ASIAN DEVELOPMENT BANK

ASIAN DEVELOPMENT BANK TAR: IND 34270 TECHNICAL ASSISTANCE TO INDIA FOR REFORM OF THE MUTUAL FUNDS INDUSTRY December 2002

CURRENCY EQUIVALENTS (as of 8 November 2002) Currency Unit Indian rupee/s (Re/Rs) Re1.00 = $0.0207 $1.00 = Rs48.24 ABBREVIATIONS ADB Asian Development Bank AMC asset management company AMFI Association of Mutual Funds in India MOF Ministry of Finance NAV net asset value SEBI Securities and Exchange Board of India TA technical assistance US-64 Unit Scheme of 1964 UTI Unit Trust of India UTI Act Unit Trust of India Act 1963 NOTES (i) (ii) The fiscal year (FY) of the Government ends on 31 March. In this report, "$" refers to US dollars. This report was prepared by a team consisting of R. Limjoco (Team Leader) and S. Thongplengsri.

I. INTRODUCTION 1. The Government of India has requested the Asian Development Bank (ADB) assistance in reforming the mutual funds industry, as part of ADB's country strategy and program for India for 2002. The technical assistance (TA) was proposed as a firm project during the country program confirmation in February 2002 and reconfirmed during the Country Programming Mission in May 2002. 1 The TA is part of ADB s strategic intervention to develop the Indian capital market, in particular the long-term debt market that is critical for expanding private sector activities and financing and developing infrastructure in India. A Fact-Finding Mission visited India from 5 to 16 May 2002 and reached an understanding with the Government on the objectives, scope, cost, and implementation arrangements for the TA. The TA framework is in Appendix 1. 2. ADB had earlier provided TA for strengthening the operations of contractual savings institutions, i.e., provident funds, and the insurance industry, and for developing the secondary debt market in India. 2 As part of this effort, the mutual funds industry, comprising institutional investments, needs to be reinforced to encourage the growth and promote the development of long-term sources of funds and to accelerate the industry's development, given its importance to the large retail market in India. Furthermore, with the Unit Trust of India (UTI), the largest player with 43% of total assets under management by mutual funds, in serious difficulty, there is urgency in addressing the problems of the industry. 3 II. ISSUES 3. UTI, the first mutual fund set up by the Government of India in 1964, is governed by a special legislation, the Unit Trust of India Act 1963 (UTI Act). UTI s mutual funds schemes were the only choices available to investors until 1987 when public sector banks and insurance companies were permitted to set up mutual funds. In 1993, the Securities and Exchange Board of India (SEBI), the capital market regulator, formulated the Mutual Funds Regulations, which for the first time established a comprehensive regulatory framework to govern all mutual funds except UTI. The regulations required the separation of the sponsor, trustee, and asset management company (AMC) in a mutual fund, to bring about an arm s length relationship for proper checks and balances; introduced disclosure and reporting requirements; standardized offer documents; and formulated investment and other rules to govern mutual funds operations. 4. The 1993 regulations set the stage for the entry of private sector mutual funds, many of which were set up in collaboration with foreign partners, contributing to more competition, improvements in product varieties and investor services, and substantial growth of the industry over the past decade. Total assets under management by mutual funds increased at an annualized rate of 12% from Rs360.5 billion in April 1992 to Rs1.08 trillion in August 2002. 5. Despite the increase in the number of players and improvements in the regulatory environment, the growth of resources of mutual funds slowed down during the past few years. 1 The TA first appeared in ADB Business Opportunities (Internet edition) on 7 June 2002. 2 ADB. 1999. Technical Assistance to India for the Reform of the Private Pension and Provident Funds System and Employees Provident Fund Organization. Manila; ADB. 2000. Technical Assistance to India for Policy and Operational Support and Capacity Building for the Insurance Regulatory and Development Authority. Manila; and ADB. 2000. Technical Assistance to India for Development of a Secondary Debt Market. Manila. 3 According to statistics of Securities and Exchange Board of India (SEBI), cumulative net assets of mutual funds as of 31 August 2002 were Rs1.08 trillion, which consisted of Rs461.8 billion of UTI s mutual funds, Rs525.6 billion of private sector mutual funds, and Rs88.9 billion of public sector mutual funds.

