Supreme Court Clarifies Winding Up Process for Mutual Funds: Franklin Templeton Case (2021)

Introduction

Date of the Judgment: 14 July 2021

Citation: 2021 INSC 424

Judges: S. Abdul Nazeer, J., Sanjiv Khanna, J.

Can mutual fund trustees unilaterally decide to wind up a scheme, or do unitholders have a say? The Supreme Court of India addressed this critical question in the Franklin Templeton Trustee Services Private Limited and Another vs. Amruta Garg and Others case. This judgment clarifies the procedure for winding up mutual fund schemes, particularly the need for unitholder consent, and interprets the relevant regulations under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996. The bench comprised Justices S. Abdul Nazeer and Sanjiv Khanna, with Justice Khanna authoring the opinion.

Case Background

The case arose from Franklin Templeton’s decision to wind up six of its mutual fund schemes. The decision was made by the majority of the trustees, citing difficulties in the market. This move impacted a large number of unitholders who had invested in these schemes. The core issue was whether the trustees could unilaterally decide to wind up the schemes, or if the unitholders’ consent was required. The affected unitholders challenged this decision, leading to this Supreme Court judgment.

Timeline

Legal Framework

The judgment primarily interprets the following regulations from the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996:

• Regulation 18(15)(c): This regulation states that trustees must obtain the consent of the unitholders when a majority of the trustees decide to wind up or prematurely redeem the units.
• Regulation 39: This regulation deals with the winding up of mutual fund schemes. Sub-regulation (2) outlines the conditions under which a scheme can be wound up: (a) if the trustees believe it is necessary, (b) if 75% of unitholders pass a resolution, or (c) if SEBI directs it.
• Regulation 40: This regulation specifies the effects of winding up, such as ceasing business activities, creating/canceling units, and issuing/redeeming units.
• Regulation 41: This regulation outlines the procedure for winding up, including the need for a unitholder meeting to authorize the process.
• Regulation 42: This regulation states that a scheme ceases to exist after all winding-up measures are completed and SEBI is satisfied.
• Regulation 60: This regulation mandates that trustees must disclose information essential to keep unitholders informed about any adverse effects on their investments.

These regulations are framed under the Securities and Exchange Board of India Act, 1992, which aims to protect investors’ interests and regulate the securities market.

Arguments

The arguments presented by the different parties are as follows:

• SEBI, Trustees, and AMC’s Arguments:
  • They argued that Regulations 39 to 42 form a complete code for winding up mutual funds.
  • They contended that prior consent of unitholders is not required when trustees decide to wind up a scheme under Regulation 39(2)(a).
  • They submitted that Regulation 18(15)(c) should be read with Regulation 41(1), which deals with the procedure for winding up, not the decision to wind up.
  • They argued that requiring prior consent would cause delays, leading to chaos and losses for unitholders.
  • They argued that the trustees, being experts, should have the final say in winding up decisions.
• Unitholders’ Arguments:
  • They argued that Regulation 18(15)(c) mandates that trustees must obtain the consent of unitholders before winding up a scheme.
  • They contended that the opinion of the trustees is not supreme and that SEBI has a role to play in protecting the interests of the unitholders.
  • They argued that the regulations suffer from arbitrariness as they do not provide for any mechanism to challenge the decision of the trustees.
  • They argued that the unitholders are not just creditors but also beneficiaries of a trust and should be given priority.

Issues Framed by the Supreme Court

The Supreme Court framed the following key issues:

1. What is the correct interpretation of Regulation 18(15)(c) of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996?
2. How do Regulations 39 to 42 interrelate with Regulation 18(15)(c)?
3. Is there any constitutional validity to the challenge to Regulations 39 to 42?

Additionally, the court also dealt with the sub-issue of whether the consent of the unitholders is required before the publication of notices under Regulation 39(3).

Treatment of the Issue by the Court

Authorities

The Supreme Court considered various authorities to support its reasoning:

Judgment

How each authority was viewed by the Court?

