SECURITIES AND EXCHANGE BOARD OF INDIA

Transparency in Payment of Commission to Mutual Fund Distributors

1 Objective

1.1 The memorandum proposes to introduce a system in which the investor

decides the commission to be paid directly to distributors depending upon
the level of service desired, thereby enhancing transparency and
empowering the investor. Currently commission is paid to the distributor by
AMC from an entry load charged to the investor by deducting it from the
amount invested.

1.2

The memorandum also elaborates the existing structure of distribution,

current practices and proposes comprehensive disclosures with regard to
the commission receivable by distributors under various schemes.

2 Current Status

Structure of Distribution for mutual fund products

2.1 Mutual fund products are sold to investors through two main channels: by
Asset Management Companies (AMCs) directly (investor service centers/
Branch offices /internet) and by entities variously known as distributors /
agents / brokers (referred to as distributors hereafter).

2.2 Traditionally, there has been a large reliance placed on distributors for
reaching out to the investors for mutual fund products. As per the data
submitted by the registrars for mutual funds for April - March 2008-09, 86%
of the gross subscriptions were received through distributors and the share

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of direct applications in gross subscriptions was 14%. The various

categories of distribution channels are given in Annexure A.
Regulatory Structure for distributors

2.3 Distributors are not registered with SEBI. Association of Mutual Funds of
India (AMFI) registers distributors. As a pre-requisite for registration,
distributors have to undergo AMFI certification (barring a few exemptions
provided by SEBI). AMFI is neither a Self Regulatory Organization (SRO)
nor an intermediary registered with SEBI.

2.4 AMFI has prescribed a code of conduct for the mutual fund distributors.
SEBI has advised mutual funds that all their distributors should strictly follow
the code and that they should monitor the activities of their distributors to
ensure that they do not indulge in any kind of malpractice or unethical
practice while selling/marketing mutual funds units. It was further stated that
in case any distributor does not comply with the code of conduct, the mutual
fund should report it to AMFI and SEBI and no mutual fund should deal with
those distributors who do not follow code of conduct.

Remuneration/ Commission to Distributors

2.5 Mutual funds compensate the distributors from funds collected by way of
entry load, exit load and annual recurring expenses paid out of the scheme
assets.

2.6 The distributors receive the commission in the following modes:

2.6.1 Upfront commission: A fixed charge is deducted from the investors
subscription by the AMC (known as entry load) and is kept in a separate
load account and the balance subscription amount is invested in terms of
the scheme objectives as specified in the offer documents. The upfront
commission to the distributors is paid out of this load account.

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2.6.2 Trail commission: From the annual recurring expense charged to investor
for various expenses incurred in running the scheme, trail commission is
paid to the distributor.

Trail commission may also be paid from the

balance in the load account1 (which has credits from entry as well as exit
loads).

2.7 While the aforesaid payments are made by the AMC from the funds
collected from the investors, the AMCs are free to pay the distributors from
its own account through various modes including, inter-alia:2

Cash

Gift vouchers

Sponsorship for training programmes (local / overseas)

Sponsorship for trip (domestic / abroad)

Adhoc payment for ongoing support (reimbursement of mailing

expenses / advertisement in their magazines / investors events etc)

Generally, the commissions and incentives depend on the scale of business

procured by the AMC through the concerned distributor. The distributors thus
get paid for advice rendered to the investors and for acting as agents of the
AMCs for selling mutual fund schemes. While the AMC has a right to decide
the extent of payment to the distributor, at present the investor has no right to
decide the extent of payment for services (including advice) rendered to the
investor.

