SEBI bats for individual investors: Important changes you need to be aware of

Published: July 31, 2020 at 10:46 am

Last Updated on July 31, 2020 at 10:46 am

SEBI has recently announced several important changes to its investment advisor regulations. Many freefincal readers and Facebook group Asan Ideas for Wealth members have played a role in influencing these changes. SEBI registered investment advisor Avinash Luthria explains what these changes are and how it would impact you.

About the author:  Avinash is Founder, Fee-Only Financial Planner & SEBI Registered Investment Adviser (RIA) at Fiduciaries. He was previously a Private Equity  & Venture Capital investor for 12 years and has a flagship-course MBA in Finance from IIM Bangalore. His articles have appeared at Business Standard, Mint and The Ken. See: publications  You can read his previous guest articles here:

SEBI bats for individual investors: But ‘buyer beware’ will always be true. The most important step by SEBI over the last decade was SEBI arm-twisting Mutual Funds (MFs) to offer ‘Direct Plans’ of MFs from 2013. Direct Plans are Zero-Commission Plans and they are the opposite of ‘Regular Plans’ i.e. Annual Commission Plans. I have explained the importance of this step is this article which is behind a paywall: The two-headed Goliath—Mutual Funds and their distributors

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A related step which was the second most important step was SEBI allowing registered Investment Advisers (RIAs) to register with SEBI starting in 2013. Regulations allow Distributors of financial products to put their own interests ahead of the client’s interests. The RIA regulations demand that RIAs put the client’s interests ahead of the RIA’s own interests i.e. that the RIA be the exact opposite of a Distributor of financial products. That is why the RIA regulations were a huge step forward by SEBI.

SEBI has now made a few small improvements to the RIA regulations to help individual investors. However, no such regulator anywhere in the world can babysit individual investors and completely protect them. So individual investors still have to be careful and beware of the risks involved (more details in this article: How financial services industries aim to take 1% of your wealth each year. 

In an earlier article – Three simple tips to choose the right financial advisor –  I had covered how individual investors should go about selecting a Fixed-Fee-Only Financial Planner (for example, most of the people listed here. Hence this article focuses only on the changes in the RIA regulations from the point of view of individual investors.

A quick recap: SEBI proposed extensive changes to the RIA regulations on 15th January 2020. Further, SEBI provided two weeks of time for anyone to send their feedback to SEBI. SEBI’s primary objective was to stop bad RIAs i.e. dangerous RIAs. But an unintended side-effect of the proposed regulation was that it would drive a majority of Fixed-Fee-Only Financial Planners out of the profession. And that would directly or indirectly hurt individual investors.

Hence Pattu, Ashal Jauhari (the creator of the Facebook group Asan Ideas for Wealth), various Fixed-Fee-Only Financial Planners (including but not limited to Melvin Joseph, Basavaraj Tonagatti, SR Srinivasan and myself) requested people to send their feedback to SEBI. More than 2,800 people sent their feedback to SEBI and this probably includes many hundreds of FreeFinCal readers. Thank you to everyone who took the trouble to email SEBI. Thank you also to Jash Kriplani at Business Standard and Sandeep Parekh, Founder, Finsec Law who wrote about it and to Pattu and Ashal Jauhari.

SEBI decided about the final regulations soon afterwards on 17th February 2020. But due to the pandemic, most of the details were announced only on 3rd July 2020 and a few key details are yet to be announced. These new regulations are effective from 1st October 2020.

This article is an oversimplified description of the key changes from the point of view of individual investors (including but not limited to current and potential clients of RIAs). The changes are largely positive for individual investors. As we discuss the changes, it may be tempting to ask why SEBI did not take an even bigger step forward. I think even this small step forward was an extremely courageous step by SEBI. For example, regulations related to RIAs in the US recently took a huge step backwards i.e. the new US regulations related to RIAs will probably hurt individual investors in the US. So, we should all appreciate this small step forward. These are the main changes in the new regulations from the point of view of individual investors:

1. Stopping Distributors from using the label ‘Financial Adviser’ or ‘Wealth Adviser’. A Distributor’s main role is to sell financial products. And Distributors can have almost zero relevant qualifications and almost zero relevant experience i.e. almost zero competence. So, though Distributors can have almost zero competence; have the completely wrong incentives; and are not accountable at all, for various reasons, Distributors continue to be allowed to pretend to offer investment advice which could wipe out the retirement savings of an individual investor. To clarify, there could be some exceptional Distributors who are competent and who overcome the wrong incentives of their business and hence recommend sensible products e.g. within Domestic Equity MFs recommend the Nifty 50 Index Fund that have the lowest commission and fees.  But overall, this is clearly a disastrous state of affairs for individual investors.

SEBI has now taken a baby step towards reducing this disastrous state of affairs. That baby step is that SEBI is now insisting that “no person…shall use the nomenclature ‘Independent Financial Adviser or IFA or Wealth Adviser or any other similar name’ unless registered with SEBI as Investment Adviser (i.e. RIA)”. SEBI is hoping to make it more clear to individual investors when they are dealing with a Distributor (i.e. a salesman of financial products) so that individual investors can be more on their guard for conflicts of interest. Some of these conflicts of interest include the Distributor pushing Equity MFs because they pay higher commissions than Debt MFs or the Distributor pushing PMS or AIFs or Structured Products that pay very high commissions.

There are various ways for Distributors to get around this restriction. For example, SEBI’s new regulations do not explicitly prevent Bank Relationship Managers or others from calling themselves ‘Relationship Manager’. And most individual investors may not realize that a ‘Relationship Manager’ has to recommend products with the highest commissions otherwise the Relationship Manager is very likely to lose his job.

