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Investors bring in the law

With the courts stepping in, the Franklin debt fund crisis has just become much more complicated

Investors bring in the law

The liquidity crisis in India's debt funds has taken a somewhat complicated turn because a number of investors have turned to courts of law. While it's the right of any Indian to turn to the law if he or she wants to (as the crores of cases in India's courts show), investors may not be acting in their own best interests in doing so in this case.

Let's recap a bit to what has led to this situation. In the last week of April, Franklin Templeton closed down six of its debt funds, froze Rs 30,000 crore of investor money. These were Franklin India Low Duration Fund, Franklin India Ultra Short Bond Fund, Franklin India Short Term Income Plan, Franklin India Credit Risk Fund, Franklin India Dynamic Accrual Fund and Franklin India Income Opportunities Fund. This is unprecedented in the history of open-end funds in India. Franklin took this action because it found that the bond markets had practically frozen and it was unable to sell off enough of the bonds held by these funds to meet redemption requests.

The fund house's plan is that it would stop the on-demand redemptions that open-ended funds normally have but keep redeeming the money as and when it was able to either sell the bonds, or when their maturity ended, redeem them with the company issuing the bonds. The interest payments on the bonds would also be disbursed as and when they came in.

On the 9th of June, investors were to participate in an e-voting process to authorise the entire process, which SEBI had approved. However, before that stage, four court cases have interrupted the process. Obviously, the details vary, but the underlying theme is the same. Investors suspect that there has been some sort of an irregularity in the running of these funds, and would like an investigation. Implicitly, they have lost trust in the regulator's ability to look after their interests. Some of them appear to feel that the entire process is being rushed and now that business expectations give some appearance of improving, it may be possible to reverse whatever Franklin has done and rescue the funds.

As the law stands, unless the voting process is completed, even money that the funds have received as interest or otherwise cannot be distributed to investors. This is a glitch in the law and should be amended at the earliest. No investor, not even those who have decided to go to the courts would want their money to be blocked in this fashion.

As I said earlier, it is the prerogative of anyone who feels wronged to seek redress from the law. However, it's also clear that by and large Indian debt fund investors have not internalised what it means to invest in funds that hold market-backed securities. The Franklin episode has not come out of the blue as a surprise. It's now almost two years that we have had many mini-blowups in debt funds, and the current one is simply the most severe.

In the investing behaviour that investors have displayed, they have implicitly, or perhaps explicitly, been encouraged both by fund companies and by fund intermediaries. In fact, at this juncture, I find that part of the outrage of investors is being fueled by fund distributors who had encouraged their customers to invest in these funds and are now trying to pass the blame by telling them that there is some malafide. Franklin's funds took higher risks and earned higher returns. Intermediaries found the higher returns an easier sell. Investors liked the higher returns. Now when the stuff has hit the fan, each one is engaged in trying to find someone else to blame and it's pretty obvious who that someone is. Once the lawyers enter the picture, then the outcomes follow a different kind of logic and have different kind of drivers.

A vast majority of the investors in the shutdown funds are not party to the court cases, and they likely had no interest in this legal detour which will inevitably delay the final closure of the matter. Unfortunately, the 'mutuality' of mutual funds seems to have come to mean that a handful of large investors who can hire powerful lawyers can drag the silent majority along with them.