Mutual funds, High Court verdict and SEC
Monday, 21 December 2009
M H Rashid
Our capital market, with a sustainable gain and the potentiality in terms of growth and expansion in the immediate future, is witnessing the most vibrant year so far. Current year's most discussed subjects in the burses are: the mutual funds; the High Court verdict on the expansion of the capital base of mutual funds in November; and SEC's comment on appeal against the verdict on the same day the High Court verdict was pronounced.
What is mutual funds? The concept of mutual funds first came in the late eighteenth century from a Dutch merchant and broker when he offered subscription to investors to form a trust which will have a relatively low risk by diversification of investment. The definition of mutual funds varies in different countries which can be defined as, a collective investment scheme which will have an actively managed portfolio by a fund manager and offers a diversification of risk by investing the fund in stocks, bonds and short-time money market as offered in its prospectus.
Mutual Funds are classified as investment companies in the US according to 'The Investment Company Act 1940' and the units are called shares. Structure of a mutual fund:
There are mainly two kinds of mutual funds, open end and closed end. All the listed mutual funds in our country are closed end and the current argument is, Can the closed end funds extend their capital base by offering Rights and/or Bonus issue or any other means or should they only disburse cash dividend?
Before we assess the argument, let's find out what is a Closed End Mutual Fund? A Closed End Mutual Fund issues a limited number of units/shares in an Initial Public Offering (IPO) and traded in a listed stock exchange. The assets of a closed end fund are professionally managed by experienced fund managers according to the investment objective of the fund. The unit price of a close end fund depends on the supply and demand on the market, earnings, therefore dividend yields and future growth on dividends and/or retained earnings.
The name 'Closed End Fund' came as opposed to the 'Open End Fund'. An open end fund does not have a limited tenure and the unit holder can buy or sell units directly to the fund, normally after the trading hours. An open end fund always has to keep some cash available for repurchasing units from its unit holders, therefore an open end fund can be less efficient than a closed end fund as it cannot utilise its whole fund. On the other hand, a closed end fund has a fixed tenure, say, 10 years. At the end of the tenure the fund can be winded up and the realised cash distributed to the unit holders or it can be renewed again for another fixed period. In substance, the second option has been exercised in our country for the past 19 years since 1st ICB Mutual Fund was listed in 1980.
Now let's see, should the Closed End Mutual Funds be able to extend there capital base?
Bonus issue: Bonus issue is a process by which a company/Mutual Fund issues new shares/units to the existing share/unit holders according to their shareholding. In accounting term, this is a process for converting money from the company's reserves into issued capital. Question is: can mutual funds do this? If the trustee/board decide to extend the fund by reinvesting the retained earnings in the fund by issuing bonus shares/units rather than distributing the cash to the unit holders, because the trustee/board thinks that the fund is profitable and can be more profitable if the fund can be expanded, because bigger the fund the less is management cost. For example, GrameenPhone's IPO was Taka 483 million and 10% was reserved for the 19 mutual funds. If the Taka 483 million IPO was distributed to each fund equally, it would be Taka 25.42 million for each fund which is bigger than some fund's current paid-up capital. So the IPO was distributed pro rata (according to their fund size). Where the investment in IPO gives more than 100% profit within a short period of time and the small funds lack capital to subscribe a bigger portion of allocated IPO, then why does SEC bar the small funds from increasing their capital? On the other hand, in recent months there is a small number of large IPOs in the market, with some waiting in the list. There is a possibility that the small paid-up mutual funds may not be able to subscribe their reserved allocation for lack of funds or they will have to sell their secondary portfolio to subscribe the primary shares which is clearly not expected in the market as this may destroy the stability of the market in short time.
Rights issue: Right issues is a method by which listed companies on a stock exchange raise new capital, in exchange for new shares subject to the approval of the SEC. The name arises from the principle of 'pre-emption rights' which is found in the company law (in the UK) according to which 'any new shares issued by a company must be offered to its existing shareholders as they are the legitimate owners of the company'. The SEC has barred the listed Mutual Funds from issuing rights shares/units.
It, on the other hand, allows the asset management companies to issue a new fund even using the name (hence the goodwill) of an old fund and also allows to issue private placement of the new fund to the outsiders according to the underwriter's choice, which is questionable, for example, ICB AMCL NRB2 and ICB AMCL NRB1, ICB AMCL2 and ICB AMCL1.
