Performance Fee on Unrealised Gains and Cross-Client Collateral at a Portfolio Manager
A SEBI-registered portfolio manager manages ₹780 crore across 460 discretionary accounts. Its standard fee is 2% of assets plus a 20% performance fee calculated on the increase in portfolio value each quarter, including unrealised gains. It operates one pooled bank account for all clients and allocates trades at the day's VWAP; when one client's margin fell short, the operations team transferred securities from another client's demat account to meet the exchange requirement. Twelve accounts now have a corpus below ₹50 lakh because of market depreciation; the firm continues to accept fresh funds from them. The marketing deck claims '28% annualised returns since inception, back-tested and audited'. The compliance officer is reviewing the quarterly investor report before it goes out.
1. Analyse the performance-fee structure against the PMS fee rules and explain whether the fee can be charged on unrealised gains.
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Issue. The firm charges a performance fee on quarterly increases in portfolio value, including gains that have not been realised. That creates an incentive to mark positions up and to churn, and it can charge a client for value the client cannot actually receive.
Rule. Under the SEBI (Portfolio Managers) Regulations, 2020 and the related circulars, fees must be disclosed in the disclosure document and the client agreement, must be transparent and non-discriminatory, and performance fees must be structured with appropriate safeguards. A fee computed on unrealised appreciation is not a realised profit and cannot simply be treated as earned. High-water-mark mechanics and crystallisation on realisation are the usual protections.
Application. A 20% quarterly fee on notional gains means a client whose portfolio later falls may have paid fees on value that never materialised, with no clawback. The compliance officer should test whether the disclosure document and client agreements actually authorise this basis, whether a high-water mark applies, and whether the fee was disclosed before onboarding.
Conclusion. Continue only under a compliant, disclosed structure; otherwise refund the excess and amend the fee terms with client consent.
2. The operations team used one client's securities to meet another client's margin. Explain why this is a segregation breach and what must be done.
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Why it is a breach. The portfolio manager is a fiduciary and each client's assets must be kept separate and used only for that client. Transferring securities from Client A's demat account to meet Client B's margin is a cross-client use of assets. It is not cured by the fact that the securities were later returned: during the period of use, Client A's assets were exposed to Client B's risk and possibly to the broker's or exchange's remedies.
Immediate action. Identify every affected transfer, reconstruct the demat and bank trail, quantify any loss, and restore each client's position in full. Notify the affected clients in writing and offer them the records. Segregate the pooled bank account into client-wise sub-ledgers and stop VWAP allocation unless it is demonstrably fair and documented.
Governance and reporting. Report the incident to SEBI and the exchange as required, place it before the board, and fix accountability for the operations instruction. Review the margin-monitoring process so a shortfall at one client is met only from that client's funds or a notice to the client, never from another client's securities. The principal officer and compliance officer should sign off on the remediation.
3. Evaluate the ₹50 lakh corpus issue and the advertising claim, and state the remediation steps.
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Minimum corpus. The PMS regulations prescribe a minimum investment per client. Market depreciation may temporarily reduce a portfolio below that figure, but the firm cannot treat the breach as an invitation to keep onboarding or to accept fresh funds from those accounts. Each of the 12 accounts should be reviewed: if the shortfall is due to market movement, document it and stop fresh inflows until the corpus is restored; if the account was admitted below the minimum, regularise or exit it. The same test should be applied to the onboarding file, not just the current valuation.
Advertising. '28% annualised returns since inception, back-tested and audited' combines a back-tested number with an implied live track record. Back-tested returns must be labelled clearly, must not be presented as actual performance, and must not be used to suggest future returns. 'Audited' should be substantiated by an actual audit of the figures. The deck should be withdrawn and reissued with the period, the basis, the benchmark, the risk warning and a clear distinction between back-tested and live performance.
Remediation. Withdraw the deck, correct the investor report, review all marketing material, and maintain a record of approvals. Report the corpus and advertising issues to SEBI with the corrective action taken.