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SEBI's Audit of Franklin Templeton: Explained

Editor, TRANSFIN
Oct 9, 2020 3:30 PM 4 min read
Editorial

The curious case of Franklin Templeton is curious no more.

After the fund house’s debacle in India earlier this year, a forensic audit ordered by SEBI has opened a can of worms. 

Let’s bring ourselves back up to speed, shall we?

A Recap of Events 

Franklin Templeton (FT) is a California-based global Asset Management Company (AMC) which started its mutual fund business in India with the launch of Templeton India Growth Fund in 1996.

When FT wound up six of its debt fund schemes with effect from April 23rd, 2020, markets were visibly distraught.

The six schemes represented around ₹25,000cr ($3.4bn) of investor assets which were effectively frozen. This meant two things:

One: Investors could no longer withdraw their money invested in these schemes

Two: The only ways to retrieve the money was:

  • Wait for FT to sell the underlying bonds which support them; or
  • Wait till those bonds attain maturity and their value can be redeemed.

That’s basically newspeak for being caught between the devil and the deep blue sea.

 

What’s the Update? 

Now the SEBI-ordered audit revealed new details:

  1. Some FT officials redeemed their personal investments in the said FT funds just before their closure.
  2. FT favoured certain companies (Reliance ADAG companies, Edelweiss, Essel etc.) by not exercising the “put options” it held against their underlyings (we’ll get to that in a minute...). 
  3. The fund house invested heavily in unlisted debt securities, which were mainly illiquid or newly incorporated.

 

Simplify It, Please!

The first is pretty straightforward and indicates how the fund managers profited via a conflict of interest. 

When it comes to the second development, one needs to understand how option trading works. An “option” is basically a contract in which its holder has an option (but not the obligation) to buy or sell an underlying asset (stocks, bonds etc.) before the contract expires. If your option is to buy, it’s a “call option” and if your option is to sell, it’s a “put option”.

Mostly, these are used by traders to speculate or hedge against what course a stock’s price may take. So essentially, if you own a put option (to sell a stock at ₹1,000), and the price of the underlying stock goes down (to say ₹800), your option will become “in the money” (translation: valuable) as it still gives you the option to sell it at a higher price (i.e. ₹1,000 and make money by buying it back at ₹800, its currently traded price).   

So when a security is downgraded in some manner (in this case bonds of the aforementioned companies), one must ideally sell it by executing the put option because otherwise it wouldn’t be a viable investment anymore. 

Seems like Franklin Templeton’s fund managers were erratic in this exercise. They executed the put option for some companies and for others they didn’t, despite a major downgrade (from category A to category D) in less than a year’s time.

Finally, the third aspect of the report hints at major follies committed by Franklin while investing in credible ventures. Their investments essentially cruised past three important red flags when it comes to deciding if a security is authentic and promising: unlisted, illiquid, newly incorporated. Due diligence died a painful death.

 

What to Take Away from This?

The recent audit report points to activities that amount to...what? Conflict of interest? Insider trading? Unjust enrichment?

Possibly, all of the above.

 

Does this Mean Franklin Templeton’s Debacle Was Purely a Puddle of its Own Making?

In April, Franklin attributed the chief reason behind winding up of its schemes to illiquidity in the pandemic-struck economy. However, it seems as if the cycle of illiquidity commenced early on through a series of careless investments. 

The fund house undertook a bold approach in 2009 by redirecting its mutual fund investments into corporate bonds. These were designed as long-term investments with exit loads imposed on investors. So, if you invest and then redeem within 12 to 30 months, you have to incur losses of up to 3%.

After the initial success of these bonds, Franklin embarked on a journey of investing extensively in securities that were in the credit-risk category. These are downgraded investments (AKA “junk bonds”) which fetch higher returns and are hence lucrative for money managers.

Unfortunately, the IL&FS-crisis turned the knob on this “chasing after yields” strategy. The resulting market illiquidity following this crisis forced many companies on Franklin’s portfolio to default on interest and principal payments. 

Added to that, the onset of COVID-19 threw Franklin Templeton’s business into a tailspin. Nobody wanted to buy junk bonds from a fund in this economic climate, and the existing investors went on a redemption spree. There weren’t enough funds generated anymore to pay off investors, ultimately forcing a wind up. 

In any case, trouble piles on for Franklin Templeton. The next update is likely to come after the Karnataka High Court’s pending hearing on the issue.

FIN.

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