clear independence is established between the asset management company and trustee, conflict of interest13 is unavoidable. Such conflict of interest dilutes the loyalty of the trustee to the unitholder. Thus, the two parts of fiduciary obligation, namely, duty of loyalty and duty of competence, are likely to be vitiated.

    As the trustee company in the current mutual fund regulations has low capital and a meagre revenue base, it does not have the capital adequacy to meet the liabilities that could be faced by the trustee company in its current form in India. While the trust law does not provide for the unitholder to sue the trustee company, individual members on the board of the trustee company could be sued under certain circumstances. Some mechanisms have been evolved in terms of director’s insurance but that seems inadequate when assets under management are large. A more robust alternative is required to deal with this risk.

    Specialist Trustee Company

    The situation mentioned above seems unique to India. In the US, the directors of the fund appoint all service providers. In the UK, there is no concept of sponsor. The trust deed is between the management company and the authorised corporate trustee. In the contractual pool form prevalent in continental Europe, the depository (which also functions as custodian) supervises the fund operations. In all these three cases, the entity that assumes the fiduciary responsibility is large, well capitalised, and specialised.

    A possible method of improving mutual fund governance in India would be to consider entrusting the trusteeship to corporations whose business is to provide trustee services.14Such practice is prevalent in the debt markets of India where debenture trustees intercede between the lenders and borrowers. This mitigates the credit risk and helps in monitoring the debenture covenants and terms more effectively.

    There are three specific advantages. First, the trustee company could be large15 and independent. Second, the specialist trustee company would be able to discharge the trusteeship duty more professionally. Third, the regulator would be able to specify the preconditions for an entity to be registered with it as a specialist trustee company. Among other conditions, it would be possible for assessing the risk of the trusteeship business and prescribing adequate risk mitigating mechanisms through a possible capital adequacy norm for the trustee company.

    Institutionalising Better Governance

    Currently, the Securities and Exchange Board of India encourages the AMFI to bring industry inputs in framing better regulations for the mutual fund industry. The Mutual Fund Advisory Committee deliberates on desirable changes in regulatory practices and recommends them to the regulator. An interesting aspect of this edifice is that the trustees are not institutionally represented in the process. AMFI is a body of asset management companies. While all activities are undertaken by the asset management companies, legally it would be difficult to assume that asset management companies represent the unitholders. In fact, the legal position points to considerable conflict of interest. It is only the trustees that can be considered to represent the unitholder interest.

    In the US, independent directors of mutual funds have established the Mutual Fund Directors Forum. It is a not-for-profit organisation, whose mission is to improve fund governance by promoting the development of vigilant and well-informed directors. This is accomplished by offering continuing education programmes to independent directors, providing opportunities for independent directors to discuss matters of common interest, and serving as advocates on behalf of independent directors.16 The forum is entirely independent of the mutual fund advisory industry.

    Economic and Political Weekly April 15, 2006

    In India too a similar initiative could be encouraged by the regulator. A forum of independent directors on the boards of trustee companies could provide the necessary checks and balances in industry governance.

    Governance Reforms

    The major heads of governance reforms in the fund industry have been addressed by Ruder (2004). These are paraphrased as follows:

  • (i) Independence of directors on the board of the trustee company (three-fourths).
  • (ii) Independent chairman of the trustee company.
  • (iii) Establishment of a nominating committee, an audit committee, a compliance committee and an investment committee, substantially composed of independent directors.

  • (iv) Facility to the trustee to hire independent counsel and staff.
  • (v) Chief compliance officer reporting to the trustee (in addition to reporting to the asset management company).
  • (vi) Written compliance policies and procedures.
  • (vii) Certification of financial statements by the chief executive officer and the chief financial officer.

    While some of these features are already present in the Indian industry, others are not. These ideas are worth considering with a view to establishing true independence of the trustee.


    If the nation has to fund its economic growth internally, mobilising household savings towards equity capital is inevitable. The mutual fund industry could play a vital role in this nation-building task. Small investors would be comfortable entrusting their meagre savings to mutual funds if they perceive good governance in the fund industry. The trustee of a mutual fund plays a crucial role in this regard. We have examined a few alternative approaches to strengthening mutual fund governance through strengthening the institution of mutual fund trustees. The Securities and Exchange Board of India has taken big strides in fostering good corporate governance in the recent past. There is an opportunity to consider strengthening governance in the mutual fund industry and make it even better.




    1 It is said that the investment trust principle originated as a device to avoid the splitting up of an estate, at the time of transfer to the heirs. Instead of taking a portion of the estate, each heir received his corresponding interest in the trust. The early investment trusts had their origin, about the middle of the 19th century, among certain Scotch lawyers engaged in the administration of estates. This first investment trust that sought public participation was the International Financial Society, London, 1863.