• The Court relied on Shri Ishwar Chandra v. Shri Satyanarain Sinha and Others [CITATION] to determine that presence of the majority of members would constitute a valid meeting.
• The Court relied on Halsbury’s Laws of England (Third Edition) to determine the presence of a quorum in a corporate meeting.
• The Court used Syed Hasan Raza Sahib Shamsul Ulama and two others v. Mir Hasan Ali Sahib and two others [CITATION] (Madras High Court) to distinguish between the electorate consisting of a definite number and an electorate composed of an indefinite number.
• The Court used Black’s Law Dictionary (10th Edition) to clarify that ‘consent’ refers to voluntary agreement.
• The Court used Shackleton on the Law and Practice of Meetings, 14th Edn. to explain the concept of majority and how it binds the minority.
• The Court used William Paul White’s thesis ‘History and Philosophy of the Quorum as a Device of Parliamentary Procedure’ (1967) to examine the various definitions of the term quorum.
• The Court referred to Section 48 of the Companies Act, 2013 to show that the rights attached to the shares of any class may be varied with the consent in writing of the shareholders of not less than three -fourths of the issued shares of that class.
• The Court referred to Section 55 of the Companies Act, 2013 in case of failure to redeem or pay dividend refers to consent of holders of three -fourths in value of the preference shares.
• The Court referred to Section 103 of the Companies Act, 2013 to show the minimum quorum for shareholder meetings.
• The Court referred to State of Tamil Nadu and Another v. T. Krishnamurthy and Others [CITATION], Shayara Bano v. Union of India and Others [CITATION], Senior Superintendent of Post Offices, Allahabad and Others v. Izhar Hussain [CITATION], and Director General, Central Reserve Police Force and Others v. Janardan Singh and Others [CITATION] to define manifest arbitrariness.
• The Court referred to Pioneer Urban Land and Infrastructure Limited and Another v. Union of India and Others [CITATION] to explain that home buyers have been held to be financial creditors under the Indian Bankruptcy Code.
• The Court relied on Alka Synthetics and Trading v. SEBI [CITATION] (Gujarat High Court) to state that the power under Section 11B is in the nature of issuing a command to persons to do or not do a certain act.
• The Court relied on Nikhil T. Parikh v. Union of India [CITATION] (Gujarat High Court) to state that Section 11B must be construed to subserve the purpose for which it has been enacted.
• The Court relied on Sterlite Industries (India) Ltd. v. SEBI [CITATION] (Securities Appellate Tribunal) to state that Sections 11 and 11B give enormous authority to SEBI.
• The Court referred to B.K. Educational Services Private Limited v. Parag Gupta and Associates [CITATION] to interpret the expression ‘due and payable’ with reference to the context in which the words appear.
• The Court relied on Union of India v. Raman Iron Foundry [CITATION] to define the word ‘payable’.
• The Court relied on Nisha Priya Bhatia v. Union of India and Another [CITATION] to state that a duly enacted law cannot be struck down on the mere ground of vagueness unless such vagueness transcends into the realm of arbitrariness.
• The Court referred to the IOSCO consultation report (August, 2016) to state that the unitholders have a right to vote/approve on matters of termination and liquidation.

What weighed in the mind of the Court?

The Supreme Court’s decision was significantly influenced by the need to protect the interests of the unitholders while ensuring the smooth functioning of mutual funds. The Court emphasized the importance of transparency and the right of unitholders to participate in decisions that affect their investments. The Court balanced the expertise of the trustees with the rights of the investors, ensuring that neither is given undue importance over the other. The court also considered the practical implications of its decision, ensuring that the winding-up process is not unduly delayed or complicated.

Logical Reasoning:

The court considered and rejected the argument that the unitholders are laypersons and cannot make informed decisions. The court observed that investment in mutual funds is a calculated risk and that the unitholders are discerning investors who are capable of making informed decisions. The court also rejected the argument that the trustees are experts and their decision should be treated as binding, stating that the trustees owe a fiduciary duty to the unitholders.

The court also considered the argument that the unitholders may reject a valid and well-considered opinion of the trustees and therefore Regulation 18(15)(c) is directory. The court rejected this argument stating that assumptions cannot be a ground to wrongly interpret Regulation 18(15)(c). The court also stated that situations could arise when the trustees may err in their opinion, in which event the unitholders may correct them.

