Leverage and borrowing are strictly regulated in portfolio management services. This article explains what SEBI permits and prohibits regarding leverage and borrowing.
The Prohibition
Borrowing on Behalf of Clients
The portfolio manager shall not borrow funds or securities on behalf of the client. This is a fundamental prohibition that protects clients from the risks associated with leverage.
Rationale
The prohibition ensures that:
- Clients are not exposed to borrowing risks
- Portfolio managers do not use client assets as collateral
- Client investments are shielded from financial instability of the portfolio manager
What is Permitted
Portfolio Manager Borrowing
When portfolio managers need additional funds, they can borrow money from commercial banks, but they must do so using their own capacity and resources, not by leveraging client assets.
Client Pledging (Non-Discretionary)
If the managers are providing non-discretionary services, then their clients can pledge their securities to raise a loan.
Client Discretion
Since the securities remain in the beneficial ownership of the client, they can be used as collateral for loans at the client's discretion.
Client's Own Assets
The client, being the legal and beneficial owner of the securities, has the right to use its own assets as collateral.
Regulatory Clarifications
Non-Discretionary PMS Clients
SEBI has clarified that ND-PMS clients may pledge securities held in demat accounts for their own borrowing.
Restrictions Apply to Portfolio Managers
The restriction on borrowing under PMS regulations applies to portfolio managers and not to clients pledging their own securities.
Client Decision
Such pledging will not violate PMS borrowing rules if decision is made by client and not portfolio manager.
Informal Guidance
According to SEBI's informal guidance note, if the managers are providing non-discretionary services, then their clients can pledge their securities to raise a loan.
Comparison with Other Products
Mutual Funds
Mutual funds may use derivatives for hedging and portfolio rebalancing within specified limits.
PMS
Portfolio managers are prohibited from borrowing on behalf of clients but may use derivatives for hedging and portfolio rebalancing with client consent.
Disclosure Requirements
Agreement Disclosure
The portfolio management agreement must disclose:
- Whether leverage or borrowing is permitted
- The extent of leverage permitted
- Risk factors associated with leverage
Risk Disclosure
The Disclosure Document must include:
- Risks associated with leverage
- Risks associated with derivatives
- Any other relevant risks
Expert Legal Guidance
Anuj Desai & Associates provides expert legal advisory services on leverage and borrowing compliance for portfolio managers. Our securities law experts help clients understand permissible activities, draft compliant agreements, and ensure regulatory compliance. Contact us for guidance on leverage and borrowing and other regulatory matters.