Let's see how the unit holders of both the Mutual Fund's (NRB1 & AMCL1) lose out from the SEC's decision. NRB1 has a paid-up capital of Taka 100 million. Rather than letting the trustee to extend NRB1's paid-up capital, the SEC gave its consent to ICB AMCL to issue NRB2 with a paid-up capital of Taka 1000 million out of Taka 400 million (this is an assumption as it could not be confirmed from the DSE website as it is experiencing technical problem but this figure should be very close) was private placement.
This can be identified as a bend of rule which bars the shareholders of the NRB1 to exercise their pre-emption right and gives the opportunity to some wealthy people (outsiders who may not be a general investor in the stock market) to make some quick gain from selling their placement shares at a high price within a short period of time (eg.1st Prime Mutual Fund). Rights issue is more preferable for a mutual fund than a placement issue. The right share is exercised by the existing shareholders and the money stays in the market, because when a small shareholder gains from the market he spends some money but reinvests a good chunk of his profit back in the market. On the other hand, private placement holders, often big investors (some of their business is only buying private placement) takes privilege over the small investors (without taking any risk) even though they may have no link with the company, its operation or the stock exchange. Question is: in which capacity had a person the entitlement to buy private placement of NRB2 or AMCL2?
In general sense, if there is a private placement of a second version of an old mutual fund, (such as AMCL2 and AMCL1), the private placement should be offered to the older fund's unit holders. For example, placement of AMCL2 should have been offered to the unit holders of the AMCL1 as AMCL2 is using the name (hence the goodwill) of AMCL1 or the AMCL1 itself should have been given the opportunity to buy the placement of the AMCL2 by offering Rights shares or Preference shares, and thus it could also increase it's capital. If mutual funds are not allowed to increase their capital by bonus or right issue, then there should not be any private placement issue for mutual funds or if there is any private placement issue for a newer version of an old fund, the placement should be offered to the older fund's unit holders.
Preference share issue: The shares, which are entitled to receive a fixed percentage of dividends regardless of the profits the company makes and does not have a voting right like the ordinary shares, belong to this category. In the event of liquidation, the Preference shareholders are paid out before the ordinary shareholders. This is a popular way of increasing funds for closed end mutual funds in some countries. The following graph (which is taken from the Internet) shows the increase in capital base of closed end mutual funds in the USA over the last 9 years by preference share issue:
The issue of the convertible preference shares could be a solution of the current argument of the Mutual Fund's capital increase. As some months ago the SEC declared that it will not allow any mutual fund, which has paid-up capital less than Taka 500 million, to be listed in the stock exchange. It also said all the listed Mutual Funds, which have paid-up capital less than Taka 500 million and want to renew for a new tenure at the end of its 10-year tenure, will also have to have at least Taka 500 million paid-up capital. But the SEC did not give any direction how the existing Mutual Funds will raise the additional fund without issuing bonus or rights issue.
Therefore, it could be a good solution for the listed Mutual Funds having less than Taka 500 million paid-up capital to issue convertible preference shares (subject to the approval from the unit holders and the SEC). Such shares can be converted to ordinary shares/units at certain intervals, targeting Taka 500 million at the end of the tenure. Then the fund can be renewed for a new 10-year tenure with a paid-up capital of Taka 500 million.
High Court verdict: On the 9th November 2009, after the High Court verdict was issued, Mr. Anwarul Kabir Bhuiyan, the Executive Director of SEC, told the Financial Express: "We will go to the Appellate Division (of the Supreme Court) to appeal against the ruling." However, Mr Mahmudul Islam, the lawyer of SEC, made a professional comment: "I have prayed for one week and the court has give us time. I will go to the Appellate Division if the SEC agrees."
The SEC needs to clarify its views regarding the issues related to the Mutual Funds industry and come across to a solution which is sustainable for the Mutual Fund industry and hence the stability and the growth of the market as whole.
The SEC can arrange meetings with all the asset management companies and seek advice to have a solution which will be acceptable to the majority. Also the SEC should make sure that none of its responsible members makes any comment regarding matters which are price sensitive in nature and needs to be decided in a meeting of the commission. Integrity, competence, objective judgement and professional behaviour are expected from the regulatory body, SEC.
The writer is a student member of ACCA, currently studying in Kaplan Financial, London
Our capital market, with a sustainable gain and the potentiality in terms of growth and expansion in the immediate future, is witnessing the most vibrant year so far. Current year's most discussed subjects in the burses are: the mutual funds; the High Court verdict on the expansion of the capital base of mutual funds in November; and SEC's comment on appeal against the verdict on the same day the High Court verdict was pronounced.
