Proprietary Trade, Performance Fee and Tax Misstatement by a Category III Manager
Orion Capital manages a Category III AIF and also runs a proprietary trading book. At 9:15 a.m., the portfolio manager buys 2 lakh shares of a mid-cap company for the proprietary book at ₹100. At 9:20 a.m., after the price has moved, he buys 5 lakh shares for the fund at ₹101. The fund's performance fee is 20% over an 8% hurdle, calculated monthly on NAV including unrealized gains; there is no high-water mark. For the year, the fund has earned ₹12 crore from listed derivatives and ₹3 crore from cash equities. In the investor letter, the manager describes all income as tax-pass-through and states that the proprietary trade was a separate strategy. The compliance officer must review the allocation, the fee calculation and the tax statement before the letter is circulated.
1. Evaluate the allocation of the share purchases between the proprietary book and the fund.
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Allocation and conflict
Buying for the proprietary book at 9:15 and for the fund at 9:20 after the price moved is a classic conflict. The manager may have used the fund's order to benefit the proprietary book, or at minimum disadvantaged the fund by ₹1 per share, or ₹5 lakh on 5 lakh shares. The manager must have a pre-trade allocation policy: aggregate orders where appropriate, allocate fills pro rata, and never let a proprietary or affiliate account trade ahead of a client fund. Labelling the proprietary trade a separate strategy does not cure the conflict. Compliance should review trade blotters, communications and best-execution records. Remediation: compensate the fund for the price difference, disclose the incident, strengthen information barriers, and consider disciplinary action. If the conduct was intentional, it may violate the code of conduct and fiduciary duty.
2. Assess the performance fee methodology and recommend corrections.
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Performance fee
A 20% fee over an 8% hurdle is permissible only if it follows the fund documents and is calculated fairly. Calculating monthly on NAV including unrealized gains, with no high-water mark, creates two problems: (i) the manager can earn fees on gains that later reverse; and (ii) after a loss, the manager can earn fees again on the recovery of the same gains. The fee should be crystallised on realised gains or on a verified NAV with a high-water mark, and the methodology must be disclosed. The manager should recalculate the fee, reverse any overcharge, and disclose the correction. If the documents permit the current method, the manager still must consider whether it is consistent with fair treatment and the code of conduct.
3. Is the manager's statement that all income is tax-pass-through correct? What should the investor letter say?
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Tax statement
The statement that all income is tax-pass-through is inaccurate. Category III AIFs do not get pass-through for business income; derivative trading gains are generally treated as business income at the AIF level. Cash-equity gains may have different character. The manager must not give investors a blanket tax assurance. It should obtain tax advice, classify income by head, disclose the fund-level tax position, and correct the investor letter before circulation. Misstating tax treatment is a disclosure and conduct issue, even if unintentional.