2.8 SEBI regulations permit mutual funds to charge a maximum load (entry plus
exit) of 7%. In equity schemes, the entry load does not generally exceed
2.25% of the subscription. Some fund houses also charge exit load in equity
schemes linked to period of holding. In liquid schemes, the industry practice
is to charge nil entry and exit loads. However, in case of debt oriented
1 SEBI has stipulated that the loads collected by the AMCs for each scheme have to be maintained in a
separate account and can be utilized towards meeting the selling and distribution expenses.
2

Source As informed by AMCs

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schemes, while the entry loads are generally nil, exit loads may be charged
depending on the period of holding of the investors (the load is higher for
lesser holding period)3.
2.9

Further, Mutual Fund Regulations also permit AMCs to charge the scheme
(under the annual recurring expense) for marketing and selling expenses
including distributors commission. While the Regulations specify an upper
limit on the annual recurring expense depending on the average weekly net
assets ( a maximum of 2.50% in case of equity schemes and 2.25% in case
of debt schemes), there is no limit specified separately for selling and
distribution expenses.

2.10 While presently the amount paid to the distributors is shown in the schemes
revenue account, there is no requirement to disclose separately the amount
paid out of the loads collected or from AMCs account.

3 Issues with the current system of commission payment

3.1

The current system of commission to distributors has led to issues of lack

of transparency and the right of investors to decide the extent of payment
for services rendered to them by the distributor.

3.2 The distributor may advise the investor to exit from an existing investment
and make a new investment, thereby increasing his inflow of commission
without disclosing the same to investor and at times at the cost of right
advice for the investment. This conflict can be resolved by mandating
disclosures of commissions.

Exit loads are applied by defining a slab structure for exit during a period since purchase for example 2%
in case of exit between 0-6 months, 1% for 6-12 months, 0.5% for 3-6 months. A scheme may apply this
exit load only for applications below a certain size say, Rs. one crore.

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3.3

In the current system of load being fixed by the AMC, the investors in effect
do not have any say in the commission that is paid to the distributor as the
load is aggregated and paid by the AMC depending on the scale of
business procured through the concerned distributor. This can be remedied
by changing the system to empower the investor to decide the payment for
services rendered.

3.4 The current practice of payment of the commissions to distributors by the

AMC has raised issues of transparency. Since varied commissions are paid
on different schemes by different AMCs, doubts have been raised whether
the advice rendered by the distributors is in the best interest of the investor
or is influenced by the quantum of commissions. There is an apprehension
that to maximise their income, the distributors might tend to sell the scheme
or plan that pays them the best.

4 Steps taken by SEBI towards empowering investors in respect of

payment of commissions

A. Waiver of Load for Direct Investments

4.1 As a first step towards empowering the investor class, SEBI has mandated
that no load be charged for direct applications received by the AMC (i.e.
applications routed without distributor intermediation). This is in force since
January 4, 2008. Prior to this, all investors irrespective of whether they
applied through or without a distributor were required to pay a fixed entry
load.

B. Towards transparency in commission payments

4.2 While deliberating the issue of waiver of load on direct applications, a

suggestion on the mechanism of variable load was also examined. The

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basic concept is that the commission paid to the distributor may be

determined by the investor in consultation with the distributor depending
upon the quality and extent of advice and service desired by the investor. It
was suggested that within the application form there would be a section
where the investor would mention the entry load that he wants to pay
signed off by the investor and the distributor. Accordingly that percentage
would get deducted from the amount received from the investor. However, a
view emerged that if implemented, variable load may lead to lot of disputes
between the investor and the distributor.

4.3 The pros and cons and the operational feasibility of the variable load model
were discussed in the meeting of Advisory Committee of Mutual Funds last
year (2008). The Committee discussed the alternative models of
implementing variable load and desired that a concept paper on variable
load be placed on SEBI website for public comments.

4.4 Accordingly, a concept paper titled Proposal on Variable Entry Load was
placed on SEBI website and public comments were sought. The concept
paper had proposed two options; first, within the application form itself, the
investor would indicate the commission payable to the distributor which would
be signed off jointly by the investor and the distributor and the AMC would then
pay the distributor. Second, the investor would issue two cheques one for his
investment in the name of the scheme and the second one in the favour of
distributor towards the commission agreed to be paid. The concept paper also

sought comments on the suggestion to make it mandatory for distributors to

disclose the commission being paid to them for the different schemes which
are being recommended to the investor as transparency in this area will
work to the benefit of the investors.

