SC says unitholders’ consent must before winding up mutual funds

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Trustees cannot give themselves air of ‘domain experts’ and treat unitholders as mere “laypersons” whose consent is not necessary before winding up, it says

The Supreme Court on Wednesday held that trustees in a mutual fund scheme have to take the consent of the unitholders, who have invested their money, before deciding to wind up the scheme or prematurely redeem the units.

Trustees cannot give themselves the air of “domain experts” and treat the unitholders of a mutual fund scheme as mere “laypersons” whose consent was not necessary before winding up, it said.

“The argument that the unitholders are lay persons and not well-versed with the market conditions is to be rejected. Investments by the unitholders constitute the corpus of the scheme. To deny the unitholders a say, debilitates their role and right to participate,” a Bench of Justices S. Abdul Nazeer and Sanjiv Khanna observed in a judgment.

The Bench was hearing an appeal filed by Franklin Templeton Trustee Services Private Limited concerning the winding up of its six mutual fund schemes. The judgment harmoniously interprets Regulation 18(15)(c) with Regulation 39 (2) (a) of the Securities and Exchange Board of India (Mutual Funds) Regulations of 1996.

Regulation 18 mandates that trustees seek the consent of the unitholders while Regulation 39 allows a close-ended mutual fund scheme to be wound up if the trustees give that opinion. The latter regulation is silent about getting prior consent from the unitholders.

Middle path

The Supreme Court opted for a middle path between the two Regulations. “The Principle of Harmonious Construction should be applied in the context of the Regulations in question… This would mean that the opinion of the trustees would stand, but the consent of the unitholders is a pre-requisite for winding up,” Justice Khanna observed in a deft manoeuvring of the law.

The court said, unlike trustees of a mutual fund scheme, the unitholders may not be domain experts. But they were “discerning investors who are perceptive and prudent”.

“The trustees are, therefore, commanded to inform and be transparent… Unitholders are not placid onlookers, impuissant and helpless when the trustees decide to wind up the scheme in which they have invested. The stature and rights of the unitholders can co-exist with the expertise of the trustees and should not be diluted because the trustees owe a fiduciary duty to them. Thus, the contention that the trustees being specialists and experts in the field, their decision should be treated as binding and fait accompli has to be rejected,” Justice Khanna wrote.

The court said there may be cases when even ‘domain experts’ go wrong.

“Situations could arise when the trustees may err in their opinion, in which event the unitholders may correct them. Money and investment of the unitholders being at stake, a wrong decision would obviously have inimical impact on the unitholders themselves. We would brace the argument that a good and intelligible decision of winding up would invariably be accepted by the unitholders,” Justice Khanna reasoned.

Upholds 1996 Regulations

The court upheld the 1996 Regulations, which draw the distinction between creditors and unitholders.

“The unitholders are investors who take the risk and, therefore, entitled to profits and gains. Having taken the calculated risk, they must also bear the losses, if any. Creditors, on the other hand, are entitled to fixed return as per mutually agreed contracts. Their rate of return is in the nature of interest and not profit or loss. Creditors are not risk takers as is the case with the unitholders,” the court distinguished.

It compared the unitholders of a mutual fund scheme with the shareholders of a company.

“The waterfall mechanism under the Companies Act, or the Indian Bankruptcy Code, gives primacy to the dues of the creditors over the shareholders. Identical is the position of the unitholders. In fact, the argument that the unitholders should be treated pari passu with the creditors is far-fetched,” the court noted.

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