2 Net resources mobilized declined from a peak of Rs190 billion (about $3.9 billion) in FY2000 to Rs72 billion (about $1.5 billion) in FY2002. Compared with other investments and savings alternatives, mutual funds accounted for a very small proportion (1.3%) of total household financial savings in FY2001 as opposed to deposits (44.3%), insurance funds (12.8%), and provident and pension funds (20.7%). 4 This could be attributed mainly to eroded investor confidence owing to the market downturn and the disclosure of mismanagement of funds in UTI, specifically the Unit Scheme of 1964 (US-64). 6. US-64 was the first open-ended funds scheme in the country and most investors perceived it to be one of the safest investments with a guaranteed return. Out of UTI s 72 schemes, US-64 remains the biggest, accounting for about 12% of the entire industry s portfolio with around 20 million investors. US-64 s governance problems stemmed from the lack of appropriate regulations as it was not under SEBI's regulatory purview. A fundamental flaw in the structure is that the scheme commingled asset management with trustee functions, and lacked performance valuation and disclosure standards. 5 The mismanagement and dubious investments of US-64 came to light in July 2001, and led to an exodus of mainly corporate investors from US-64 and the subsequent need for the Government to provide a bailout package to cover the difference between the net asset value (NAV) of US-64 and the assured price to investors. 6 This anomaly in US-64 shook investor confidence in the mutual funds industry and brought to the fore the urgent need to review and address critical flaws in current operations and practices, 7 including the offering of assured-return schemes. 8 7. To restore investor confidence, the Government recognizes the need to strengthen the governance and regulatory framework while providing the enabling business environment to promote the growth of mutual funds as key institutional investors in the Indian capital market. SEBI revised the 1993 regulations to strengthen good governance of mutual funds, prevent malpractices of mutual funds operators, and provide better investor protection. However, there remains a fundamental question about the appropriate governance structure for mutual funds that could provide institutionally appropriate checks and balances, prevent potential conflicts of interest, and provide effective funds administration. Currently, a mutual fund is set up in the form of a trust under the Indian Trust Act, which was enacted in 1882 to essentially govern private trusts and charitable institutions. The trust structure, among others, has posed certain practical difficulties for mutual funds, including the issue of individual versus collective liability of trustees, which has deterred experienced persons from serving as trustees of mutual funds. 9 4 Estimate by Reserve Bank of India. 5 Though UTI voluntarily made its net asset value (NAV)-based schemes SEBI compliant, its assured-return schemes including US-64 remained outside the ambit of SEBI regulations. 6 Under the bailout package, UTI will repurchase US-64 units up to 5,000 units per unitholder starting from the price of Rs10 per unit in August 2001 and increasing by 10 paise per month until it reaches Rs12 per unit by May 2003. The gap between the NAV and the assured price will be financed by the Government. US-64 has started disclosing its NAV in SEBI format from December 2001 and disclosed NAV at Rs5.80 per unit as of 1 August 2002. 7 On 29 October 2002, the Cabinet promulgated an ordinance to repeal the UTI Act and approved a plan to bifurcate UTI into UTI-I, comprising US-64 and other assured-return schemes, and UTI-II, comprising NAV-based schemes. Both will be structured as per the SEBI regulations. UTI-I will be managed by a Government-appointed administrator while UTI-II will be managed by a professional management and privatized. 8 As of 31 August 2002, total assets of debt-oriented schemes with assured returns were Rs147 billion, accounting for 14% of total assets under management of the mutual funds industry. According to SEBI s annual reports for 1996-2001, there had been cases where the schemes were unable to generate adequate income to meet their obligations of payments of returns as specified in their offer documents. In such cases, SEBI intervened and directed the sponsors or AMCs of mutual funds to honor their commitment of assured returns. 9 The provisions of the Indian Trust Act prohibit limiting or extinguishing the obligations and liabilities of the Trustees or indemnifying the Trustees for losses or damages. Internationally, a mutual fund can be set up as either a company or a trust. Each structure will have different legal implications.