What is mutual funds? The concept of mutual funds first came in the late eighteenth century from a Dutch merchant and broker when he offered subscription to investors to form a trust which will have a relatively low risk by diversification of investment. The definition of mutual funds varies in different countries which can be defined as, a collective investment scheme which will have an actively managed portfolio by a fund manager and offers a diversification of risk by investing the fund in stocks, bonds and short-time money market as offered in its prospectus.
Mutual Funds are classified as investment companies in the US according to 'The Investment Company Act 1940' and the units are called shares. Structure of a mutual fund:
There are mainly two kinds of mutual funds, open end and closed end. All the listed mutual funds in our country are closed end and the current argument is, Can the closed end funds extend their capital base by offering Rights and/or Bonus issue or any other means or should they only disburse cash dividend?
Before we assess the argument, let's find out what is a Closed End Mutual Fund? A Closed End Mutual Fund issues a limited number of units/shares in an Initial Public Offering (IPO) and traded in a listed stock exchange. The assets of a closed end fund are professionally managed by experienced fund managers according to the investment objective of the fund. The unit price of a close end fund depends on the supply and demand on the market, earnings, therefore dividend yields and future growth on dividends and/or retained earnings.
The name 'Closed End Fund' came as opposed to the 'Open End Fund'. An open end fund does not have a limited tenure and the unit holder can buy or sell units directly to the fund, normally after the trading hours. An open end fund always has to keep some cash available for repurchasing units from its unit holders, therefore an open end fund can be less efficient than a closed end fund as it cannot utilise its whole fund. On the other hand, a closed end fund has a fixed tenure, say, 10 years. At the end of the tenure the fund can be winded up and the realised cash distributed to the unit holders or it can be renewed again for another fixed period. In substance, the second option has been exercised in our country for the past 19 years since 1st ICB Mutual Fund was listed in 1980.
Now let's see, should the Closed End Mutual Funds be able to extend there capital base?
Bonus issue: Bonus issue is a process by which a company/Mutual Fund issues new shares/units to the existing share/unit holders according to their shareholding. In accounting term, this is a process for converting money from the company's reserves into issued capital. Question is: can mutual funds do this? If the trustee/board decide to extend the fund by reinvesting the retained earnings in the fund by issuing bonus shares/units rather than distributing the cash to the unit holders, because the trustee/board thinks that the fund is profitable and can be more profitable if the fund can be expanded, because bigger the fund the less is management cost. For example, GrameenPhone's IPO was Taka 483 million and 10% was reserved for the 19 mutual funds. If the Taka 483 million IPO was distributed to each fund equally, it would be Taka 25.42 million for each fund which is bigger than some fund's current paid-up capital. So the IPO was distributed pro rata (according to their fund size). Where the investment in IPO gives more than 100% profit within a short period of time and the small funds lack capital to subscribe a bigger portion of allocated IPO, then why does SEC bar the small funds from increasing their capital? On the other hand, in recent months there is a small number of large IPOs in the market, with some waiting in the list. There is a possibility that the small paid-up mutual funds may not be able to subscribe their reserved allocation for lack of funds or they will have to sell their secondary portfolio to subscribe the primary shares which is clearly not expected in the market as this may destroy the stability of the market in short time.
Rights issue: Right issues is a method by which listed companies on a stock exchange raise new capital, in exchange for new shares subject to the approval of the SEC. The name arises from the principle of 'pre-emption rights' which is found in the company law (in the UK) according to which 'any new shares issued by a company must be offered to its existing shareholders as they are the legitimate owners of the company'. The SEC has barred the listed Mutual Funds from issuing rights shares/units.
It, on the other hand, allows the asset management companies to issue a new fund even using the name (hence the goodwill) of an old fund and also allows to issue private placement of the new fund to the outsiders according to the underwriter's choice, which is questionable, for example, ICB AMCL NRB2 and ICB AMCL NRB1, ICB AMCL2 and ICB AMCL1.
Let's see how the unit holders of both the Mutual Fund's (NRB1 & AMCL1) lose out from the SEC's decision. NRB1 has a paid-up capital of Taka 100 million. Rather than letting the trustee to extend NRB1's paid-up capital, the SEC gave its consent to ICB AMCL to issue NRB2 with a paid-up capital of Taka 1000 million out of Taka 400 million (this is an assumption as it could not be confirmed from the DSE website as it is experiencing technical problem but this figure should be very close) was private placement.
