[Ajitesh Arya is the 4th year BA LLB (Hons.) students at NALSAR University of Law, Hyderabad]
Recently, the Securities Exchange Board of India (SEBI) floated a consultation paper proposing the expansion of the SEBI (Prohibition of Insider Trading) Regulations, 2015 [Insider Trading Regulations] to encompass mutual fund units. The move is interesting as it comes in the aftermath of a front running controversy that allegedly resulted in significant losses in the mutual funds market. In the consultation paper, SEBI records its dismay over the practice of redemption of the mutual funds units by the insiders using undisclosed information.
In this post, I argue that while such practices are needed to be dealt with, the attempt by SEBI to bring mutual funds under the regulatory framework of insider trading regulations might be excessive, unprincipled, and practically difficult.
Currently, mutual funds are governed by the SEBI (Mutual Funds) Regulation, 1996 [Mutual Funds Regulations] and directions and circulars issued by SEBI from time to time. The consultation paper suggests some major changes in the Insider Trading Regulations in order to integrate mutual funds into the same. The definition of “securities” in the Regulations is proposed to be amended to do away with the exemption provided to mutual funds. It is proposed that “trading” will include trading in the units of the mutual funds and that the expression “unpublished price sensitive information” (UPSI) will include information impacting the net asset value of mutual funds. The “connected persons” for the purpose of mutual funds would include any person associated with the mutual funds, directly or indirectly, in any capacity. This definition has a very wide import covering an array of parties.
Through various circulars, SEBI has previously placed restrictions on the fund managers and employees of the asset management companies (AMCs) for dealing in the securities market. Initially, there were only restrictions on trading in listed securities, but in 2021, through the circular dated October 28, 2021, the employees, directors of AMCs, board members of trustees, including access persons (as defined in the said Circular) were also prohibited from transacting in any scheme while in possession of certain sensitive information.
Keeping this in mind, a case can be made that the recent move by SEBI of bringing the mutual funds under the purview of the Insider Trading Regulations is nothing but a move to consolidate the previously existing regulation to a large extent. However, this move is unprecedented and unprincipled.
The traditional theory of insider trading does not squarely apply to the cases of trading in the units of mutual funds. The traditional theory as also reflected in the Indian insider trading regulations states that an insider is in the wrong if he or she trades in the security of the issuer based on any material unpublished information. This theory would not apply to mutual funds for two major reasons. Firstly, mutual funds are traded in a different manner from other forms of securities, and there is a lesser need for the regulators to be concerned with the information asymmetry. Secondly, the NAV of a mutual fund is directly derived from the values of the underlying securities and is not contingent upon insider information.
The US Court of Appeal of 7th Circuit has also asserted a similar argument in Securities and Exchange Commission (SEC) v. Jilaine Bauer. The case involved the redemption of the units of Heartland Advisors by its Chief Compliance Officer; she had allegedly based her decision on insider information pertaining to the difficulties in assigning the fair market value. The SEC had brought a claim against her and, while the district court had made a finding on insider dealing, the appellate court noted the difficulty in applying the traditional theories of insider trading to the fact situation and remanded the case.
At a secondary and a more practical level, there are likely to be challenges with regard to the enforcement of insider trading regulations vis-à-vis mutual funds. The proposed definition of “connected person” encompasses any person who was associated with the mutual fund in any capacity in the preceding two months. This is a very wide definition and will therefore cover a large number of persons and entities. SEBI does not have the resources to be tracking all the parties involved. The difficulty further arises in obtaining the relevant evidence. The Supreme Court in Balram Garg v. Securities Exchange Board of India has arguably raised the burden of proof on SEBI in cases of insider dealings. SEBI now has to satisfy an arguably high burden of proof for admitting the circumstantial evidence in the insider trading cases. In light of the extended burden, enforcement becomes harder, especially in the cases of mutual funds as they deal with a large number of parties on a regular basis.
This post does not attempt to downplay the issues of malpractice prevalent in the mutual funds market as highlighted by SEBI. Prof. Bullard, who has taken a strong stance against the extension of insider trading law to mutual funds, has conceded that the insider dealing regulations might be efficient in dealing with the problem of front running. As front running directly impacts securities, there is a stronger case for insider trading regulation there. But in my opinion, instead of looking for recourse under the insider trading regulations, there is a need to clarify, elaborate, and strengthens the regulations on front running. Currently, only regulation 4(2)(q) of SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market), 2003 deals with front running.
Similarly, it has been argued that the abuse of the insider position by fund managers and employees can be curbed strongly using internal checks and balances like a code of conduct, a whistleblower mechanism, and other extralegal practices. SEBI can look to strengthen the code of conduct enshrined in the Mutual Funds Regulations as an alternative.