3 8. More recently, mutual funds were allowed exposure in new types of financial instruments including derivatives and foreign securities, and expand their activities into such businesses as pension funds, provident funds, and venture capital funds management. As a result, regulations and operating standards related to disclosure, valuation, performance measurement as well as internal control, governance, and risk management systems need to be expanded to take into account these new activities. Further, the enforcement and investigative capabilities of the regulator require strengthening to cope with the increasingly complex financial transactions and expansion in the scope of mutual funds operations. 9. A deeper study is needed to identify the impediments to further growth of mutual funds, and recommend ways to enhance the role of mutual funds in the equity and debt markets. 10 Mutual funds can play an increasingly important role as the third pillar in a multipillar pension system. Earlier studies have revealed the inadequate pension and social security coverage of the Indian workforce and have cited mutual funds as another contractual savings alternative to complement the mandatory pillars. 11 Moreover, an analysis to determine the appropriate tax or other incentives and fee structure needs to be undertaken to strike a balance between the promotion of the mutual funds industry and the fiscal impact of tax incentives. III. THE TECHNICAL ASSISTANCE A. Purpose and Output 10. The TA will assist the Government in enhancing the role and promoting the growth of the mutual funds industry as key institutional investors in the capital market. 11. The expected output of the TA will cover three major areas: (i) corporate governance, (ii) regulation and supervision, and (iii) incentive structure. The TA is expected to enhance good governance in mutual funds operations, including the establishment of appropriate checks and balances, disclosure and reporting for mutual funds offering, valuation methods, and performance measurement. Regarding the regulatory framework, the TA will strengthen regulations as well as the enforcement and investigative capabilities of the regulator, particularly in dealing with malpractices. The TA will recommend appropriate incentives and other necessary supportive facilities to promote the growth of the mutual funds business. B. Methodology and Key Activities 12. The TA will engage international and domestic who will maintain discussion and dialogue with the Executing and Implementing Agencies, market participants, and ADB to review and identify deficiencies in the current practices, regulatory environment, and industry structure; and recommend, based on best practices and after consultation with various 10 TA 3473-IND: Development of a Secondary Debt Market (footnote 2) noted considerable growth of bond funds recently due partly to tax arbitrage and enabling investment regulations and expected that participation by retail investors will likely be the more sustainable path for the development of the mutual funds industry in the long run. 11 The multipillar pension system consists of (i) a government budget-financed mandatory public pillar; (ii) a mandatory, fully funded, publicly regulated, yet privately managed pillar; and (iii) a voluntary, privately managed, fully funded pillar. Project OASIS (Old Age Social and Income Security) by the Ministry of Social Justice and Employment noted that only 11% of the working population was covered by the employees pension and provident funds, while the remaining 89% was in the informal sector. The report focused on developing a pension system for this latter group. It recommended that inves tments should maximize returns and suggested investments in index funds to benefit from upside potential gain in the equities market. TA 3473-IND (footnote 10) suggested pension and provident funds management especially for small and medium enterprises be outsourced to professional mutual fund managers to increase economies of scale and bring in professional expertise.

