Addressing The Concern Regarding Insider Trading And Frontrunning By Connected Persons of Mutual Fund Companies
Introduction
SEBI on 22nd Nov,2022 have notified, SEBI(Prohibition of Insider Trading) (Amendment) Regulations,2022, which has amended the Regulation (1)(i)of SEBI (Prohibition of Insider Trading Regulation which provided the definition of the term securities as defined under section 2(h) of Securities Contracts (Regulation) Act,1956. In earlier definition the Mutual Funds (MF) were specifically excluded from the ambit of the term ‘securities’ by the phrase “except the units of Mutual Fund” in the definition of securities but as per amended regulations the excluding phrase has been omitted, which effectively brings the mutual funds under the ambit of term “Securities” and therefore, under the SEBI (Prohibition of Insider Trading) Regulations,2015 which regulates the transaction in securities. This is done in subsequence of various rounds of consultation with the stakeholders. The regulations have triggered the debate around various provisions, necessity and possible effects of the regulations.
Loopholes In the Prior Regulatory Framework
Insider trading, is the malpractice of selling or buying securities such as equity and bonds by the based on the unpublished information shared by insiders of a company, which includes the employees, directors, executives and promoters or any connected person of the company. To prevent such acts and to promote fair trading in the market for the interest of common investors, the stock market regulator SEBI (the Securities and Exchange Board of India) has prohibited the firms to purchase their own shares from the secondary market. As per Regulation 2(1)(g) of the SEBI (Prohibition of Insider Trading) Regulations, 2015, insider is a Person who is “Connected” with the company, and who could have the Unpublished Price Sensitive Information (UPSI).
Frontrunning can be explained as an investment based on UPSI, where any related party by using privileged prior insider information regarding the shares purchasing decisions of the company, buys the share on the personal account, before making the investment on behalf on the investors of the mutual fund. The investment made on behalf of the investors result in increased price of the shares, and fetches unparallel profit to the involved related parties of the company, who made the prior investment on the personal account.
Front running as an offence was not defined in earlier legislations regulating securities market, like SEBI (Prohibition of Insider Trading) Regulations, (PIT Regulations) or SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating of Securities Market) Regulations, 2003 (PFUTP Regulation), it finds its first mention in “Master Circular for Mutual Funds” dated 24 August,2020 which prohibits the act of front running by the access persons or any connected persons of Asset Management Company’s (AMC). The concept of front running could be understood by an example of mutual fund entity which collects the funds of large number of small investors and utilises that fund to purchase wide range of securities or basket of securities, while the amount of each individual investor that is invested in MF is small but the amount that MF invests in the basket of securities gets compounded to form the large chunk of fund, and when this fund is invested in a basket of securities the valuation of shares of the securities tends to increase, this increase in the share price of the securities is called push support. Due to the push support and subsequent increase in the price of the securities results in increased profit margin of the involved parties of Mutual Fund Company (MFC).
The key position holders in various Asset Management Companies (AMC) which tends to get the UPSI regarding the future investment decisions of the MF, tend to invest their personal funds or utilises the UPSI for to gain financial advantage. When, the information is related to securities, in which the MF has decided to invest in and when the funds of MF Company gets invested in the same securities the price of the securities rises which puts the investors who invested in the securities based on UPSI in unparallel advantageous position over investors of the MF who did not had such information.
The purpose of the amendment is to curb the unfair practises, where SEBI had no legislative backing in the proceedings of the cases where the employee of AMC’s who allegedly made the transaction on the basis of UPSI, were not prosecuted as did not had enough legislative backing. In the case of Samir C. Arora v. SEBI, SEBI was required to presented with heavy evidentiary requirement to prove the case against the appellant, therefore, SAT and SC ruled against the financial regulator, on the ground of lack of evidence against the appellant.
Practical Applicability of SEBI Regulation to Bring MFC’s under Insider Trading Regulation
In case of equity funds, a scheme’s portfolio cannot hold more than 10% in a particular stock. In case the shares are unlisted, which are riskier because there is less monitoring from SEBI and the stock exchange, this limit is 5%. Whereas, in case of debt schemes, the portfolio cannot hold more than 10% in investment grade (BBB- and above) bonds of an issuer. This can be increased to 12% with the approval of the trustees. The limit does not apply to government bonds. These regulations were enforced by SEBI to make sure that the MF AMC’s does not engage in any fraudulent practise, therefore, they marked a ceiling cap on, what would be the maximum percentage of the Net asset value of a fund can be invested in each type of security.
Though, putting the cap on, the percentage of fund an AMC can invest in any particular security, was an attempt to protect the shareholders’ interest by curbing the possible fraudulent practises, and it is true that the cap would shield the interest of investors who invest in the securities of companies having large market capitalisation, but there was scope for AMC’s which have large amount of fund to invest and influence the market price of security.
Suppose, an AMC having fund scheme that has a total amount of Rs. 1000 Cr. to invest, and there is a listed company ‘A Ltd.’ having market capitalisation of Rs 200 crore, and having listed share capital of Rs. 100 crores. Now, the AMC can purchase the large chunk of the shares that are listed and may even purchase majority of listed shares SEBI (Substantial Acquisition Of Shares And Takeovers) Regulations, 2011, which may result in influencing the share price of the company and putting investors’ interest at risk.
Though, this practise of Mutual fund AMC’s can be said to be a fraudulent practise but since the definition of securities which excluded mutual fund could be used to shield the persons engaged in such price manipulation be AMC’s. Therefore, the regulation by including the AMC’s under the Insider trading regulations would bring the Mutual Fund companies under the regulatory ambit of SEBI and the framework that regulates the employees of listed companies would apply to mutual fund companies as well, which might lead to increased security of investors of mutual fund company and shareholders.
Therefore, it can be said that the regulations may not have much influence on the securities of the companies having large share capital, but the regulations would protect the investors of companies which have comparatively small share capital.
Conclusion
The amendment to bring the MF under the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015 is a step to give teeth to the financial regulators SEBI in the proceedings relating to insider trading by the employees of the MF Companies, the amendment would instil the confidence of MF investors and protect their investments from being jeopardised by any unfair and fraudulent trade practise which may be instituted by the employees of MF Company. Critics are of the view that the amendment would be of little avail, as the margin on the investment made any person investing in mutual fund units, gets diluted when the person invests in the mutual fund scheme, which contains any particular security, of which the person had the UPSI under his possession, as the Mutual fund schemes contains the basket of securities, which may have securities that may incur loss and hence, making the information of such nature that makes the information void of any profit motive, and therefore, absolves any person from falling under the definition of Insider, as held in Securities and Exchange Board of India V SEBI. Though the initiative of SEBI is indicative of its intention of SEBI to provide protection to the investors, against any fraudulent practise by AMC’s but amidst all the appreciation and criticism, on the ground impact of the of the amendments remains to be seen.
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