2. Making it more difficult for MF Distributors to claim to be RIAs. A dangerous category is the small number of Distributors that are also RIAs (let’s call then ‘Hybrids’). A subset of these Hybrids extracts high annual commission from clients while also charging the same client an explicit fee for their Investment Advice. The main problem here is that once the client has paid an explicit fee, the client lets their guard down and does not check whether a high annual commission is also being extracted from them.

SEBI’s new regulations continue to allow such Hybrids to exist. However, the new regulations insist that such Hybrids that are MF Distributors can no longer earn a commission from and also charge fees for Investment Advice from the same client (the keywords here are ‘same client’). Since annual commissions are usually very attractive, such MF Distributors will prioritize their annual commissions and will stop charging fees from most of their clients. So, in case you are engaged with a Hybrid you still have to check whether you are engaged with the MF Distributor division or the RIA division. There is one further important loophole that we will look at next.

3. But Distributors of Insurance Investment products may still claim to be RIAs. SEBI has not stopped Hybrids that are Distributors of Insurance Investment products from extracting a high annual commission while also charging fees for Investment advice from the same client. The commissions on Insurance Investment products (e.g. ULIPs) are obscenely attractive. So, there is a perverse incentive for some RIAs to charge zero or very low fees for Investment Advice; gain the trust of the client, and then up-sell Insurance Investment products to them. This problem of up-selling is all-pervasive in financial services and other fields, but we won’t go into that over here. So individual investors have to beware of this dangerous structure and tactic.

4. A few bad RIAs may voluntarily surrender their licence over the next 3 years. There are bad RIAs that recommend dangerous products including but not limited to Futures & Options and micro-cap stocks to their clients. It is difficult for SEBI to identify a bad RIA in advance. So usually, SEBI is able to investigate them only after these bad RIAs have done some harm to one or more individual investors. SEBI has tried to increase its ability to extract a monetary fine from such bad RIAs. This may create an incentive for a few bad RIAs to voluntarily surrender their licence over the next 3 years. But many of these bad RIAs will not voluntarily surrender their licence. So individual investors still have to beware of bad RIAs that make enticing claims and recommend dangerous products.

5. It is difficult for SEBI to prevent non-RIAs from claiming to be RIAs. Some non-RIAs will claim to be RIAs. For all practical purposes, these are criminals. But SEBI may be able to act only after someone brings this to their attention. Hence investors have to beware. The SEBI website has a list of all RIAs

6. RIAs that use an individual structure can engage with only 150 clients. An RIA can choose to be structured as an individual or as a corporate entity (for example, a Private Limited company). If an RIA chooses a corporate structure, then the corporate entity has to always have fixed deposits from the RIA’s own money of at least Rs 50 lakhs i.e. the RIA cannot use this money for business or personal expenses.

If an RIA decides to be structured as a corporate entity, then the RIA can have any number of clients. However, if an RIA decides to be structured as an individual, then the new regulations specify that the RIA can have a maximum of 150 clients. Further, if such an RIA has more than 150 clients, then they have to bring down their number of clients to 150 clients by September 2020.  This is very unfortunate for a few such RIAs but that topic is outside the scope of this article. It is also unfortunate for individual investors because they will not be able to get Investment Advice from a few such RIAs.

7. Some possible minor hassles are yet to be announced. Some elements of the new regulations are yet to be announced. These might add some minor hassles for individual investors. Some of these open items are that SEBI might dictate that the agreement between RIAs and clients have to include certain additional aspects and hence the agreement document may become even longer and/or more complex. Or that every 6 months (not every 12 months) the client and the RIA have to mutually decide whether or not to continue the engagement. To reiterate, SEBI’s decision on these aspects are not yet known.

Conclusion: Overall, SEBI is trying to make things better and safer for individual investors. It is not possible for SEBI to solve all such problems. So, ‘buyer beware’ remains true.

In case an individual investor plans to engage with a Fixed-Fee-Only Financial Planner, then Pattu’s list of Fixed-Fee-Only Planners is a good starting point. There are many complex criteria that an individual investor would not realize but Pattu has tried to incorporate those criteria to create this list. This does not eliminate the need for ‘buyer beware’ but it is a good starting point for your research.

Further, there are several aspects that are unique to you that you have to factor in while deciding which Fixed-Fee-Only Financial Planner to engage with. For example, whether you are looking for a low fee so that it will be an easy decision to renew the engagement for the next 10-20 years. Or whether you are looking for someone who will put in 15-20 hours of effort into the engagement to educate you about financial planning and investing so that you will not feel the need to renew the engagement for the next 3-5 years. The second half of this article provides an illustration of a 15-20 hour engagement. Further, my earlier article which defines ‘Fixed-Fee-Only Financial Planning  is a starting point to help you to think through these difficult tradeoffs.

A necessary but not sufficient condition for a successful retirement is educating yourself about financial planning and investing. And this cannot be completely outsourced to anyone else, not even to a Fixed-Fee-Only Financial Planner.

Avinash Luthria is Founder, Fixed-Fee-Only Financial Planner & SEBI Registered Investment Adviser (RIA) at Fiduciaries; He was previously a senior Private Equity & Venture Capital investor for 12 years and has a flagship-course MBA in Finance from IIM Bangalore; He writes about Financial Planning & Investing in Business Standard, Mint etc ( ); This article is not intended to be Investment Advice nor legal advice; Due to the pandemic, the author has not fact-checked this article; Views expressed here are of the author and do not necessarily reflect the views of FreeFinCal

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