Supreme Court Denies Commission to Mutual Fund Distributors Post Winding Up: Franklin Templeton Case (12 August 2022)

Introduction

Date of the Judgment: 12 August 2022

Citation: I.A. NO. 53453 OF 2022 in CIVIL APPEAL NOS. 498-501 OF 2021

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

Can mutual fund distributors claim commission even after a mutual fund scheme has been shut down? The Supreme Court of India recently addressed this question in a case involving Franklin Templeton, clarifying the extent of distributors’ rights to commission post-winding up. The court held that distributors are not entitled to commission once the scheme is wound up, as such commissions are not considered expenses related to the winding-up process. This decision has significant implications for mutual fund distributors and the interpretation of regulations governing mutual fund operations. The judgment was delivered by a two-judge bench of Justices S. Abdul Nazeer and Sanjiv Khanna, with the opinion authored by Justice Sanjiv Khanna.

Case Background

The case arose from an application filed by the Foundation of Independent Financial Advisors (FIFA), seeking payment of commission for mutual fund distributors. FIFA claimed that its members were entitled to commissions from Franklin Templeton Asset Management (India) Private Limited, even after the winding up of six mutual fund schemes. These commissions were allegedly due for the period between April 23, 2020, and March 17, 2021. The dispute centered around whether such commissions constituted ‘recurring expenses’ under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, and whether they were payable even after the schemes were closed.

Timeline

Course of Proceedings

The Foundation of Independent Financial Advisors (FIFA) filed an application seeking payment of commission for mutual fund distributors for the period from April 23, 2020, to March 17, 2021. This application was filed in the context of the winding up of six mutual fund schemes managed by Franklin Templeton. The Supreme Court initially issued a stay order on April 12, 2022, while considering the application. However, on August 3, 2022, the Court dismissed FIFA’s application and directed the distribution of Rs. 684 crores to the unitholders, vacating the stay. The present order provides the reasons for the dismissal of FIFA’s application.

Legal Framework

The judgment primarily revolves around the interpretation of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, specifically:

• Regulation 52: This regulation deals with the fees and expenses that an asset management company can charge to a mutual fund scheme. Sub-clause (i) of Regulation 52(4)(b) includes ‘marketing and selling expenses, including agents’ commission, if any’ as part of recurring expenses.
• Regulation 39: This regulation outlines the procedure for winding up a mutual fund scheme. Regulation 39(3)(b) specifies that upon publication of a notice for winding up, the trustees/asset management company must cease business activities related to the scheme.
• Regulation 40: This regulation mandates the ceasing of business activities once the notice under Regulation 39(3)(b) is published.
• Regulation 41: This regulation details the procedure and manner of winding up a scheme. Regulation 41(2)(b) states that the proceeds from the sale of assets should first be used to discharge liabilities due under the scheme and to cover expenses related to the winding up.

The interplay between these regulations determines whether distributors’ commissions can be considered a liability of the scheme post-winding up.

Arguments

Arguments by FIFA:

• FIFA argued that independent financial advisors/mutual fund distributors are entitled to commission as agreed with Franklin Templeton Asset Management (India) Private Limited.
• They contended that these commissions are recurring expenses under Regulation 52 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996.
• FIFA relied on Regulation 52(4)(b)(i), which includes ‘marketing and selling expenses, including agents’ commission’ as recurring expenses.
• They argued that the commission was ‘due and payable under the scheme’ as it had accrued before the publication of notices under Regulation 39(2)(b), even if payable in the future.
• FIFA claimed that the commission was for services rendered to the unitholders prior to the winding up.
• They also cited a circular issued by the Securities and Exchange Board of India (SEBI) dated 22nd October 2018, which mandates a full trail model of commission without upfront payments, to support their claim.

Arguments by Franklin Templeton:

• Franklin Templeton argued that after the publication of notices under Regulation 39(3)(b), the company ceased to carry on business in respect of the six schemes, as per Regulation 40.
• They contended that Regulation 52, which allows deduction of expenses including commission, applies only when the scheme is in operation and not post the decision of the trustees to wind up the scheme.
• They argued that if FIFA’s contention was accepted, the asset management company would be entitled to fees and expenses under Regulation 52 even after the publication of notices, which would be incorrect.
• Franklin Templeton argued that the commission payable to mutual fund distributors is not an expense connected with the winding up of the scheme, as required under Regulation 41(2)(b).
• They stated that the commission is in the nature of a trail, which is a recurring liability and not a present liability.
• They argued that the circular dated 22nd October 2018, does not confer any right on the mutual fund distributors to claim expenses under clause (b) to Regulation 41(2).

Submissions Table

Issues Framed by the Supreme Court

The Supreme Court addressed the following issue:

1. Whether mutual fund distributors are entitled to commission for the period after the publication of notices for winding up of the mutual fund schemes under Regulation 39(3)(b) of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996.