4 stakeholders, measures to improve governance, strengthen the regulatory framework, and introduce incentives to promote the growth of the mutual funds industry in India. 12 13. With respect to governance, the TA will (i) recommend appropriate checks and balances that address issues of conflicts of interest; (ii) define elements of appropriate disclosure standards and investment policies; (iii) recommend appropriate fund pricing, valuation methods, and performance benchmarks; (iv) strengthen due diligence, internal audit, and risk management practices; (v) recommend measures to upgrade the professionalism of mutual funds operators; and (vi) strengthen investment/portfolio management systems and mutual funds administration. 14. Regarding the strengthening of the regulation and supervision of mutual funds operations, the TA will (i) introduce regulations that prevent or deter malpractices by fund managers; (ii) determine the appropriateness of existing practices, such as funds' offering of assured returns; (iii) help develop an early warning system to detect malpractices; (iv) strengthen the investigative capabilities of the regulator; (v) define suitable punitive measures for malpractices and frauds; (vi) refine regulations and documentation for the launch of new schemes; (vii) recommend measures to expand distribution channels to attract more retail investors and strengthen standards of conduct regarding sales, distribution, and advertisement of mutual funds; and (viii) explore ways to enhance the role of mutual funds as the third pillar in the pension system. The TA will integrate the recommended standards into a handbook of standards of best practices for mutual funds operations. 15. At the same time, the continued development of the industry and the market for mutual funds will be addressed by reviewing the current incentive structure with a view to (i) enhancing the tax framework, other concessions, and the fee structure; and (ii) achieving uniformity in application. 16. The TA will also include capacity-building activities for the officials of the Government and the regulator. A study tour will be prepared for 6-8 key officials from the Ministry of Finance (MOF) and SEBI to visit and discuss with regulatory authorities, mutual funds associations, and major mutual funds in more advanced economies so as to increase knowledge and understanding of corporate governance, regulations, and practices of mutual funds. Furthermore, a workshop on investigating and handling malpractices and frauds in mutual funds operations will be conducted in India tentatively at the end of 5 months from the start of the TA using illustrative cases to enhance the enforcement and investigative capabilities of the regulator. 17. To enhance the sense of ownership by the Government, regulatory authorities, and market participants, the TA will finance the holding of a national forum on the reform of the mutual funds industry for policy makers and regulators, such as MOF, SEBI; market participants such as AMC, trustees, agents, and distributors, stock exchanges, and Association of Mutual Funds in India (AMFI). The will present in the forum their findings and recommendations, which will include a detailed implementation plan of the suggested reform program as well as potential constraints and additional resources needed. The participants will discuss courses of actions to implement the reform program. Subsequently, the study tour will be organized for key officials to further discuss the implementation of the reform program with their counterparts in more developed markets. 12 SEBI informed the Fact-Finding Mission that the USAID was already addressing investor education through its Financial Institutions Reform and Expansion (FIRE) Project.

5 18. The successful implementation of the TA will rely substantially on the commitment and support of the Government and regulatory authorities, skills and capabilities of relevant regulatory agencies to implement the reform, and close discussion and dialogue among ADB, the, the Executing and Implementing Agencies. C. Cost and Financing 19. The total cost of the TA is estimated at $1,000,000 equivalent, comprising $669,000 in foreign exchange cost and $331,000 equivalent in local currency cost. ADB will finance $800,000 equivalent comprising the entire foreign exchange cost plus $131,000 equivalent of the local currency cost. The TA will be financed on a grant basis by ADB s TA funding program. The Government will provide the balance amounting to $200,000 equivalent for counterpart staff, office accommodation, and other logistical support requirements. The details of the cost estimates are in Appendix 2. D. Implementation Arrangements 20. MOF, Department of Economic Affairs (Capital Markets Division) will be the Executing Agency for the TA, while SEBI will be the Implementing Agency and will provide suitable office space, counterpart staff, and other facilities and support services to enable the to accomplish their work. 21. ADB will engage the services of an international consulting firm in collaboration with domestic to provide consulting services totaling 28 person-months: 17 international, and 11 domestic. The terms of reference of the are in Appendix 3. Shortlisted consulting firms will be invited to submit full technical proposals, and a consulting firm will be selected and engaged on the basis of quality and cost-based system (QCBS) in accordance with ADB s Guidelines on the Use of Consultants and other arrangements satisfactory to ADB for engaging domestic. 22. The will submit an inception report within 3 weeks from the start of services. An interim report that contains initial findings and a work plan for the succeeding months until TA completion will be submitted to ADB and the Government at the end of 3 months. The national forum on the reform of the mutual funds industry will be held at the end of 6 months and a draft final report will be delivered to ADB and the Government at least 2 weeks before the date of the forum. After ADB and the Government clear the draft final report within 1 week from receipt, the draft final report will be distributed to confirmed participants on a limited basis. The Government, the, and ADB will hold a tripartite meeting to consider the discussions of the forum and plan to implement the reform program. The comments from the forum and the tripartite meeting will be taken into account in finalizing the report that is to be submitted at the end of 7 months. An electronic copy of the report and at least five hard copies of each will be submitted to ADB and the Government. The TA is expected to start in January 2003 and be completed by August 2003. IV. THE PRESIDENT'S DECISION 23. The President, acting under the authority delegated by the Board, has approved the provision of technical assistance not exceeding the equivalent of $800,000 on a grant basis to the Government of India for Reform of the Mutual Funds Industry, and hereby reports this action to the Board.

