Market regulator SEBI has taken action against Kotak Mahindra Asset Management Company (Kotak AMC) for delay in payment of maturity proceeds to unitholders in six of its Fixed Maturity Plans (FMPs). SEBI in its order stated that Kotak AMC did not pay investors full proceeds based on the declared Net Asset Value (NAV) of the schemes on their respective maturity dates. The order pertains to FMP Series 127, 183, 187, 189, 193, and 194 that matured between April and May 2019.

At the time of maturity, the AUM of six FMPs was Rs 2,092 crore, but the AMC repaid only 1,740 crore. The fund house repaid the balance amount to investors along with interest in September 2019. However, according to SEBI, in doing so Kotak AMC violated certain provisions of the Mutual Fund Regulation.

SEBI provisions state that all securities of a closed-end debt scheme (such as an FMP) must mature on or before the scheme’s maturity, which Kotak AMC failed to adhere to. According to SEBI, Kotak AMC also violated other provisions such as, lack of proper due diligence, non-disclosure of important information to the unitholders, violation of norms for segregation of portfolio, and wrong method of valuation of securities.

Consequently, SEBI has restrained Kotak AMC from launching any new FMPs for a period of six months. It has imposed a fine of Rs 50 lakh on the AMC, which it has to pay within 45 days. Additionally, SEBI has asked the AMC to refund part of the investment management and advisory fees collected from the unitholders of six FMPs along with a simple interest at the rate of 15% per annum. The interest will be calculated from the date of FMP maturity to the date of actual payment.

What are Fixed Maturity Plans?

Fixed Maturity Plans (FMPs) are close-ended debt mutual fund schemes that invest in debt instruments which have similar maturity profile as that of the tenure of the scheme. The tenure of FMP can range between a few months to a few years, but it is usually slightly over 3 years or 5 years.

FMPs generally hold the securities till maturity; and thus, the interest rate risk is minimal. These schemes provide better post-tax returns compared to Bank FDs, if held above a certain period, due to the indexation benefit. Since there is no buying or selling securities in the scheme, it reduces the volatility and expenses related to the scheme.

What caused the delay in payment of maturity proceeds?

The six schemes of Kotak mutual fund in question had invested an aggregate sum of Rs 300 crore in Zero Coupon Non-Convertible Debentures (NCDs) of Konti Infrapower & Multiventures Pvt. Ltd. and Edison Utility Works Pvt. Ltd. Both the companies belonged to the Essel Group, the promoter of Zee Entertainment Enterprises Ltd. (ZEEL).

According to SEBI, instead of carrying out due diligence process to ascertain the credit worthiness of the issuers before investing in them, Kotak AMC relied heavily on the reputation and past history of the Essel Goup.

Moreover, the cash in hand of issuers, mandatory for such transactions was missing from balance sheets of Konti and Edison. Kotak Mahindra AMC tried to insulate itself from the credit risk by accepting collateral in the form of pledged shares of Zee Entertainment Enterprises.

However, in January 2019, shares of ZEEL fell sharply due to financial difficulties and the promoters expressed the inability to provide additional collateral cover. Therefore, to prevent any adverse impact of any possible default on the part of the issuing companies or its promoters on their invested schemes, Kotak AMC entered into an agreement with issuers of the NCD. It decided to extend the maturity period of these till September 30, 2019 in violation of provisions of the management of close-ended funds.

SEBI noted that by delaying payout for the portion of its exposure in Essel Group companies, Kotak Mahindra mutual fund in a way segregated its units like a side-pocket. Notably, a scheme can only create side-pockets if a security is downgraded to below investment grade and if the scheme’s offer document explicitly says so. This, SEBI observed, did not happen here.

SEBI has also alleged Kotak AMC of wrongly valuing securities on amortization basis rather than on fair valuation basis during the preceding 60 days from the original date of maturity of those securities.

Reacting to the SEBI order, a spokesperson Kotak Mahindra Group while speaking to media said,“In the interest of our unit-holders, we decided to provide additional time to the promoters for optimal recovery, which led to partial deferment of maturity payout. This ensured that all dues along with interest of 11.1 per cent were paid to our investors in September 2019. We are reviewing the SEBI order and will evaluate the next steps”.

Does it make sense to invest in FMPs?

Many fund houses position FMPs as an alternative to Bank FDs. However, FMPs are not risk-free. Though the interest rate is minimal, FMPs have the flexibility to invest across credit profiles. If the scheme invests heavily in below AAA rated papers, it could expose investors to credit risk. Often fund houses have to seek extension or rollover of their FMPs to recoup the losses.

When you invest in FMP, there is a lack of transparency about the portfolio’s characteristics. You will find out about the composition of the portfolio only when the units get allotted to you.

Ideally, you should avoid investing in close-ended debt mutual fund schemes. Invest in safely managed open-ended debt mutual fund schemes that align with your investment objective, risk profile, and time horizon of your financial goals.

SEBI’s penalty on Kotak mutual fund, one of India’s largest fund houses, will hopefully ring a strong message to mutual fund schemes/AMCs that chase AUM by investing in risky securities in anticipation of higher returns, and thereby expose investors to undue risks.

This article first appeared on PersonalFN here