June 21, 2021

SEBI’s Uncovering Of The FT Liquidity Crisis

SEBI’s order against Franklin Templeton (FT) earlier this month, and the subsequent adjudication order make for a fascinating read.  SEBI has painstakingly compiled and analyzed FT’s actions and omissions, leading to the winding up of its 6 debt funds.  It establishes, with a wealth of evidence, that what happened was much more of FT’s own making than was generally understood, or FT cared to admit.

While the orders offer a lot to take away and think about, in this post, I want to focus on some select findings on how FT’s choices contributed to the liquidity crisis.  Thanks to reporting in the mainstream media and conversations on social media, it seems to be widely recognized that on FT’s part there was inadequate due diligence in selecting issuers, and diminished oversight of existing holdings.  I want to touch upon two equally serious issues that SEBI has uncovered and which, to the best of my knowledge, haven’t got much media attention.  The first is about exit options that FT didn’t exercise. The second is the questionable terms on which many investments were made by FT. 

Exit options that weren’t exercised

SEBI quotes a communication from FT that admits that “signs of stress began to emerge” in the scheme portfolios in October 2019.  In that, FT also acknowledges that after 1 October 2019, the unlisted securities in the scheme portfolios were “no longer marketable to most other market participants.”  Logically, then, FT should have started exiting illiquid securities that offered it an option to do so.  Yet, for reasons that are somewhat murky, based on the evidence that is available, very few exit options were exercised.

SEBI cites the specific example of Franklin India Ultra Short Bond Fund which, from October 2019 to March 2020, had 8 put options that were not exercised, and which otherwise would have liquidated around 900 crore of AUM.  If one considers interest rate resets, SEBI counts 15 additional instances amounting to 4,708 crore, where that scheme did not exit even though the securities had become illiquid.

From what I can make out, FT’s primary contention is that the decision on whether or not to exercise an exit option was taken by the investment team based on their “business judgment”.  SEBI offers an unsparing response:

[FT] brings out the reasons of ‘business judgment’ to defend questionable decisions; however, it is seen that these decisions which involve deployment of public funds are barely documented.

To be fair, FT does appear to have explained its rationale to SEBI, some of which is laid out in one of the orders.  Unfortunately, it makes the decisions to not exit, look even more questionable.

Investments made on dubious terms

This aspect gets highlighted in the extracts of the term sheets shared by SEBI.  As an illustration of how problematic some of the terms were, consider the investments that FT made in certain floating rate bonds.

One peculiarity of floating rate bonds that a prospective investor needs to recognize is that when interest rates are reset (or continued), the decided rate may not be to one’s liking.  For that reason, it makes sense to prefer bonds that allow investors to exit if that happens.  It makes all the more sense if such instruments are illiquid or thinly traded.  It would be common sense for an open-end fund to only deal in such floating rate bonds.

Despite the obviousness of that, the orders show that there were multiple instances of floating rate bonds held by FT’s schemes that, in SEBI’s words, “had no explicit option available to exit on the interest rate reset date”.

What is especially troubling is that, to quote SEBI:

These deals were negotiated deals where [FT] subscribed to 100% or close to 100% of the issuance and yet had failed to pay specific attention to the term sheets of such privately placed securities.

Apparently, FT tried to justify these by saying that there was a “commercial understanding” to which SEBI makes this scathing comment:

[FT] has defended its position by citing the existence of ‘commercial understanding’ between itself and the Issuer but it needs to be borne in mind that a commercial understanding cannot be enforced in a Court of law in the absence of clearly documented covenants.

Furthermore, SEBI mentions at least one instance where such a “commercial understanding” appears to have failed.  This pertains to floating rate bonds issued by Edelweiss Rural & Corporate Services Ltd. (ERCSL), maturing in 2027.  To quote SEBI:

[FT] had informed ERCSL that it was willing to exit on the next interest rate reset date (i.e. June 30, 2020) and had appraised the Issuer in advance to plan for the prepayment. However, the Issuer vide communication dated April 30, 2020, had informed [FT] that under the terms of the Agreement, the discretion of issuance of interest rate reset notice is solely at the option of the Issuer and it had decided not to propose a revised rate.

From what I can see, based on the latest portfolios, the 5 schemes that held these bonds a year ago, continue to do so.  It remains to be seen if FT will come to some real understanding with ERCSL before 2027.

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