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5 Feedback and Analysis

5.1 An analysis of the responses received from distributors, AMCs and

individuals revealed that 93% did not favor variable load, 2.8% favored
variable load in application form (first option),0.7% favored the two cheque
system (second option) and 3.5% agreed with only the concept of variable
load (without indicating choice of option). Of the responses received from
distributors, 94.5% were not in favour of variable load and in case of
individuals, 88% were not in favour of the same. Only 3 AMCs replied with 2
against and 1 in favour of variable load.

5.2 In respect of disclosure of commissions, only 11 responses were received

out of which 6 were in favour of disclosures of commissions by distributors.

5.3 From the above analysis, there appears to be an overwhelming opposition

to the concept of variable load. However, many responses used an identical
language and were written in a similar fashion though were coming from
different persons/ email ids. Such multiple and similar responses may have
led to distortion in the analysis and hence a definitive conclusion cannot be
drawn.

5.4 AMFI feedback on variable load : AMFI had in October 2007 while giving
its comments on no load for direct applications stated that variable load is
the most suitable proposal and would usher in a new architecture in the
business of distribution of mutual funds. However, in March 2009 they
stated that in view of the current extremely depressed market situation
characterized by very low net inflow particularly to the equity segment,
variable load concept may not be introduced immediately. Further, they
recommended that instead of introducing variable load concept in isolation,
it should form an integral part of introduction of the Multiple Share Class

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Structure differentiated by loads (on lines of Multiple Share Classes of

mutual fund units in a few foreign markets) which is elaborated below:
Plan A (Dividend or Growth) In this plan, variable entry load would be as
agreed by investor and distributor; and exit load/CDSC4 and annual
recurring expenses would be as per current provisions of Regulations.
Plan B (Dividend or Growth) In this plan, there would be no entry load;
exit load/CDSC would be as per current provisions of Regulations and;
annual recurring expenses limit would be uniformly increased by 0.75%
across existing slabs.

5.5

According to AMFI, introducing variable load structure as part of Multiple

Share Class Structure would give choices to investors without impacting
distributors in terms of commissions. The distributor would either get upfront
commission and lower trail in plan A or low / no upfront commission and
higher trail commission in plan B. AMFI also states that higher trail
commission (paid out of higher annual recurring expense) would reduce the
incentive to the distributor to churn the investors portfolio and also
discourage New fund Offer (NFO) trend.

5.6 The following regulatory changes would be required to introduce the

multiple plan structure:

The regulatory limit for annual recurring expense in Plan B will need
to be increased by 0.75%.

Expense limits would be at plan level, not scheme level which

would mean that there would be two limits for annual recurring
expenses.

Management fee payable to AMC will require to be made fungible

with other expenses within limit on annual recurring expense.

Reimbursement of Service Tax on various annual expenses to be

taken outside the regulatory limit for annual recurring expense.

CDSC - Contingent deferred sales charge

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5.7 An examination of the AMFI proposal brings out the following pit falls:

In the rationale given that- long term investment will be promoted by

distributors since they will get a higher trail commission the cost to
investors has not been factored. As stated in Cadogan Report5 In
theory a trail commission rewards loyalty, but the loyalty it rewards is
the distributors and not the clients. In fact for a long-term client the
continued payment of marketing expenses out of the fund may act as
a positive disincentive to hold for the long term.

There is no limit suggested on exit loads in either plan unlike the

international models.

The increased annual expense which is stated to be used for trail

commission is at par with the 12b-1 fees6 charged by mutual funds in
the US. However, this fee is subject to checks and balances in the
US.

AMFI proposal on Multiple Share class would not lead to desired

transparency in disclosure of commission, does not appear to be
beneficial to the long term investors and will not result in simplification of
the already complex terminologies for schemes and plans used in the
market.

