Tensing Rodriques examines the legal ramifications of mis-selling and fraudulent actions in the context of the ‘Know your distributor’ norms
The Association of Mutual Funds of India (AMFI), on the prodding of the Securities and Exchange Board of India (SEBI), has directed all asset management companies (AMCs) to undertake an identification process for their distributors. The process called know your distributor (KYD), similar to the ‘Know your customer’ norms for investors and bank account holders, involves verification and registration of the identity, address, PAN number and bank account details of the distributor.
The additional requirement for the distributors of mutual funds will be biometric identification. Every distributor will have to provide the impression of his/her right hand index finger. The new rules have come into force for new registrations and renewals with effect from September 1. For the distributors who are already registered have to complete the KYD procedure within six months, or by the end of February, 2011.
SEBI’s intent in mandating the procedure is to put in place a stringent verification process that would look into “the past record of the distributors to minimise the risk of mis-selling and other potential fraudulent activities.”
Before we visualise actions on the part of the distributor that could be construed as mis-selling or fraudulent, we will have to ascertain the meaning of these terms as used by SEBI. Let us assume that SEBI has used these terms to mean an action which causes a financial loss to the investor and for which a distributor can be held liable.
Let us be clear about the term distributor and its scope for assigning responsibility and legal liability. Unless otherwise specified, distributor means a person or who facilitates investment by a prospective investor in mutual fund schemes. This facilitation shall not include any advice by the distributor to the investor, unless such advice has been sought and paid for by the investor. It is not the function and obligation of the distributor to render any advice to the investor. The distributor’s only duty is to truthfully explain the attributes of the product that she is distributing, including the deficiencies and risks involved. Only in the case where the distributor also functions as an advisor, and the investor seeks her advice, the distributor may tender advice for a fee. Only when the fee is paid the advisor becomes liable for the advice tendered.
Let us look at both the instances where the distributor only facilitates purchase and where the distributor also functions as an advisor. Let us begin with a case where the investor decides to purchase MF units of a certain scheme all by himself and merely uses the facilitating services of the distributor. Let us suppose he loses his capital or does not earn a reasonable return. In such a case, the distributor can be held liable for a fraudulent action if he or she does not disclose all the attributes of the scheme including its deficiencies and the risks involved. If the purchase has been done on the advice of the distributor, and if the investor has paid for such advice, the latter will have to prove the malicious intent of the distributor. If the distributor has informed the investor of the possibility of a loss of capital or earning a lower rate of return, than the distributor cannot be held liable for the loss caused to the investor. Concealment of facts is definitely fraudulent; mere judgment on possible outcomes is not.
We have to keep in mind that an advisor is not a guarantor or insurer. In any investment, the risk of investment has to be borne by the investor alone. This is obvious from the fact that the advisor is paid a flat fee, a certain sum of money or a certain percentage of the amount invested, and does not have a share in the gains of the investor from the investment. If the investor does not share the gains, then the investor should not expect the advisor to share losses, if any! The investor is free to disregard the advice of the advisor. The advisor can be held liable only in case of concealment or misrepresentation of facts, or if her malicious intent is proved. If the advisory contract includes sharing of gains, then the distributor is liable to compensate the investor for losses to the extent specified in the contract.
A very common instance construed as mis-selling is where a distributor advises an investor to invest in a scheme that pays him a higher commission. Though such a possibility is thin now, after the abolition of entry loads and the subsequent drastic cut in commissions, it does exist. But here the onus of proving malicious intent lies on the investor; because, mere receipt of a higher commission is not evidence of malicious intent.
There is no reason to fear the new requirements; the distributor has nothing to lose from going through the KYD procedure. On the other hand, I personally feel, the procedure could protect the distributor against fraudulent actions by other participants in the MF transactions, including the investors. To what extent the procedure will protect the investor is doubtful. In fact the attempt to over protect the investor by treating the distributor as “guilty unless proved otherwise” may go against the interests of the investors; as has happened in the healthcare sector in the west, where occupational liability statutes are very rigorously executed and abused. The patient is given access to bare minimum medical records and the entries in the records are ambivalent, to ensure that these are not used against the doctor; and the doctor takes the minimum risk necessary, leaving the patient to dig his own grave. If the relationship between the distributor/advisor and the investor changes from one of trust to one of distrust, I do not think the change could be regarded as a change for the better by any stretch of imagination.
Tensing has been active in the Retail Financial Products space, both in marketing and training, for the last fifteen years.