The court also considered the argument that the unitholders should be treated pari passu with the creditors. The court rejected this argument stating that the unitholders are investors who take the risk and are therefore entitled to profits and gains. The court also stated that the creditors are entitled to fixed returns as per mutually agreed contracts and are not risk takers as is the case with the unitholders.

The Court also considered the argument that the unitholders are identically placed as home buyers under the Indian Bankruptcy Code. The court rejected this argument stating that home buyers pay money to the builder and enter into a contract for purchase of immovable property and are not risk takers like investors in a mutual fund.

The court also considered the argument that the expression ‘due and payable’ with reference to the liabilities is vague. The court rejected this argument stating that the words ‘due and payable’ have to be interpreted with reference to the context in which the words appear. The court also stated that in case of any dispute a summary but thorough inquiry may be made to ascertain whether the liability is due and payable.

The court also considered the argument that the Regulations are in the nature of economic regulations and therefore the court would exercise restraint unless clear grounds justify interference. The court stated that policy decisions can only be faulted on the grounds of mala fides, unreasonableness, arbitrariness and unfairness, in addition to violation of fundamental rights or exercise of power beyond the legal limits. The court also stated that the principle of manifest arbitrariness requires something to be done in exercise in the form of delegated legislation which is capricious, irrational or without adequate determining principle. The court held that the Regulations under challenge do not suffer from the vice of manifest arbitrariness.

The court also considered the grey area of whether the AMC or the trustees are bound to honour and pay the redemption or repurchase proceeds for requests received before the date of publication of notice in terms of Regulation 39(3). The court stated that it would like to have greater clarity on the factual matrix before answering this aspect.

The Court quoted from the judgment, “We would rather accept a reasonable and pragmatic ‘construction’ which furthers the legislative purpose and objective. The underlying thrust behind Regulation 18(15)(c) is to inform the unitholders of the reason and cause for the winding up of the scheme and to give them an opportunity to accept and give their consent or reject the proposal. It is not to frustrate and make winding up an impossibility.”

The court also quoted, “Investments by the unitholders constitute the corpus of the scheme. To deny the unitholders a say, when Regulation 18(15)(c) requires their consent, debilitates their role and right to participate.”

The court also quoted, “The trustees are therefore commanded to inform and be transparent.”

Key Takeaways

• Unitholder Consent: Mutual fund trustees cannot unilaterally decide to wind up a scheme; they must obtain the consent of the unitholders.
• Timing of Consent: The consent of the unitholders is required after the publication of the notice under Regulation 39(3), not before.
• Transparency: Trustees must disclose the reasons for winding up a scheme to unitholders.
• Protection of Investors: The judgment reinforces the importance of protecting the interests of the investors in mutual funds.
• Constitutional Validity: The Supreme Court upheld the constitutional validity of the relevant regulations.
• No priority to unitholders: The unitholders are not to be treated pari passu with the creditors.

Directions

The Supreme Court did not give any specific directions in this order but stated that directions to await the orders in the adjudication proceeding have been incorporated in the order dated 12th February 2021. The Court also expressed the hope that the proceedings under the SEBI Act would conclude expeditiously.

Development of Law

The ratio decidendi of this judgment is that Regulation 18(15)(c) of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, mandates that trustees must obtain the consent of the unitholders before winding up a mutual fund scheme. This decision clarifies the interplay between various regulations and ensures that the unitholders’ rights are protected. The judgment also reinforces the fiduciary duty of trustees towards unitholders and emphasizes the need for transparency and participation in decisions affecting their investments. This judgment has clarified the law and has removed any ambiguity on the interpretation of the regulations. The court has also made it clear that the unitholders are not to be treated pari passu with the creditors.

Conclusion

The Supreme Court’s judgment in the Franklin Templeton case is a landmark decision that clarifies the winding up process for mutual fund schemes. It emphasizes the importance of unitholder consent and ensures that trustees cannot unilaterally decide to wind up a scheme. The judgment balances the expertise of the trustees with the rights of the investors, promoting transparency and accountability in the mutual fund industry. This is a significant step towards investor protection and enhances the overall integrity of the Indian securities market.