Thread by @leading_nowhere

Decoding the SEBI order against Franklin Templeton (FT). Quoted verbatim, "a fall out of the obsession to run high yield strategies without due regard from concomitant risk".

A thread 👇

FT’s recent issues with its debt schemes are widely known. In this thread, I distill the SEBI order dated 07 June 2021 against Franklin Templeton and outline the primary (alleged) misdemeanours by FT. Find the order here: sebi.gov.in/enforcement/or… (1/n)

Setting the tone of this topic is this statement by the SEBI in its concluding paragraphs. Obsession with yield, strange dealings with debt issuers and complete lack of risk management. The whole nine yards. (2/n)

The broad heads of FT's misdemeanours can be summarized as:
(A)Incorrect scheme categorization
(B)Manipulation of Macaulay Duration
(C)Refusal to exercise exit options
(D)Valuation malpractices
(E)Lack of risk management and due diligence. (3/n)

(A)Scheme categorization: FT ran 6 debt schemes like a credit risk fund, a specific category with highest risk rating. Schemes had common managers and securities. Most securities were subscribed solely by FT. Category norms violated since 1 scheme was masquerading as 6. (4/n)

Why? The most logical answer is expense fees. Imagine you have 1 scheme generating 50 crore in fees per annum. Why not make it 6 schemes and make 300 crore instead while dealing in substantially the same debt securities? Different names attract different investors. (5/n)

While scheme categorization may not seem like a big issue, it has huge risk ramifications once you read the next part on Macaulay Duration. (attached) A very brief explanation on Macaulay Duration to enable understanding. (6/n)

(B)Manipulation of Macaulay Duration: FT allegedly suppressed MD through interest reset clause. For example - 10 year security with interest reset on 3/5/7/9 years. FT took the reset date as the end of the tenure of the security. Insightful extracts from the order. (7/n)

The suppression of MD ties in with the scheme miscategorization – showing a shorter MD for a security allowed FT to put the same security in multiple schemes and choose how it wanted to show them depending on the scheme that needed it. (8/n)

(C)Non-exercise of exit options: FT had the option to exit/redeem several securities in FY19-20 and did not exercise these options in most instances despite liquidity stress. Interest reset rights, where available, were not exercised even when market rates where higher. (9/n)

(D) Valuation malpractices: Looks suspiciously like evergreening of loans. FT bought debt securities of OPJ Trading and then took 3.5 crores in 3 tranches from OPJ to NOT exercise its put option, i.e. right to redemption. It then wrangled +2% interest on the last year. (10/n)

Both these activities were undertaken through unsigned documents and emails between FT and OPJ. SEBI alleges that FT knew OPJ was close to default and instead of recovering its money through the put option, covered up by granting an extension. (11/n)

This shows the fund essentially converting itself from an investor to a bespoke financial product offeror (a lender, basically). Regulations do not permit mutual funds to create lending arrangements such as these. (12/n)

This isn’t the only example. FT invested in 1000 crore in Future Group NCDs that ought to have been marked as defaulted on 18 Apr 20, but inexplicably did not inform credit agencies for over 10 days till 28 Apr 20. Again, FT held 100% of that type of debt security . (13/n)

(E)Lack of risk management and due diligence: Well, this one covers a long list of issues, some related to the ones already discussed. First, extremely high % allocation to illiquid securities, which constituted 70-100% of the portfolio of the FT schemes. (14/n)

Second, SEBI points out the misuse of inter-scheme transfers for liquidity management. FT used excess funds in one scheme to meet liquidity requirements in other debt schemes. Over 30% of outflows were met by IST from other debt schemes of FT. (15/n)

Third, SEBI takes strong offence to the assertion that board cannot be held responsible for investment decisions. SEBI points out that risk management committee had flagged credit risks, liquidity risks, etc. regularly but no concrete action was taken by the FT board. (16/n)

Fourth, SEBI points out several lapses in procedure relating to evaluation, monitoring and due diligence relating to investments by FT. A small snapshot is provided in the attached screenshot. (17/n)

SEBI thus found FT guilty of breaching mutual fund regulations and applicable SEBI circulars. Ordered disgorgement (taking back) of the expense fees charged by FT for the 6 debt schemes from mid-2018 to 23 Apr 20 and redistribution to unitholders, with interest. (18/n)

How much can 2% expense fees really amount to? Quite a lot. Total disgorgement is INR 450 crore, and with interest, a massive INR 512 crore for about 2 years. Further, for most of the issues highlighted in (E) above, SEBI further authorized action against the management. (19/n)

On a side note, a director of FT sold INR 30 crore worth of debt schemes units held in his personal capacity in the month leading up to the schemes being officially declared in winding up mode. Got slapped with a huge fine, of course. (20/n)

This SEBI order is a must-read for anyone who wants to understand what can go wrong on the debt side in the hunt for yield, and how it can be artfully hidden. You can take the government view with a pinch of salt, but the questionable conduct is apparent. (21/n)

Investing in debt, just like investing in banks, necessitates an overarching focus on fiscal prudence and risk management. Banking is essentially risk management - the better your manager assesses and contains risks, the safer you are as an investor. (22/n)

This raises another point on misaligned incentives. When your money manager is concerned more with making higher fees than acting as a custodian for your money, you inevitably land up in situations where AUM (for AMCs) / loan book growth (for banks) takes precedence. (23/n)

There are several clues that are particularly enlightening as far as incentives are concerned. For eg. FT did not exercise put options and redemption rights several times when it needed liquidity. Favors for issuer or plain greed for a few crores in fees? (24/n)

FT misled investors on objectives and risks in the debt schemes, utilizing the same pool of illiquid securities and putting them in all the schemes. Where investors believed they were safer in one scheme vs another, they all carried similar risks. Objective = more fees. (25/n)

FT used its 6 schemes like a Ponzi arrangement, bouncing money between schemes to manage liquidity while hiding severe credit risks and evergreening loans. It further failed to report debt restructurings and act in the best interest of investors. Objective = more fees. (26/n)

Some decisions such as subscribing to 70-100% of the entire debt issuance by a company (OPJ, Future Group) with little diligence and evaluation suggests that the fund acted like a piggy bank for borrowers instead of acting for the investors. Objective = more fees. (27/n)

These practices may be present in other AMCs too, since a commonly-cited defence in the order is industry practices. Transactions flagged at FT were with counterparties who run well known AMCs and NBFCs of their own. (29/n)