6 Appendix 1 TECHNICAL ASSISTANCE FRAMEWORK Design Summary Performance Indicators/Targets Monitoring Mechanisms Assumptions and Risks Goal Enhance the role of mutual funds industry in India to strengthen longterm debt and equity markets Percentage share of mutual funds out of total savings increases Percentage of long-term holdings of debt and equity papers rising as a proportion of total mutual funds assets Consultants report Financial and capital market statistics Household savings report Government s commitment to pursue reform Increased investments in debt and equity securities by mutual funds in primary market Increased trading volume and value in debt and equity securities by mutual funds in secondary market Purpose Promote the growth of mutual funds industry in India by reinforcing investor confidence through strengthened corporate governance, regulation, and supervision and instituting an appropriate incentive structure Output 1 Improvements in mutual funds governance Increase in resources mobilized by mutual funds Increase in number of investors of mutual funds Improved comparative returns from mutual funds investments vis-à-vis performance indexes/ benchmarks Reduction in malpractices of mutual funds operators and investors grievances Appropriate standards of best practices for mutual funds operations established, including disclosure and reporting for mutual funds offering, valuation, and performance measurement Program for licensing key market participants set up and number of accredited/ licensed personnel increased Consultants' report Mutual funds statistics Financial and capital market statistics Household savings report Statistics from Securities and Exchange Board of India (SEBI) and Association of Mutual Funds in India (AMFI) Consultation and dialogue with the Government and Review missions Consultants' interim and final reports Government s willingness to bear additional fiscal burden and transition cost Skills and capabilities of relevant regulatory agencies and associations Adequate coordination mechanisms and public information campaign built into the implementation process Skills and capabilities of relevant authorities to enforce good governance Coordination and cooperation of concerned agencies Competent and committed Adequate supervision of and dialogue with ADB staff

Appendix 1 7 Design Summary Performance Indicators/Targets Monitoring Mechanisms Assumptions and Risks Comments and feedback from forum on reform of mutual funds industry staff Activities Recommend appropriate checks and balances to guard against possible conflicts of interest Examine the current three-tier structure of a mutual fund and recommend more efficient alternatives (if any) Define disclosure and reporting norms for the industry, elements of investment policies, and uniform bases for determining net asset values Review existing risk management system, investment/portfolio management systems, and administration of investments/securities employed by various funds and recommend measures to strengthen the existing systems Recommend performance indexes and benchmarks Recommend appropriate procedures to ensure transparency and propriety of transactions and deals by mutual funds Recommend measures to upgrade professionalism of market participants and enhance the role of AMFI as a selfregulatory organization Analyze and recommend the role of asset management company in the context of pension fund management Organize a forum on reform of the mutual funds industry before finalizing the report Output 2 Strengthened regulatory and supervisory framework of mutual funds operations Draft of new or amendments to legislations and regulations introduced Strengthening of mutual funds monitoring and surveillance systems in terms of technology and capacity SEBI reports Consultation and dialogue with the Government and Review missions Consultants' interim and final reports Supervisory capabilities of relevant authorities Coordination and cooperation of concerned agencies Competent and committed Comments and feedback from forum on reform of mutual funds industry Adequate supervision of and dialogue with ADB staff Activities Review present regulatory and supervisory framework and pinpoint any weaknesses Determine appropriateness of current practices and conventions of mutual funds operations as well as disclosure and reporting requirements Define suitable types and levels of penalties Recommend ways to strengthen the monitoring and surveillance systems as well as investigative capabilities of key officials Design and develop early warning system to detect fund managers' deviations from accepted practices Output 3 Appropriate incentive structure to promote investments in mutual funds Introduction of tax or other incentives to promote the mutual funds business Draft of new or amendments to tax and other relevant legislations Statistics from SEBI and AMFI Consultation and dialogue with the Government and Government s willingness to give incentives Competent and committed Review missions Adequate supervision of and dialogue with ADB

