Liability in Case of Default

SEBI (Portfolio Management Services) Regulations, 2020 lay down the core liability provisions for both portfolio managers and their distributors. Section 13 of the Regulations mandates that a PM must act in the best interest of the client and that any breach attracts monetary penalties, disgorgement of gains and possible suspension.

Liability is also reinforced by the SEBI (Investment Advisers) Regulations, 2013 where a distributor is treated as an intermediary and is required to ensure that the PM they appoint complies with all statutory norms. Failure to do so makes the distributor jointly liable for client losses arising from the PM’s default.

For the exam, remember that SEBI assigns a dual‑layer liability: the primary liability rests with the PM, and a secondary, contingent liability rests with the distributor if the PM’s assets are insufficient to compensate investors.

• Primary liability – PM’s own capital and client‑segregated assets.
• Secondary liability – Distributor’s indemnity obligations under the agreement.

Contractual liability arises from the agreement between the client and the PM. The contract usually contains a clause specifying the PM’s responsibility to return the exact amount invested, plus any accrued returns, if a default occurs.

Statutory liability is imposed by SEBI regulations. It includes penalties such as a fine up to 10% of the defaulted amount, disgorgement of any unjust enrichment, and possible imprisonment for willful fraud.

Fiduciary liability is the duty of care and loyalty that the PM owes to the client. Breach of fiduciary duty can lead to civil suits, where the court may order the PM to compensate the investor for actual loss and lost opportunity.

Exam‑wise, the three categories are often asked together: you may be given a scenario and asked to label the type of liability that applies.

A default can occur in several ways. The most common are:

1. Failure to execute client orders – The PM does not place a buy/sell order as instructed, leading to missed market opportunities.

2. Misappropriation of client funds – The PM uses client money for personal or unrelated business purposes, violating segregation rules.

3. Breach of segregation – Client assets are not kept in a separate account, making them vulnerable to the PM’s own creditors.

4. Incorrect valuation of securities – Over‑ or under‑valuing holdings can cause investors to receive wrong NAV calculations, which SEBI treats as a material default.

Each scenario triggers a specific penalty schedule under SEBI, and the exam frequently tests your ability to match the scenario with the appropriate penalty.

When a default is declared, SEBI requires the PM to restore the investor’s position. This may involve returning the original principal, plus any accrued interest calculated on a simple interest basis, unless the contract specifies a different method.

If the PM’s own assets are insufficient, the distributor’s indemnity agreement may be invoked. The indemnity typically states that the distributor will cover the shortfall up to a pre‑agreed ceiling, often expressed as a percentage of the total assets under management (AUM).

For exam preparation, memorize the hierarchy: (1) PM’s own assets, (2) client‑segregated accounts, (3) distributor’s indemnity fund, and finally (4) SEBI’s compensation fund, which is a last‑resort safety net for retail investors.

Portfolio managers mitigate default risk through robust internal controls. Key practices include daily reconciliation of client accounts, independent audit of segregation compliance, and real‑time monitoring of order execution.

Distributors add another layer by conducting due‑diligence on the PM’s capital adequacy, reviewing the indemnity agreement annually, and ensuring that the PM maintains a minimum net‑worth as prescribed by SEBI.

For the exam, remember the acronym R‑C‑A – Reconciliation, Capital adequacy, and Audits – as a quick recall tool for the three pillars of default risk mitigation.

SEBI mandates immediate disclosure of any material default to both the client and the regulator. The disclosure must detail the nature of the default, the amount involved, and the remedial actions being taken.

Distributors must also file a separate compliance report within 15 days of the default, indicating whether the indemnity clause was triggered and the status of any compensation paid.

Exam questions often test the reporting timeline; remember the 15‑day window for distributor reporting and the “as soon as practicable” rule for the PM’s client notice.

Investors can pursue several remedies: (1) Direct claim against the PM for restitution, (2) Claim against the distributor under the indemnity agreement, (3) File a complaint with SEBI which may order a disgorgement and impose penalties, and (4) Initiate civil litigation for damages including lost opportunity.

SEBI’s Compensation Fund is a safety net for retail investors when both PM and distributor are insolvent, but access to the fund requires a formal complaint and proof of loss.

For the exam, prioritize the order of remedies: PM → Distributor → SEBI Compensation → Courts.