Failure To Rebalance Portfolios As Per Agreed Strategy is breach of fiduciary duty, breach of SEBI PMS / IA / RA Regulations, and negligence.

Agreed Strategy = Disclosure Document + PMS Agreement + Risk Profile + Asset Allocation mentioned in SID / KFS / Advisory Agreement - e.g. 60% Equity / 40% Debt, or Large Cap oriented, or Max 25% in single stock.

Rebalancing is required when:

• Market movement causes drift - e.g. 60/40 becomes 75/25 - passive breach
• Cash flow - redemption, fresh inflow
• Change in risk profile, age, goal
• Corporate action, rating downgrade

SEBI Framework

1. PMS - SEBI (Portfolio Managers) Regulations, 2020 read with Circular SEBI/HO/IMD/IMD-I/DOF1/P/CIR/2022/112 dated 26 Aug 2022:

Prudential limits on investment in associates/related parties. In event of passive breach of specified investment limits [i.e. not arising out of omission and/or commission of portfolio manager], rebalancing shall be completed within 90 days from date of breach. Requirement of rebalancing and waiver shall be disclosed in consent form.

Active breach - intentional deviation - is violation on Day 1. Cannot wait 90 days.

2. Mutual Funds - SEBI Circular on Rebalancing Timelines 2022:

Mandated rebalancing period for all schemes except Index/ETF is 30 business days for passive breaches. If not done within 30 days, justification in writing including efforts taken shall be placed before Investment Committee. Committee can extend up to 60 business days. If still not rebalanced, AMC cannot launch new scheme till rebalanced and shall not levy exit load.

3. Investment Adviser - SEBI (IA) Reg 15 - Suitability and Risk Profiling:
Adviser must rebalance as per agreed risk profile and review periodically. Failure = violation of fiduciary duty and Code of Conduct.

4. SIF - Specialised Investment Fund - SEBI 2025 mechanism:
Notice of 30 calendar days to investor to rebalance to comply with minimum investment threshold. If fails to rebalance, units frozen and auto-redeemed at NAV.

Failure to rebalance leads to:

• Concentration risk
• Deviation from risk-return promise - mis-selling
• Tax inefficiency
• Client pays higher fees for strategy not implemented

Case Laws - India and International

A. Indian - Portfolio Management Negligence

1. Kotak Securities Ltd. v. Gaurav Goel, Bombay High Court Arbitration Petition No. 310 of 2007 decided 31 Aug 2012
Most cited Indian case on PMS. Client gave written instructions for one month including rate, date. Broker failed to act as per agreed strategy and claimed instructions were vague. NSE Arbitral Tribunal awarded damages to client. Bombay High Court upheld Tribunal's approach that stock broker cannot be expected to act on vague instructions, but where instructions are clear in Disclosure Document and agreement, broker must act. Held: If manager deviates from Disclosure Document or agreed strategy, liable for fiduciary negligence. Cannot claim damages for loss of profits if client himself gave vague instructions, but must rebalance as per mandate.

2. Peerless Securities Ltd. v. Vostok (Fareast) Securities Pvt. Ltd., Bombay High Court Arbitration Petition No. 157 of 2021
Court set aside arbitral award of Rs 7.18 lakhs for losses due to unauthorized trading and failure to rebalance F&O portfolio. Held apportionment of liability without evidence is akin to Panchayati approach. Principle: Arbitrator must examine whether deviation from agreed strategy caused loss, with contract notes, margin statements, SMS evidence.

3. Sharekhan Case - Bombay High Court 24 Dec 2024 - Justice Sandeep V. Marne
Set aside awards directing Sharekhan to bear 50% of speculative F&O losses suffered by clients solely due to failure to maintain SEBI-mandated trade confirmations. Held broker cannot be held automatically liable for F&O losses due to procedural lapses if loss arises from market risk, but if failure to rebalance as per agreed stop-loss / strategy is proved, liability attaches.

4. SEBI Order against Karvy Portfolio Management - Inspection FY 2018-19
SEBI observed non-compliance with PMS Regulations, 1993 [now 2020]. Disclosure Document mentioned placement fee in two sections contrary to each other. Manager failed to rebalance portfolio after change in fee structure, leading to deviation from agreed net asset allocation. SEBI held deviation on account of exigency only allowed with prior written approval of Principal Officer and Compliance Officer with detailed rationale.

B. US - Fiduciary Duty to Monitor and Rebalance - Continuous Duty

5. Tibble v. Edison International, 575 U.S. ___ (2015) - US Supreme Court - Unanimous
Landmark. Plaintiffs were beneficiaries of Edison 401(k) Plan. Plan fiduciaries offered expensive retail class shares instead of cheaper institutional class shares of same funds and failed to monitor and rebalance. 9th Circuit held claim time-barred after 6 years. Supreme Court reversed: ERISA fiduciaries have continuing duty to monitor investments and remove imprudent ones. Failure to rebalance and replace with cheaper share class is breach. A fiduciary's allegedly imprudent retention of investment is an action that triggers 6-year statute of repose. Every day failure continues is fresh breach.

Applied to India: PMS manager has continuing duty, not one-time.

6. Hughes v. Northwestern University, 142 S.Ct. 737 (2022) - US Supreme Court
Participants alleged fiduciaries violated duty of prudence by failing to remove imprudent investments from plan offerings. Supreme Court vacated 7th Circuit judgment for defendant, held duty to monitor is not satisfied by offering low-cost investments as options. Must rebalance and remove imprudent.

7. Knox, Rowe, Saxton Cases - New York Surrogate's Court - Trustee Duty to Diversify
In Matter of Knox, Rowe, Saxton, Dumont, Hyde, Creighton - each case held bank trustee liable for damages because it was negligent for retaining concentrated positions and not diversifying/rebalancing portfolio. Damages calculated by determining when concentrated holding should have been sold.

Principle adopted in India under Indian Trusts Act, 1882 Sec 20 and PMS Reg 14 - manager must diversify.

8. Worthing and Worthing v. Lloyds Bank Plc [2015] EWHC 2836 (QB) - UK
High Court clarified existence of continuing duties of care for IFAs. Terms of contract did not impose strict liability for continuing monitoring, but where agreement provides for periodic rebalancing, failure to do so is negligence.

Consequences of Failure to Rebalance

• SEBI: Penalty under Sec 15HB - up to Rs 1 Crore, suspension of PMS license, debarment of Principal Officer. In PMS, breach = violation of Reg 22 Disclosure Document.
• Civil: Client can claim actual loss as difference between portfolio return if rebalanced vs actual return - as in Knox formula.
• SCORES: SEBI orders refund of fees + compensation.
• Criminal: If mala fide diversion, Sec 447 Companies Act fraud.

Defence for PMS/IA

To avoid liability, you must maintain:

1. Agreed Strategy in writing - asset allocation bands e.g. Equity 60% +/-10%
2. Rebalancing triggers - time based [quarterly] and threshold based [drift >5%]
3. Audit trail of rebalancing - order logs, rationale if waiver taken
4. Client consent for passive breach waiver - as required by SEBI circular 2022
5. Minutes of Investment Committee if not rebalanced within 30/90 days