8 Appendix 1 Design Summary Performance Indicators/Targets Monitoring Mechanisms Assumptions and Risks Consultants' interim and final reports dialogue with ADB staff Comments and feedback from forum on reform of mutual funds industry Activities Recommend appropriate incentives including taxes, concessions to promote mutual funds business Recommend new instruments and types of funds to be introduced in the Indian market Recommend necessary support to facilitate mutual funds operations such as hedging mechanisms Recommend an appropriate uniform fee structure for the industry Analyze growth trends of various types of mutual funds, identify any impediments to growth, and recommend ways to remove such impediments Output 4 Strengthened capacity of regulators and Government officials in supervising and developing mutual funds industry Training needs identified and formal training and development program for policymakers and regulators established Training evaluation records Feedback and reports from the study tour Learning capacity and commitment from Government officials Activities Conduct a workshop on investigating and handling malpractices and frauds Prepare a suitable study tour for key officials of the Government and regulatory agency Inputs TA $800,000, 17 person-months of international and 11 personmonths of domestic Support from MOF, SEBI, and other concerned ministries Comments and feedback from the forum on reform of mutual funds industry with target participants including key officials from MOF, SEBI, other concerned ministries, AMFI, and market participants to finalize the ' reports Implementation of activities specified as outputs Presentation of inception report within 3 weeks, interim report within 3 months from the start of the TA (tentatively in January 2003) Conference to be held at the end of 6 months Presentation of final report at the end of 7 months Inception, interim and final reports of the Consultation and dialogue with the Executing and Implementing Agencies and the Review missions Progress reports Commitment and cooperation of Ministry of Finance (MOF), SEBI, and concerned agencies Competent and committed Adequate supervision of and dialogue with ADB staff

Appendix 2 9 COST ESTIMATES AND FINANCING PLAN ($'000) Foreign Local Total Item Exchange Currency Cost A. Asian Development Bank Financing a 1. Consultants a. Remuneration and Per Diem i. International Consultants 500.0 0.0 500.0 ii. Domestic Consultants 0.0 66.0 66.0 b. International and Local Travel 30.0 5.0 35.0 c. Reports and Communications 7.5 0.0 7.5 2. Training, Seminars, and Conferences 0.0 25.0 25.0 3. Study Tour 50.0 0.0 50.0 4. Representative for Contract Negotiations 5.0 0.0 5.0 5. Contingencies 76.5 35.0 111.5 Subtotal (A) 669.0 131.0 800.0 B. Government Financing 1. Office Accommodation and Transport 0.0 60.0 60.0 2. Remuneration and Per Diem 0.0 120.0 120.0 of Counterpart Staff 3. Others 0.0 20.0 20.0 Subtotal (B) 0.0 200.0 200.0 Total 669.0 331.0 1,000.0 a ADB s TA funding program. Source: Asian Development Bank estimates.

10 Appendix 3 A. International Consultants OUTLINE TERMS OF REFERENCE 1. Mutual Funds Governance Expert (7 person-months) 1. This expert will serve as the team leader, oversee the implementation of the TA, and prepare the integrated report. The consultant must have extensive background in mutual funds operations both at the fund level and in regulation and supervision. Experience in major developed economies in the field and exposure to mutual funds operations in other developing countries will be preferred. The specific tasks follow. (i) (ii) (iii) (iv) (v) (vi) (vii) Review the existing corporate governance framework for mutual funds industry in India. Summarize international standards and best practices for mutual funds governance including disclosure and reporting standards, net asset values (NAVs) calculation, performance presentation, and funds administration. Recommend appropriate checks and balances to guard against possible conflicts of interest or abuse of discretion that may arise in the funds management structure; the composition, selection, and functions of the board of directors; the selection and qualifications of fund managers or asset management companies (AMCs); the responsibilities or accountabilities of trustees; the selection and responsibilities of both internal as well as external auditors; the investment decision-making; and the interfund sales and transfers, particularly for similar funds under management, among others. Review the existing management information system to determine if it is adequate for pinpointing and exposing possible malpractices within the fund and whether standard operating procedures are being followed. Examine whether the current legal form of a mutual fund as a trust, and the three-tier structure, namely sponsor, trustee, and AMC as well as their respective roles as defined by the regulatory authority is the most appropriate structure; and recommend more efficient alternatives (if any) in light of the Indian setting and experiences in other jurisdictions. Define disclosure norms for the industry specifying, based on best practice, the form and extent of disclosure required and the required reports and suitable media, such as placement memorandums, investment performance reports to investors, major publications for NAVs. Define the elements of investment policies to guide investors in their investment decisions and as a basis for effective supervision: type of investments, scope of investments (geographic, type of instruments, etc.) allocation if any to various investments, investment restrictions, exemptions, disclaimers. Define uniform bases for determining NAVs, particularly how unlisted and inactive securities should be valued, how appropriate dividend policies should be formulated and implemented for various types of funds. After reviewing the existing risk management system of domestic funds, recommend measures that may be required to strengthen the present system.

