When should companies recoup pension fund losses?

By Paras Parekh and Hitesh Jain, Parinam Law Associates

Exempted employers have to make good on payment defaults by issuers only in the event of a shortfall in interest payout, argue Hitesh Jain and Paras Parekh

The Employees Provident Fund and Miscellaneous Provisions Act, 1952 (PF Act), envisages provident funds for employees in factories and other establishments. Under the scheme, the employee and employer each contribute towards employees’ provident fund. These funds are managed by a Central Board of Trustees assisted by the Employees Provident Fund Organisation (EPFO), a regulatory body. This is a statutory requirement in India aimed at ensuring that employees are provided with benefits in addition to their wages with contributions by the employer.

Paras Parekh

However, various organizations are granted exemption from registering with the EPFO and can constitute a board of trustees for managing the provident fund. Such “exempted establishments” are required to comply with conditions specified under the Employees’ Provident Funds Scheme, 1952 (EPF Scheme), and exemption orders issued by the EPFO (conditions). These provident funds also invest in debt instruments issued by reputed companies – generally with higher credit ratings.

Trusts of provident funds (pension funds in certain jurisdictions) of exempted establishments in India are faced with a spate of defaults by issuer companies on payments on debt instruments.

The conditions require the employer to, in certain cases, make good on losses by the provident fund. These include a requirement upon the employer to meet a shortfall in the rate of interest prescribed by the government to be paid to employees. Other conditions envisage making good on losses in circumstances such as theft, burglary, defalcation, misappropriation, fraud, wrong investment decisions and any other reason.

Hitesh Jain

This raises a pertinent question on the regulatory treatment of these losses – leading to confusion on the way forward with potential for regulatory action by the provident fund regulator.

The issue here is whether a default on repayment by issuer companies triggers an automatic need for the employer to make good on losses or whether, so long as the interest payout to the employees is maintained, no such obligations arise. In other words, does an exempt establishment need to recoup any shortfall in the corpus of the provident fund or do they only have to ensure that the statutory rate of interest payout is met? It is also important to see what defences could an entity take if the EPFO directs that the entire loss be recouped from the employer.

The EPFO (also an investor in some such defaulting debt instruments) is silent on the issue. There is a 2015 notification of the EPFO dealing with a fall in the credit rating of certain issuers requiring exempted establishments to monitor the portfolio. There is a mention, in the passing, of the obligations of the employer to recoup the losses on account of wrong investment decisions (triggered by a fall in the credit ratings of the issuer) – without explicitly directing any recouping of losses.

Another approach could be where the EPFO may direct recouping of the interest that the issuers have defaulted on as there may not be a default on the instrument itself yet. In such a case, many employers may opt to recoup the interest component while creating reserves in case of a default on the instrument. Some employers appear to opt for this in anticipation of regulatory action with a view to space out the payment obligation and avoid a larger payout. The employer may, however, choose to question the regulator’s directive and argue that there is no automatic liability to recoup every fall in the value of the portfolio. The following could, however, be argued in case of any regulatory direction for the recouping of losses.

The direction for automatic recouping of losses is based on the simplistic approach that the employer underwrites the entire corpus of the provident fund. This argument asserts that any dip in the corpus of the fund triggers an obligation to recoup regardless of whether there is an interest default by the fund. This argument proceeds largely on the assumption that there are generic terms such as “any other reason” and “wrong investment decision” in the conditions that imply such an obligation.

However, a closer look at the conditions reveals a different picture. The interest rate payable by the provident fund is not linked to the corpus of the fund. Such payout is a percentage of the contributions to the fund. This means that in a basket of instruments held by the fund, any increase or decrease would not trigger a payout if the overall payout meets the prescribed percentage. Therefore, only in the event of any shortfall in the payout of interest is the employer obligated to recoup the difference.

The conditions dealing with fraud, defalcation misappropriation, etc, are separate and are a class of events that would automatically trigger the obligation to recoup. A cardinal rule of interpretation requires general words appearing in a provision to be read considering the special words appearing in the group. Where the law cannot prescribe every situation leading to an obligation, it could end the provision with general terms, which ought to be read as a class of the words appearing before that.

Therefore, to read general terms such as any other reason, in this case, would defeat the purpose of the legislation. The conditions dealing with extraordinary situations such as fraud, misappropriation, etc, cannot be expanded to a situation where there is a dip in the corpus on account of a default on the debt instruments.

The term wrong investment decision is also a specific extraordinary situation arising from a blatant disregard of basic diligence expected from a reasonable person. Investments by the EPFO in instruments of similar or the same issuer companies could lead credence to the argument of no wrongful investment decision if there is no other factor showing a blatant lack of diligence.

Another argument against an automatic recouping of losses is that the conditions dealing with fraud, misappropriation and defalcation are situations where parties responsible for the maintenance of the provident fund cause such losses.

Instances could be where the bodies responsible for the management of the provident fund misappropriate the funds or securities or where there is an investment decision based on extraneous considerations and not keeping the best interest of the provident fund at heart.

For instance, an investment by the trustees in an instrument where the trustees themselves have a pecuniary interest while there were better investment opportunities available. Or an instance where the trustees receive kick-backs for investments in securities that signal wrongful investment decisions. Or even a blatant and obvious disregard of apparent signs denoting wrong investment decision.

These are instances requiring an employer to recoup the loss to the value of the portfolio. Since the conditions cannot envisage every situation of this type, the generic wordings in the conditions can be read to cover situations denoting a wrongful intention on part of the trustees involved in the decision making or faulty handling of the portfolio by parties in charge of operations.

The employer stands as an underwriter only in such extraordinary instances. These conditions cannot, however, be stretched to a situation, where the provident fund is itself subjected to defaults by the issuer. The employer cannot be the underwriter to the issuer company whose instruments are held by the provident fund.

Therefore, the default by issuer companies cannot automatically trigger the employers’ obligation to recoup the losses if the overall portfolio can service the prescribed interest rate.

The obligation to recoup could also be triggered if it can be demonstrated that the investment at the time of the decision-making, was a wrong investment option or is affected by wrong motives.

Paras Parekh and Hitesh Jain are partners at Parinam Law Associates.