This can be identified as a bend of rule which bars the shareholders of the NRB1 to exercise their pre-emption right and gives the opportunity to some wealthy people (outsiders who may not be a general investor in the stock market) to make some quick gain from selling their placement shares at a high price within a short period of time (eg.1st Prime Mutual Fund). Rights issue is more preferable for a mutual fund than a placement issue. The right share is exercised by the existing shareholders and the money stays in the market, because when a small shareholder gains from the market he spends some money but reinvests a good chunk of his profit back in the market. On the other hand, private placement holders, often big investors (some of their business is only buying private placement) takes privilege over the small investors (without taking any risk) even though they may have no link with the company, its operation or the stock exchange. Question is: in which capacity had a person the entitlement to buy private placement of NRB2 or AMCL2?
In general sense, if there is a private placement of a second version of an old mutual fund, (such as AMCL2 and AMCL1), the private placement should be offered to the older fund's unit holders. For example, placement of AMCL2 should have been offered to the unit holders of the AMCL1 as AMCL2 is using the name (hence the goodwill) of AMCL1 or the AMCL1 itself should have been given the opportunity to buy the placement of the AMCL2 by offering Rights shares or Preference shares, and thus it could also increase it's capital. If mutual funds are not allowed to increase their capital by bonus or right issue, then there should not be any private placement issue for mutual funds or if there is any private placement issue for a newer version of an old fund, the placement should be offered to the older fund's unit holders.
Preference share issue: The shares, which are entitled to receive a fixed percentage of dividends regardless of the profits the company makes and does not have a voting right like the ordinary shares, belong to this category. In the event of liquidation, the Preference shareholders are paid out before the ordinary shareholders. This is a popular way of increasing funds for closed end mutual funds in some countries. The following graph (which is taken from the Internet) shows the increase in capital base of closed end mutual funds in the USA over the last 9 years by preference share issue:
| Billions of dollars, year-end, 2000–2008 | |||
| Preferred1 | Common2 | Total | |
| 2000 | 25 | 118 | 143 |
| 2001 | 28 | 113 | 141 |
| 2002 | 36 | 123 | 159 |
| 2003 | 49 | 165 | 214 |
| 2004 | 59 | 195 | 254 |
| 2005 | 60 | 217 | 277 |
| 2006 | 60 | 238 | 298 |
| 2007 | 60 | 253 | 313 |
| 2008 | 42 | 146 | 188 |
| 1A closed-end fund may issue preferred shares to raise additional capital, which can be used to purchase more securities for its portfolio. Preferred stock differs from common stock in that preferred shareholders are paid dividends, but do not share in the gains and losses of the fund. | |||
| 2All closed-end funds issue common stock, which is also known as common shares. | |||
The issue of the convertible preference shares could be a solution of the current argument of the Mutual Fund's capital increase. As some months ago the SEC declared that it will not allow any mutual fund, which has paid-up capital less than Taka 500 million, to be listed in the stock exchange. It also said all the listed Mutual Funds, which have paid-up capital less than Taka 500 million and want to renew for a new tenure at the end of its 10-year tenure, will also have to have at least Taka 500 million paid-up capital. But the SEC did not give any direction how the existing Mutual Funds will raise the additional fund without issuing bonus or rights issue.
Therefore, it could be a good solution for the listed Mutual Funds having less than Taka 500 million paid-up capital to issue convertible preference shares (subject to the approval from the unit holders and the SEC). Such shares can be converted to ordinary shares/units at certain intervals, targeting Taka 500 million at the end of the tenure. Then the fund can be renewed for a new 10-year tenure with a paid-up capital of Taka 500 million.
High Court verdict: On the 9th November 2009, after the High Court verdict was issued, Mr. Anwarul Kabir Bhuiyan, the Executive Director of SEC, told the Financial Express: "We will go to the Appellate Division (of the Supreme Court) to appeal against the ruling." However, Mr Mahmudul Islam, the lawyer of SEC, made a professional comment: "I have prayed for one week and the court has give us time. I will go to the Appellate Division if the SEC agrees."
The SEC needs to clarify its views regarding the issues related to the Mutual Funds industry and come across to a solution which is sustainable for the Mutual Fund industry and hence the stability and the growth of the market as whole.
The SEC can arrange meetings with all the asset management companies and seek advice to have a solution which will be acceptable to the majority. Also the SEC should make sure that none of its responsible members makes any comment regarding matters which are price sensitive in nature and needs to be decided in a meeting of the commission. Integrity, competence, objective judgement and professional behaviour are expected from the regulatory body, SEC.
The writer is a student member of ACCA, currently studying in Kaplan Financial, London