Mutual funds and their sponsors and associate companies are involved in back-to-back arrangements to the detriment of small investors

Further, if a mutual fund pays dividend, then it will be liable to pay dividend tax at 22 per cent under section 115R. But open-ended equity-oriented funds (i.e., those in which more than 50 per cent of the investible funds are invested in equity shares in domestic companies) are exempt from such tax for three years, beginning April 1, 1999.

Similarly, dividend income received on units of a mutual fund is exempt from tax under section 10(33) of the Income Tax Act. Therefore, an investor of a mutual fund scheme is not liable to pay any tax on the dividend that he receives from the scheme.

That is why companies flush with funds and sponsors of the mutual fund (which must be an existing financial services company that has been in business for more than five years) would like to invest in mutual fund schemes.

This would not have been possible had the sponsor received dividend on direct investments in companies because, in that case, the dividend income would have been taxed under the Income Tax Act.

Second, the profits earned by the sponsor from buying and selling securities is also liable to be taxed in the hands of the sponsor.

This would not have been possible if it were to invest the money on its own in the stock market. In effect, then, a financial services company cashes the tax-free status of the mutual fund business by floating a mutual fund.

Now it is the turn of the mutual fund schemes to do their sponsors or associate or group companies a good turn by investing in them. Again, this is a clear case of a back-to-back arrangement right under the supervision and direction of Sebi.

Take the case of Templeton Mutual Fund. The Templeton asset management company, has invested a total of Rs 19.55 crore in three schemes: Templeton India Growth Fund, Franklin India Growth Fund and Templeton India Liquid Fund. These same schemes have invested a total of Rs 20.08 crore in the associate/group companies of Templeton Mutual Fund.

On its part, Sebi is quite happy if disclosures are made in the financial results of the mutual funds. Regulation 25(11) of the Sebi (Mutual Funds) Regulations, 1996, provides for the following: “In case any company has invested more than 5 per cent of the net asset value of a scheme, the investment made by that scheme or by any other scheme of the same mutual fund in that company or its subsidiaries shall be brought to the notice of the trustees by the asset management company and be disclosed in the half-yearly and annual accounts of the respective schemes with justification for such investment.”

The disclosures under the above regulations throw up some startling revelations. It appears that a company or a group of companies bail out a poorly subscribed mutual fund at the time of its initial public offer (IPO). And thus, after having been so subscribed, the same mutual fund scheme invests in the securities of that company. This practice has remained unchecked by Sebi and, once again, violates its code of conduct.

To illustrate the point, the half-yearly results of Zurich Mutual Fund for the period ended March 31, 2001, reveal that its schemes have invested more than 50 per cent of their net assets in only 13 companies. The aggregate cost of acquisition during the financial year 2001 and the previous year amount to Rs 424.63 crore against total net assets of Rs 838.64 crore. And these are the same companies that have invested in more than 5 per cent of net assets in any scheme of Zurich Mutual Fund.

Shockingly, in the case of Alliance Mutual Fund, Rs 3,903.82 crore was invested in only four companies by Alliance Cash Manager and Alliance Liquid Income schemes during the six-month period ended March 31, 2001. Out of this, Rs 3,452.2 crore was invested in ICICI Securities and Finance Ltd and Rs 359.74 crore was invested in ICICI Ltd respectively.

However, on March 31, 2001, there was no outstanding investment in the case of ICICI Securities and Finance and in the case of ICICI, the outstanding investment was only Rs 124.88 crore (at market price).

This means that there was exodus of roughly Rs 3,700 crore from the scheme (or virtually the whole corpus of the scheme) during the six months.

Nowadays, the function of a development financial institution (which is supposed to provide long-term financial assistance to the industry) is more of a saviour of distressed mutual funds by bailing out their issues. The same is also true for commercial banks.

Thus, mutual funds have left no avenue untapped for subscription to their schemes. Having already used their linkages in the corporate circles, their associate and group companies now turn to development financial institutions and banks to lend them a helping hand. The net result: the small investor for whom the schemes exist hardly get a look-in.

(The writer is a lecturer at Delhi University)