[Aryan Rawat is a 4th year B.B.A LL.B. (Hons) student at National Law University, Odisha]
On 5 August 2024, the Securities and Exchange Board of India (‘SEBI’) issued a circular to all asset management companies (‘AMCs’) and mutual funds (MFs), calling upon them to establish institutional mechanisms to curb front running and fraudulent securities transactions. This circular was issued at a time when SEBI also announced the enforcement of the SEBI (Prohibition of Insider Trading) (Amendment) Regulations, 2022 (‘Insider Trading Amendment’) from 1 September 2024. The purpose of this circular is to institutionalize best practices in the securities market by AMCs for effective implementation of the regulatory framework to deter market abuse. The circular aims to set up a mechanism with continuous reporting, with the accountability to implement the suggested framework being vested upon the Chief Executive Officer (‘CEO’)/Managing Director (‘MD’) of MFs or Chief Compliance Officer (‘CCO’) of AMCs. The aim of this post is to discuss the possible implications of this suggested mechanism and the risk of vesting broad discretionary powers to employees with non-public information.
Background
On 28 October 2021, SEBI issued a circular regarding the investments and trading of securities covering all the employees, board members of the AMC and trustees of MFs with the aim of safeguarding sensitive information, termed as unpublished securities information (‘UPSI’). In November 2022, the Insider Trading Amendment expanded the concept of insider trading to include communications of insiders for the trading of MFs. The aforesaid amendment came in the wake of a Consultation Paper published by SEBI in July 2022 with a proposal to expand the applicability of the SEBI (Prohibition of Insider Trading) Regulations, 2015 (the ‘Insider Trading Regulations’) to encompass units of MFs.
Front running is an illegal practice, as stipulated by regulation 4 (q) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) (Amendment) Regulations, 2018 (‘PFUTP Regulations’), which occurs when one in possession of sensitive information about a fund’s buying or selling activity leaks it. This information is used by an individual or an entity to build prior positions with the objective of booking profit when the stock moves after the actual trade by the fund house takes place. To prohibit insider trading, the definition was expanded to include knowledge of substantial impending transactions in securities along with their underlying securities, or their derivatives.
The existing regulations governing MFs and AMCs lack a structured system of enforcement to identify and restrict market abuse. The existing regulations also do not mandate the AMCs to adopt a vigil mechanism or whistleblower framework. Furthermore, the existing regulations attribute the acts of market abuse to individual employees without obligating the AMCs to have an adequate system to deter such fraudulent acts. However, this move of SEBI has asked all the MFs and AMCs to adopt an operative framework to detect market abuse in tandem with the related regulations, thereby protecting the interest of asset holders and investors.
Notable Instances of Front Running in MFs
Due to increased instances of front running in a few of the most trusted mutual funds in India, this clamp-down regulatory move was much awaited.
SEBI probe for LIC mutual fund trades
SEBI issued an order against five entities involved in a front running scheme related to Life Insurance Corporation of India (‘LIC’) and reported gains amounting to Rs. 2.44 crore through these trades. Curtailing the front running, the confirmatory order in this matter directed individuals to ‘cease and desist’ from manipulative and unfair trade practices.
Episode involving Axis Mutual Fund
In June 2024, by interim order-cum-show cause notice, SEBI alleged that Axis MF’s CEO devised a front running scheme. He shared sensitive non-public information about upcoming large orders of Axis MF with his associates, who then took positions in the market, benefiting from the price movements triggered by the large orders. A whistleblower complaint and items seized during searches helped unravel the fraudulent scheme. This case raised concerns about the integrity of mutual funds market and the effectiveness of robust whistleblower mechanisms.
Ongoing investigation into Quant Mutual Fund
There are ongoing investigations undertaken by SEBI to probe front running activities by the prominent investment firm Quant Mutual Fund. In the ongoing investigation, SEBI suspected that the fund may have traded non-public information to other investors about forthcoming deals which could move shares significantly. The market regulator carried out search and seizures at registered office of Quant Group and seized electronic devices after the surveillance system red-flagged some activities, suggesting a fraudulent trading pattern in Quant’s trades.
Analysis of Power Conferred with Unchecked Authority
The circular aims to establish a uniform implementation mechanism and the Association of Mutual Funds in India (‘AMFI’) has been directed to develop implementation standards to ensure synergy in all units and AMCs. With a focus on elements of accountability, surveillance, and reporting, the circular has placed the responsibility for establishing the implementation framework on the CEO or MD of MFs and CCO of the AMCs. The broad powers granted to these company employees can lead to potential abuse of power. Notably, SEBI itself flagged the incident of front running and suspicion of malpractice by the CEO in the case of Axis MF and by an official in Quant MF. Without proper checks and balances, these company employees could misuse their authority for personal gains, neglecting the original objective of preventing market exploitation. Furthermore, these officials have not only been directed to comply and establish a mechanism but also have been subsequently vested with the responsibility to alert and report incidents. However, the absence of independent oversight can lead to misuse of authority for personal gains. The entity that can potentially cause the illegal act of front running has been tasked with enforcement.
Information Barriers for Employees to Prevent Insider Trading
The extant circular has compared the policies in the United Kingdom and Singapore. However, inspiration can be drawn from the measures laid down by the Securities Exchange Commission (‘SEC’) in the United States (‘US’). Through rule 10b-5 of the Exchange Act and section 204A of the Investment Advisers Act of 1940 (‘Advisers Act’), the SEC has been instrumental in preventing the misuse of material non-public information (‘MNPI’) by investment advisers or any associated person in US securities market.
The function of advising the clients is integral to units of MFs and AMCs. In the US, the regulatory framework enables advisory firms to set up ‘information barriers’ designed to wall off employees with MNPI. Practically, when an advisory firm acquires MNPI about a security, even accidentally, it becomes subject to insider trading restrictions. The firm cannot trade the security or advise clients to do so. These controls often include information barriers to separate employees with MNPI from those making investment decisions, maintaining restricted lists or blackout periods, monitoring employee trading and communications, and educating employees about insider trading. The specific controls depend on the size, structure, and nature of the MNPI they are likely to encounter. It has been settled in SEC v. Charles Schwab Investment Mgmt. that insider trading policies for MNPI will apply to advisers of MFs.
This approach of an information gateway with setting up wall-offs can address the prevailing issue of front running in the Indian securities market. A system with proper checks and balances through an independent mechanism can prove to be more effective for detecting, reporting and mitigating the incidents of insider trading in MF units and AMCs.
Conclusion
SEBI has adopted a laudable step by, firstly, expanding the ambit of the Insider Trading Regulations to include units of MFs and, secondly, embarking on the effort to roll out an institutional mechanism for enforcement of these regulations. However, in the suggested framework, there is a lack of autonomous oversight to supervise the fraudulent acts (like front running). Moreover, the concern lies in the possibility of abuse of power by the stakeholders who have been trusted with establishing and complying with these institutional policies. The endeavours by SEBI to regulate insider trading are not limited to merely compliance and adoption of policies; rather they majorly rely upon transparency, accountability and strict vigilance through subsequent reporting and altering the authorities about securities fraud in the long run.
– Aryan Rawat