Treatment of the Issue by the Court

Authorities

The Supreme Court considered the following legal provisions:

• Regulation 52 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996: This regulation pertains to the fees and expenses that an asset management company can charge to a mutual fund scheme. Specifically, sub-clause (i) of Regulation 52(4)(b) includes ‘marketing and selling expenses, including agents’ commission, if any’ as part of recurring expenses.
• Regulation 39 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996: This regulation outlines the procedure for winding up a mutual fund scheme. Regulation 39(3)(b) specifies that upon publication of a notice for winding up, the trustees/asset management company must cease business activities related to the scheme.
• Regulation 40 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996: This regulation mandates the ceasing of business activities once the notice under Regulation 39(3)(b) is published.
• Regulation 41 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996: This regulation details the procedure and manner of winding up a scheme. Regulation 41(2)(b) states that the proceeds from the sale of assets should first be used to discharge liabilities due under the scheme and to cover expenses related to the winding up.

The Court also referred to its earlier judgment:

• (2021) 9 SCC 606: The Court referred to paragraph 78 of this judgment to explain the meaning of the expression ‘due and payable’ in the context of the regulations.

Authorities Table

Judgment

How each authority was viewed by the Court?

• The Court interpreted Regulation 52 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 to mean that it applies only when the scheme is in operation, and not after the publication of the notice for winding up.
• The Court used Regulation 39 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 to establish the date from which the business activities of the scheme must cease.
• The Court used Regulation 40 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 to establish the ceasing of business activities.
• The Court interpreted Regulation 41 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 to define expenses connected with winding up, and held that distributor commissions do not fall under this category.
• The Court referred to its earlier judgment in (2021) 9 SCC 606 to define the term ‘due and payable’ and held that recurring liabilities are not present liabilities.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the need to ensure that the winding-up process is conducted efficiently and fairly, without burdening the unitholders with unnecessary expenses. The Court emphasized that the regulations must be interpreted harmoniously to avoid anomalies and adverse consequences for the unitholders. The Court was also keen to ensure that the mandate of ceasing business activities upon notice of winding up is upheld.

Logical Reasoning

Judgment

The Supreme Court dismissed FIFA’s application, holding that mutual fund distributors are not entitled to commission after the winding up of a scheme. The Court reasoned that:

• Regulation 52, which allows for deduction of expenses including commission, applies only when the scheme is in operation.
• After the publication of notices under Regulation 39(3)(b), the trustees/asset management company must cease business activities, and therefore, cannot claim any payment on account of recurring expenses.
• The commission payable to mutual fund distributors is not an expense connected with the winding up of the scheme, as required under Regulation 41(2)(b).
• The term ‘due and payable’ refers to present liabilities, and recurring liabilities, such as trail commissions, are not considered present liabilities.
• The circular dated 22nd October 2018, does not override the regulations and does not confer any right on the distributors to claim expenses under Regulation 41(2)(b).

The Court emphasized that “Regulations 40 and 52 need to be read harmoniously. When read together, Regulation 52, authorising and specifying the limit of the fees and expenses payable to the asset management company, would apply only when the scheme is in operation, and not after publication of the notice under Clause (b) to sub-regulation 3 to Regulation 39 resulting in ceasure of any business activities in respect of the scheme to be wound up.”

The Court further clarified that “Commission payable to mutual fund distributers is certainly not an expense connected with the winding up of the scheme.”

The Court also stated that, “The recurring liability is not a present liability, but an obligation which, on satisfaction of certain conditions, may accrue in future. The right to claim commission may not accrue and become due and payable. Distributor commission, as a recurring liability, is not payable if the unitholder (s) redeem the unit. Winding up of the scheme entails similar effects and consequences.”

There were no dissenting opinions in this judgment. The decision was unanimous.

Key Takeaways

• Mutual fund distributors are not entitled to commission after the winding up of a mutual fund scheme.
• Regulation 52 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, applies only when the scheme is in operation.
• Expenses connected with the winding up of a scheme, as per Regulation 41(2)(b), do not include distributor commissions.
• The term ‘due and payable’ refers to present liabilities, not future or recurring liabilities.
• The SEBI circular dated 22nd October 2018, does not override the regulations regarding winding up.
• This judgment clarifies the rights and obligations of mutual fund distributors and asset management companies during the winding up process.

Directions

The Supreme Court directed that Rs. 684,00,00,000 (Rupees Six Hundred and Eighty Four Crores) be distributed to the unitholders.

Development of Law

The ratio decidendi of this case is that mutual fund distributors are not entitled to commission after the winding up of a mutual fund scheme. This decision clarifies the interpretation of Regulations 39, 41 and 52 of the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, and establishes that distributor commissions are not considered expenses related to the winding-up process. This is a significant clarification that affects the rights of mutual fund distributors and the obligations of asset management companies during the winding up of a scheme. There is no change in the previous position of law but rather a clarification of the existing law.

Conclusion

The Supreme Court’s decision in the Franklin Templeton case clarifies that mutual fund distributors cannot claim commissions after a scheme is wound up. The court emphasized that regulations must be interpreted harmoniously to protect the interests of unitholders and ensure an efficient winding-up process. This ruling sets a precedent for future cases involving mutual fund winding-up and distributor commissions.