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SEBI Order Penalises Outsourcing of Core Functions: Structuring Lessons for Asset Management Industry

Summary: This blog analyses a recent SEBI order dated May 26, 2026, which penalised a portfolio manager for outsourcing core investment functions to a technology company under the guise of “technology consulting”. SEBI held that the prohibition on outsourcing core activities under the Outsourcing Circular and Applicable Laws is absolute, and that “investment decisions” extend beyond model portfolio approval to include all downstream steps such as quantities, timing, and client-level trade execution. The portfolio manager and its key personnel were restricted from onboarding new clients for 21 days and were collectively penalised Rs 42,00,000. The article draws broader structuring lessons for the asset management industry, cautioning that SEBI will look at substance over form, that fee structures linked to performance fees signal participation in the investment process, and that individuals in control will face personal liability.

INTRODUCTION

India’s securities regulator, the Securities and Exchange Board of India (“SEBI”), has long recognised that the integrity of regulated intermediaries depends not merely on who holds a licence, but on who performs the licensed activity.

In this regard, a portfolio manager registered under the SEBI (Portfolio Managers) Regulations, 2020 (“PMS Regulations”), is expected to exercise independent professional judgment in managing client funds. It cannot delegate that function, even partially, to an external entity, regardless of how the arrangement is commercially labelled.

WHAT CANNOT BE OUTSOURCED?

SEBI’s Circular on Guidelines on Outsourcing of Activities by Intermediaries, dated December 15, 2011 (“Outsourcing Circular”)[1], draws a clear line. While intermediaries may outsource support and ancillary functions, they are expressly prohibited from outsourcing their core business activities and compliance functions.

The rationale applies consistently across all SEBI-registered intermediaries. The core activities of an intermediary will rest on its own exercise of the licensed function. Outsourcing that function to a third party, even within the same group, or even where the intermediary retains formal approval authority, does not discharge the regulatory obligation. The Outsourcing Circular further provides that outsourcing arrangements must not affect investor rights against the intermediary, and that the intermediary remains fully liable for the acts and omissions of the third party.

For portfolio managers specifically, Regulation 24(10) of the PMS Regulations[2] reinforces this by providing, in absolute terms, that a portfolio manager shall not invest client funds based on the advice of any other entity. Read together, the Outsourcing Circular and the PMS Regulations create a clear prohibition on the outsourcing of core investment-related activities and on the investment of client funds based on the advice or inputs of any external entity.

THE ORDER: A CASE STUDY

A recent SEBI Final Order QJA/MN/IMD/IMD-SEC-4/32418/2026-27, dated May 26, 2026, (the “Order”), illustrates how these principles apply in practice. A SEBI-registered portfolio manager (the “Portfolio Manager”) had engaged an artificial intelligence and technology company under a contract described as “technology consulting”. SEBI conducted an on-site inspection and a forensic audit covering a period of approximately two and a half years. The findings revealed that the arrangement was, in substance, an outsourcing of core investment-related activities.

The Portfolio Manager argued that the “investment decision” was completed at the model portfolio stage, and that basket files were merely mechanical translations. SEBI rejected this, holding that an investment decision extends beyond initial securities identification to encompass quantities, timing, allocation percentages, sequencing of trades, and translation of the model portfolio into actual client-level transactions.

SEBI found violations of Regulation 24(10), Clauses 1, 3 and 13(a) of Schedule III (Code of Conduct), read with Regulation 21[3] of the PMS Regulations, and the Outsourcing Circular. The Portfolio Manager was restricted from accepting new clients for 21 days and was directed to cease outsourcing core investment activities. A monetary penalty of Rs 14,00,000 was imposed on each of the three noticees — the entity, its managing director, and its director-cum-principal officer — totalling Rs 42,00,000 in aggregate.

STRUCTURING LESSONS FOR THE ASSET MANAGEMENT INDUSTRY

The Order carries lessons that extend well beyond its specific facts. The following points should be considered carefully when structuring or reviewing any such arrangement:

  • Outsourcing of core investment functions is an absolute prohibition under the Outsourcing Circular. If external input drives or informs investment at any stage, from model portfolio formulation to client-level trade implementation, then it will be considered as outsourcing of core investment functions, and it is prohibited.
  • Governance documents must reflect the actual role of each participant. Where a third-party consultant is included in any core activity, SEBI will look at the substance of that inclusion, not the commercial label.
  • The expression “investment decision” is broader than model portfolio approval and extends to all downstream determinations involved in translating that portfolio into actual client-level transactions. Third-party systems or personnel participating in any such determination will attract scrutiny as conduits for external investment advice.
  • A fee structure linking third-party compensation to management fees and performance fees is inconsistent with a limited or ancillary third-party role. Performance fees are intrinsically linked to investment outcomes, and such a structure will be treated by SEBI as participation in the investment process.
  • Persons controlling the affairs of a SEBI-registered intermediary who are directly involved in or are aware of a non-compliant outsourcing arrangement will be held personally liable alongside the entity. Personal liability does not require deliberate wrongdoing; knowledge of and involvement in the arrangement is sufficient.

WHAT CAN BE OUTSOURCED?

Not all outsourcing is prohibited. The Outsourcing Circular permits intermediaries to outsource support and ancillary functions — for example, technology infrastructure maintenance, legal support and similar services that do not constitute core business activities. The line is crossed when external parties begin to participate in, generate, or drive core business activities.

BOTTOM LINE

This Order is a timely reminder that the regulatory framework governing outsourcing by portfolio managers is not merely a procedural requirement; it goes to the heart of what it means to be a registered intermediary. Entities and individuals structuring funds, PMS platforms, or investment vehicles should carefully review their arrangements against the Outsourcing Circular and the applicable regulations to ensure that core investment functions are not, in substance, being performed by an external party.

[1] SEBI | Guidelines on Outsourcing of Activities by Intermediaries

[2] Regulation 24(10) states: “The portfolio manager shall not invest client’s fund based on the advice of any other entity.”

[3] Regulation 21 requires every portfolio manager to abide by the Code of Conduct set out in Schedule III of the PMS Regulations. The relevant obligations include Clause 1 (honesty, integrity, and fairness), Clause 3 (due diligence, and independent professional judgment), and Clause 13(a) (compliance with SEBI laws and circulars). The Outsourcing Circular (SEBI Circular CIR/MIRSD/24/2011 dated December 15, 2011) provides that intermediaries “shall not outsource their core business activities and compliance functions and investment related activities in case of Mutual Funds and Portfolio Managers.”