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RIA regulations look like a New Year gift to MFDs

Vijay Venkatram, Managing Director, Wealth Forum

2nd January 2018

SEBI has delivered two unexpected googlies in its RIA consultative paper issued today - which, if my understanding is right, looks like a good New Year gift for MFDs. It effectively plugs all loopholes that would allow any intermediary - big or small - from operating a hybrid model of RIA and MFD. But more importantly, it seems to have left enough on the plate for MFDs to offer a reasonably client centric proposition - one which may not compel them to run towards the RIA model - unless they really want to. And, in an ironic turn of events, SEBI may, in the next 15 months, see a sizeable drop in the number of registered RIAs - a sea change from the earlier dispensation that seemed very keen on seeing RIA registrations grow rapidly.

Level playing field on hybrid model

Since 2013, one issue that individual distributors kept raising to the regulator was the unfairness of allowing a hybrid model for the big boys (banks, NDs and large IFAs with sizeable teams) while forcing smaller individual IFAs to choose between the MFD model and the RIA model. In one fell swoop, SEBI has unwound its earlier "SIDD" provisions under which most large players currently operate as MFD and RIA, has withdrawn its proposal for a subsidiary to substitute the SIDD and has mandated that all intermediaries - big and small - have to make a clear choice by 31st March 2019 on whether they will go the RIA route or the MFD route. The backdoor for the big boys has effectively been shut.

Click here to see the full text of SEBI's new consultation paper

In the spirit of a true level playing field, SEBI has also cut off the "back door" that many IFAs were proposing to use - which is to have one member in the family as an MFD and another as an RIA. By defining immediate relatives to include parents, children, brothers, sisters, spouse and similar relatives of the spouse as well, SEBI has quite effectively plugged the hybrid model for individual IFAs. Unless of course you start looking towards uncles, aunts, nephews and nieces to operate a backdoor hybrid model! An extended joint family may well prove to be an advantage for some IFAs!

Language of the background para is of paramount importance

The background para sets an important context on how to read the new proposals. It effectively suggests that while the June 2017 release was meant to clarify certain points from the Oct 2016 paper, this paper presents a revised set of proposals, after incorporating feedback from market participants. We will therefore assume that we no longer need to refer to any portions of the Oct 2016 or the June 2017 versions and we will treat this as the new version 2.0 of the RIA regulations. Therefore, for example, since this paper is silent on any disclaimers to be issued by MFDs stating that they may or may not be acting in clients' best interests (See our June 2017 article: SEBI's new RIA regulations humiliate MFDs), we presume that no such disclaimer needs to be issued. Thank you SEBI, presuming my understanding is correct.

Another crucial aspect which hinges on whether to read this paper as an addendum to the previous ones or a revised set of proposals - as the background paper clearly suggests - is the do's and don'ts for MFDs.

MFDs can offer risk profiling and asset allocation as part of "appropriateness"

In the previous version (Jun 2017), MFDs were supposed to be responsible for product suitability but were explicitly banned from offering risk profiling and goal planning - two activities that most intermediaries believe, and global best practices suggest, are integral to establishing product suitability. In the current proposal, such definitive statements have been done away with and we have instead a far more generic statement:

"Mutual Fund Distributors (MFDs), while distributing their mutual fund products can explain the features of products to client, and shall ensure the principle of 'appropriateness' of products to the client. As per the extant SEBI circulars, appropriateness is definedas selling only that product categorization that is identified as best suited for the client."

We know that the existing RIA regulations clearly state that if you are offering financial planning services, you ought to register as an RIA. However, there is no such definitive statement regarding risk profiling and asset allocation. This was included in the June 2017 version but has not been included in this paper. One can perhaps therefore conclude that SEBI recognizes that for an MFD to establish product appropriateness, steps like risk profiling and asset allocation are useful and needed. Specifically, the mention that extant SEBI circulars demand that MFDs remain responsible for product categories that are best suited for the client would mean that you ought to offer at least a basic version of asset allocation in order to establish suitability of the product category for an investment that is under consideration.

The words "appropriateness of products to the client" clearly mean that MFDs will not have to confine themselves to only product descriptions (which the earlier versions suggested), but can cross the line between product and client to establish whether a product is indeed right for a particular client or not. To me, this sounds quite similar to "advice that is incidental to distribution", without quite saying so.

What therefore is the big change?

So what then is the big change between the existing RIA regulations (of 2013 with FAQs issued in 2015) and the proposed one? To my mind, it is plugging the loophole for all intermediaries - big and small - to operate as both MFD and RIA. A choice has to be made by 31st March 2019 on which way you want to go.

So, which way will you go?

Whether you are a large bank or an ND or a big IFA or a small IFA, I guess the truth is that over 95% of intermediaries will first want to look at whether they can operate a viable and customer centric MFD model, and if the answer is yes, will happily stay as MFDs. There is a small and growing tribe of pure RIAs on the other hand, who will be very happy to see the demise of hybrid models - which makes them a lot more competitive in the advisory space.

If my understanding of these proposals is correct, it seems to me that you can indeed operate a reasonably customer centric MFD model by focusing on fund research, risk profiling and asset allocation - what you cannot do is financial planning. About the financial viability of the model - it clearly is very viable now - but will diminish over time as SEBI brings down expense ratios in mutual funds. To what extent they will bring it down and what therefore will be the knock-on effect on trail commissions is what we will have to wait and watch. For now, if my understanding is right, MFDs can continue to operate as such, will suitable adjustments in their business models which include avoiding financial planning and avoiding calling themselves advisors. Presuming that the 2015 FAQs to the RIA regulations are still valid, distributors of multiple SEBI governed products (MF, PMS, AIFs, bonds) will have to become RIAs.

What about the RIA model now?

For now, it appears that SEBI has backed down from its erstwhile missionary zeal of nudging MFDs to convert to the RIA model. The very apparent erstwhile stance of favouring RIA over MFD as a "preferred" intermediation model seems to be a thing of the past. All that SEBI now seems to be saying is don't try to be both - chose one. RIA clearly offers clients a superior proposition over MFD, but for the moment, MFD for most intermediaries appears a more viable financial model. It might therefore be reasonable - if my understanding is right - to assume that it will be largely status quo for most MFDs. Most of those who converted to the hybrid model, will most likely unwind back to an MFD mode by 31st March 2019. I can't see banks and NDs abandoning MFD in favour of the RIA mode. The reverse seems more likely. If all of this pans out the way I think it might, from a situation where SEBI appeared to be working with a numbers based target to get RIA sign-ups, we are likely to see in the next 15 months, a substantial reduction in number of RIAs in the market from the current crop, while on the other hand, the rise of a new breed of pure RIAs who will seek to carve out their niche in the market place, without having to compete with hybrids that were largely MFDs with just a veneer of RIA to remain compliant.

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