Appendix 3 11 (viii) (ix) (x) (xi) (xii) (xiii) (xiv) (xv) (xvi) (xvii) Recommend performance indexes, benchmarks, comparative indicators, and ways they can be set up so that the relative performance of various funds can be measured or even rated on a weighted and continuing basis. Recommend appropriate procedures for ensuring the transparency, propriety of transactions and deals by the various funds (due diligence, internal audit process, and procedures), and for setting up appropriate mechanisms for redressing investors grievances. Review the present investment/portfolio management systems of various funds and introduce measures that can enhance the systems and processes. Review the administration of investments/securities of various funds and recommend ways for strengthening the integrity of the current systems. In collaboration with the international mutual funds regulatory and supervisory expert, draft a handbook of standards of best practices for mutual funds operations by incorporating practices, norms, or systems recommended in the areas of activities (ii) to (xi) as well as standards of conduct for sales, distribution, and advertisement of mutual funds schemes. Recommend measures to upgrade the professionalism of market participants, by defining minimum qualifications and possible licensing of officials that will undertake fiduciary functions and related risk insurance that may be required. Review the functions and activities of the existing Association of Mutual Funds in India including the certification program for mutual funds agents and distributors, and recommend ways for enhancing its role as a self-regulatory organization. Identify any policy impediments to the development of the mutual funds industry, in particular those affecting competition among the different players and recommend ways to remove such impediments. Analyze whether the entry of foreign fund managers into India s mutual fund industry as partners of local firms has improved industry practices, and whether there are any regulations or policies that limit foreign funds scope of operations and need to be changed. Prepare a suitable study tour for key officials of the Government and the regulatory authorities centering on corporate governance and how this is implemented in more advanced economies; this will include alternative institutions and countries where key officers can be met to discuss Indian concerns. This could include mutual funds associations, major mutual funds, and regulatory authorities. (xviii) Arrange for a conference forum on the reform of the mutual funds industry. Present to the forum findings and recommendations including a detailed implementation plan of the suggested reform program as well as potential constraints and additional resource requirements; incorporate comments and feedback in the final report; and finalize the reform program jointly with the

12 Appendix 3 international mutual funds regulatory and supervisory expert and the international mutual funds industry specialist. 2. Mutual Funds Regulatory and Supervisory Expert (6 person-months) 2. The consultant will have broad and long-time experience in regulating and supervising mutual funds and in developing capital markets in a major developed economy, preferably with exposure to developing country mutual funds and capital markets operation. Experience in India will be an added advantage. (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) Review present regulatory and supervisory framework for mutual funds in India. In collaboration with the international mutual funds governance expert, recommend ways for integrating a handbook of standards of best practices into the current regulatory framework for mutual funds operations. Pinpoint gaps and weaknesses in the current regulatory framework, particularly in dealing with malpractices, and introduce regulations to deal with them. Determine the appropriateness of current practices and conventions, such as the offering of assured returns by various funds. Determine if current reporting requirements and the contents of required reports for mutual funds are sufficient to safeguard investor interest and market integrity. Define, based on comparative practices, suitable types and levels of penalties and other punitive measures for dealing with malpractices in the industry, particularly with respect to fraudulent schemes and remedial measures that can be taken. Recommend ways for strengthening the present monitoring and surveillance setup of the regulatory authority. Help design and develop an early warning system to detect fund managers' deviations from accepted practices. Review current supervisory capabilities and recommend ways for sharpening the investigative capabilities of key officials involved in supervision. Conduct a workshop on investigating and handling malpractices and fraud in mutual funds operations, using illustrative cases. Review regulations and documentation related to the launch of new schemes and recommend improvements to the regulations, including simplifying offer documents to bring in new investors like pension funds, provident funds. Review the regulatory framework and current practices of the distribution industry. Recommend measures to expand the distribution channels. Analyze and recommend the appropriate role of mutual funds agents, including the transition from being a provider of application forms to financial planner.