    2 The idea of starting a unit trust was before the government of India since 1931 [Aney 1963:3226].

    3 The original scheme of US-64 stipulated NAVbased sale and repurchase prices. This was amended in June 1965 allowing UTI to vary the sale and repurchase prices from the NAVbased levels to the extent it deemed fit [Pendharkar 2003:212]. In addition to NAVbased pricing, UTI pioneered the reinvestment plan, voluntary savings plan, children’s gift plan, savings-cum-insurance plan, distribution through bank branches, distribution through post offices, multidimensional approach to marketing, creation of a strong agency network, use of vernacular language for communications with unitholders, etc [also see Bhatt 1996].

    4 Asset management companies are the members of AMFI.

    5 The corporate customers and high networth investors have been able to take advantage of bond funds and short-term liquid funds under certain circumstances. The value of the schemes held by them ranged from 60 per cent to 90 per cent. See the report on Reform of Mutual Funds in India prepared by Cadogen Financial and A F Ferguson and Co in November 2003.

    6 In 2001 there were 11.8 million households investing in mutual funds in India. This was

    6.7 per cent of all households. Middle to high income households dominated. Retail investment in mutual funds was mostly from urban centres. See Survey of Indian Investors, SEBI-NCAER, March 2003.

    7 There are other forms of legal structures for mutual funds. In the US, the legal structure is an investment company. In some parts of Europe, mutual funds are contractual pools. In the UK and Australia, mutual funds are unit trusts.

    8 The terms shareholder and unitholder are used interchangeably by us in the context of mutual funds. In India, the term unitholder is used; in the US, the term shareholder is used.

    9 Three parties should see the price as fair: the selling/buying shareholder, the other shareholders who do not intend leaving the mutual fund, and the asset manager. If the price deviates from the fair value, then the exiting shareholder either gets subsidy or offers subsidy. Fair price means the precise value of his share of the investments. Valuation of the investment is likely to be a complex and contentious matter under most circumstances. There is one notable exception, however. If the asset has a competitive market, the market price is likely to be the fairest method to value the asset. For this reason, mutual funds are mandated to focus investments on marketable securities.

    10 The trustee’s supervisory function includes:

    (i) Advisory fees and fees of other entities providing services.

    (ii) Compliance with representations made in documents distributed to prospective investors.

    (iii) Performance of the fund portfolio.

  • (iv) Quality and cost of portfolio executions.
  • (v) The manner and cost of distribution of fund units.
  • (vi) The custody of fund securities.
  • (vii) Administration of individual investor


    11 This is only an illustrative list.

    12 Mutual funds collect trustee fees. This fee would be about 0.05 per cent of the assets under management or may be even lesser. In all probability, this could be the smallest item of expense in a mutual fund scheme in India.

    13 See Erlichman (1993) for descriptions of conflicts of interest.

    14 See ADB Report TA 4010-IN.

    15 The Securities and Exchange Commission noted in 2003: Our concern is that in many fund groups the fund adviser exerts a dominant influence over the board. Because of its monopoly over information about the fund and its frequent ability to control the board’s agenda, the adviser is in a position to attempt to impede the directors from exercising their oversight role. In some cases, boards may have simply abdicated their responsibilities, or failed to ask tough questions of advisers; in other cases, boards may have lacked the information or organisational structure necessary to play their proper role (Investment Company Governance, Rel IC-26323, January 15, 2003, p 3).

    16 In 2003, Securities and Exchange Commission asked the forum to develop guidelines and best practices in five areas where directors’ oversight and decisions are critical for the protection of fund shareholders.


    Asian Development Bank (2004): ‘India: Reform of Mutual Funds’, Final Report TA 4010-IN.

    Aney, M S (1963): ‘Proceedings of Lok Sabha, December 5, 1963, Unit Trust of India Bill, 1963’, p 3226.

    Bhatt, R S (1996): ‘Unit Trust of India and Mutual Funds’, UTI Institute of Capital Markets, Navi Mumbai.

    Brown, D A (2000): ‘Towards Improved Fund Governance: The Way Forward’, Ontario Securities Commission.

    Erlichman, S I (1993): ‘Managing Potential Conflicts of Interest’ in Mutual Funds: New Products, New Competitors, New Rules, the Canadian Institute, Toronto.

    Pendharkar, V G (2003): ‘Unit Trust of India: Retrospect and Prospect’, UBS Publishers’ Distribution, New Delhi.

    Ruder, David S (2004): ‘Mutual Fund Reform’, Statement, Committee on Banking, Housing, and Urban Affairs of the US Senate.

    Stevens, David P (2002): ‘Trust Law Implications of Proposed Regulatory Reform of Mutual Fund Governance Structures’, Goldman and Carr LLP.

    The Law Commission (1993): ‘Collective Investments: Other People’s Money’, Report Number 65, the Companies and Securities Advisory Committee, Commonwealth of Australia.

    Thompson, J K and Sang-Mok Choi (2001): ‘Governance Systems for Collective Investment Schemes in OECD Countries’, Financial Affairs Division, Occasional Paper, Number 1, OECD.

    Economic and Political Weekly April 15, 2006

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