5.8 In the first of the two options suggested in the concept paper, there is a
possibility of increased disputes between the distributors and the investors
5

Cadogan Financial, UK was mandated by Asian Development Bank (ADB) on behalf of Government of
India to undertake review of various aspects of Mutual Fund industry in India. The report was submitted in
March 2004.
6
In the US a mutual fund may deduct an annual fee from the funds assets that can be used to compensate
selling brokers and for other marketing expenses. Section 12(b) of the Investment Company Act and the
SECs rule 12b-1 permit such payments only if they are approved by the funds board and a majority of the
board is independent of the management company. Fees deducted from the funds assets to meet marketing
expenses are therefore known as 12b-1 fees. Rules of the National Association of Securities Dealers limit
12b-1 fees to 1 percent of the mutual funds assets annually

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while there is still some lack of transparency as to how much of the entry
load paid by the investor is received by the distributor. In view of the above,
the second option of direct payment of commission is a better alternative.
The second proposal about distributors disclosing all the commission paid to
them under various schemes is obviously in favour of transparency.

6 Proposals:

6.1 The present system of payment of commission has led to a lack of control
by the investor over the quality of service vis--vis the commission being
borne by him. This has also led to a situation where the advise rendered to
the investor could be influenced by factors other than investors interest.
There appears to be a need to empower the investor in deciding the
commissions paid to the distributors and also to ensure transparency in
commissions being paid for mutual fund products.

6.2 Accordingly, the following proposals are placed before the Board for
consideration:

6.2.1 There shall be no entry load for all schemes launched by an AMC.

6.2.2 The upfront commission to distributors shall be paid by the investor to the
distributor directly. The scheme application forms may carry a disclosure
that the investor shall pay the commission to the distributors directly based
on his assessment of various factors, including the service rendered by
the distributor.

(It might not be desirable to provide an upper limit as any

such limit is likely to be made the norm by the distributors.)

The aforesaid proposals will segregate the streams of payment for the two roles
of distributor, an agent of the AMC and an adviser to the investor.

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6.2.3 The distributors shall disclose all the commissions (in the form of trail
commission or any other mode) payable to them for all the different
schemes/ different mutual funds which are being distributed by them
irrespective of the scheme(s) which is/are being recommended to the
investor. The AMCs shall monitor the compliance of the same by their
distributors.
The board may approve the above proposals and may authorize the Chairman to
make such amendments to SEBI (Mutual Funds) Regulations, 1996, and issue
such guidelines as may be necessary, consequential and appropriate to give
effect to the above proposals.

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Annex A
Categories of Distribution Channels

Currently, the main categories in the distribution channel of mutual funds are:
Banks, National / Regional distributors and Independent Financial Advisors
(IFAs). While National/ Regional distributors have larger presence and generally
a corporate set up, IFAs cater to the needs of the local/ neighbourhood investor
class. Based on gross sales of equity schemes during April-March 2008-09,
IFAs, National/ Regional distributors and banks have a share of 33%, 32% and
26% respectively.

In debt schemes, where retail participation is generally low,

IFAs have a negligible share of 3% of gross sales, National / Regional

distributors have a share of 60% followed by banks with 23% of gross sales
(based on the data for April to March 2008-09). A pie chart representation of the
share of the various distribution channels in equity schemes and debt schemes
for AprilMarch 2008-09 is given below:

Share of Distribution channels in Equity Schem es

Dire ct
IFAs
9%
33%
Banks
26%
National/
Re gional
Distribution
Companie s
32%

Share of Distribution channels in Debt Schem es

Dire ct
14%

IFAs
3%

Banks
23%
National/
Re gional
Distribution
Companie s
60%

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The top 20 distributors on the basis of total commission paid (upfront and trail)
are either banks (11) or National/ Regional distributors (9). Of the total
commission paid, 27% was paid to the 11 banks among the top 20 distributors
and 13% was paid to the 9 National/ Regional distributors, thus the top 20
distributors have a 40% share in the total commission paid.

These distributors advise on/ sell not only mutual funds but a whole array of other
products like insurance (life and general), savings products originating from
government (post office deposits/ schemes, PPF/ other small savings scheme),
bank deposits and corporate deposits. Unlike the insurance industry where there
is a tied agency concept i.e. an agent can sell insurance product from one life
insurance company only, distributors can sell products of any registered mutual
fund.
**********

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