Appendix 3 13 (xiii) (xiv) Review current regulations, standards of conduct, and practices pertaining to sales, distribution, and advertisement of mutual funds schemes and recommend measures to strengthen the regulations and standards of conduct in these areas. Identify measures for internal control and checks and balances for AMCs that expand their activities to pension funds, provident funds, or venture capital funds management. Summarize the regulatory framework for the management of pension fund assets by AMCs in other developed and developing markets. In collaboration with the international mutual funds industry specialist, recommend measures to enhance the role of mutual funds as the third pillar in the pension system, including ways for promoting retirement schemes; and recommend whether it would be advisable, given the current state of the Indian mutual funds industry to privatize pension management. 3. Mutual Funds Industry Specialist (4 person-months) 3. The consultant should preferably be a key practicing member of a major mutual fund industry association responsible for dealing with the concerned government and mutual fund members regarding incentives that cover, taxation, concessions, industry support, and the fee structure for mutual funds, in an advanced economy. The consultant should have a strong economic background. The specific tasks follow. (i) (ii) (iii) (iv) (v) (vi) (vii) Advise the Government on what possible incentives that are performance based and have proven effective in other countries can be provided. Review the tax structure and recommend possible concessions that can be provided. Determine what other incentives will be suitable for developing the market for mutual funds. Recommend tax or other incentives to promote retirement schemes as the third pillar in the pension system. Recommend new instruments and types of funds that can be introduced in India to deepen the market for mutual funds. Analyze and recommend the appropriate timing and scope of investments of mutual funds in foreign securities. Analyze (a) the breakdown of mutual funds schemes in terms of repurchase/redemption mechanisms (close-ended vs open-ended), investment objectives (income/debt-oriented, growth/equity-oriented, and balanced schemes) and other special-purpose funds (e.g., assured return, retirement schemes); and (b) the growth trend and market share of these schemes. Identify any impediments to growth of those schemes, and recommend ways to remove such impediments and facilitate increased investment of those schemes in equity and debt instruments. Identify any potential new business activities for AMCs and recommend appropriate timing to expand into such businesses in light of the Indian capital market and regulatory environment. Recommend necessary supports for facilitating mutual funds operations, such as the development of price indexes, hedging and liquidity support mechanisms.

14 Appendix 3 (viii) Recommend an appropriate uniform fee structure for the industry that compensates for risk and is justified by current services provided. B. Domestic Consultants 4. The domestic will assist the team leader in organizing and preparing the forum on the reform of the mutual funds industry. After the forum, the domestic will be responsible for providing expert input into finalizing the reform program. 1. Mutual Funds Governance Specialist (7 person-months) 5. The consultant should have experience in mutual funds operation in India in a senior capacity, and must be familiar with governance and regulatory issues. The specific tasks follow. (i) (ii) (iii) (iv) (v) Assist the international mutual funds governance expert and the mutual funds regulatory and supervisory expert in all aspects of the tasks to be undertaken. Provide background information on and the status of mutual funds governance, regulations, and operations in India as well as the Government's policies related to the mutual funds business. Discuss with the international governance expert any problems or obstacles to mutual fund operations. Arrange meetings and help conduct discussions with key practitioners, mutual fund experts, and mutual fund officials in key areas of operations in India. Help draft the technical assistance (TA) report, paying particular attention to sensitivities and nuances in the local environment. 2. Mutual Funds Operations Specialist (4 person-months) 6. The consultant should have broad knowledge and experience in all areas of mutual funds operations in India. The specific tasks follow. (i) (ii) (iii) (iv) Assist the international mutual funds industry specialist in all aspects of the tasks to be undertaken. Discuss with the international mutual funds industry specialist any potential new activities and various innovative instruments that can be introduced in the local market to fill the perceived gaps in the market for mutual funds. Provide background information on the current tax and incentive structure, statistics on mutual funds together with data and information regarding various practices in the domestic mutual funds industry concerning, among others, valuation techniques, portfolio/investment management, risk management, and investment administration being carried out by existing funds. Help arrange meetings with relevant persons having specific expertise in the areas of mutual fund operations to be covered by the TA.