Inclusion of Mutual Funds in PIT Regulations: Narrowly Missing the Bull's Eye
[Aryan is a student at MIT World Peace University, Faculty of Law, Pune.]
On 8 July 2022, the Securities and Exchange Board of India (SEBI) issued a consultation paper recommending that the SEBI (Prohibition of Insider Trading) Regulations 2015 (PIT Regulations) should be expanded to include units of mutual funds within the scope of securities vis-à-vis insider trading norms. This decision of the market regulator is speculated to have come in the wake of the recent Franklin Templeton crisis and the front-running scandal at Axis Mutual Fund. In both instances, key members of the respective mutual fund schemes redeemed their unit holdings to earn unsolicited profits by using their knowledge of the non-public information. This resulted in the market watchdog recognizing the dire need to implement measures to protect the interest of the investors of the mutual funds, who are not privy to price-sensitive, non-public information due to information parity.
This post summarizes the inclusion of units of mutual funds in the PIT Regulations and analyses the lack of bandwidth of the codified regulation to incorporate units of mutual funds in its ambit. The post suggests the inclusion of insider trading of mutual funds in the Securities and Exchange Board of India (Mutual Funds) Regulations 1996 (MF Regulations) to ensure uniformity and effective implementation of laws regulating mutual funds.
Franklin Templeton and Axis Mutual Funds
The mutual funds market took a hit after the Franklin Templeton crisis came to light in April 2020. During the COVID – 19 pandemic, the Franklin Templeton Mutual Fund decided to wind up six of its schemes for redemption on demand by its unitholders. All these schemes had a similar portfolio and sixty-five percent of their portfolios were securities that were AA rated or below. Pursuant to an investigation, it was discovered that several of the fund’s key personnel had withdrawn their holdings in these schemes prior to their winding up announcement to the public.
A similar situation arose in the Axis Mutual Fund scandal wherein the fund manager and the chief dealer were held for ‘front-running’. Front-running is the unlawful trading of securities by a person with prior knowledge of a significant imminent transaction that would impact the prices. Front-running provides the inner circle of the fund including its key personnel unitholders non-public price sensitive information which creates an information parity, providing an unfair advantage to the inner circle for placing an order on the units on basis of the non-public price sensitive information. According to the Regulation 4(2)(q) of the PIT Regulations, “any order in securities placed by a person, while directly or indirectly in possession of information that is not publicly available, regarding a substantial impending transaction in those securities, its underlying securities or its derivative” is a manipulative, fraudulent and unfair practice.
SEBI’s Early Steps
SEBI had made several attempts to address the issue of insider trading in mutual funds in the past by issuing multiple circulars. The circular dated 17 November 2016, regulated and consolidated investment in securities by employees of an asset management company (AMC) and trustees of mutual funds. The circular was recently modified through another circular issued on 28 October 2021 where it was reiterated that employees of an AMC, board members of an AMC and a trust shall not place an order for units in any scheme while being in possession of certain non-public information that could materially alter the Net Asset Value (NAV) of the scheme. These were the early steps taken by SEBI which hinted at the potential inclusion of mutual funds in the PIT Regulations, which was made concrete through the consultation paper. It was a bold step by SEBI to carve a way for the integration of insider trading in mutual funds in a pre-existing jurisprudence having concrete legislation regarding the regulation of insider trading in securities.
Currently mutual funds are exempted from the scope of PIT Regulations. The fundamental reason for the exclusion was the differentia in trading mutual funds from the securities covered under the PIT Regulations. A mutual fund is a pooled investment vehicle wherein investment in equity and debt securities, separately or jointly, are spread across a wide cross-section of industries and sectors, depending upon the risk appetite of the mutual fund unit investor unlike investment in other forms of equity and debt securities that are traded directly on the recognized stock exchanges. Hence, the legislative intent behind PIT regulations of prohibiting insider trading of the directly traded securities, to an extent that the definition of the unpublished price-sensitive information (UPSI) contained in Regulation 2(n) is strictly restricted to having access to non-public information relating to a single company or any its securities. The structuring of the regulations needs to be reconsidered before inclusion of the framework of mutual funds in its ambit.
Due to the lack of parity in the mechanism of trading, the definition of UPSI for the sake of mutual funds is inherently different from that of other securities, thereby connected persons who have access to the UPSI, specific to mutual funds are also different from that of other securities. For mutual funds, information becomes price sensitive in a situation where it can alter the NAV of the scheme. Such information may include any changes in the investment objectives of the concerned mutual fund scheme, creation of a segregated portfolio; conversion of a close-ended scheme to an open-ended scheme or vice versa, etc. A situation may arise where a person may have UPSI vis-à-vis one specific security which is part of the portfolio of the mutual fund but may not have any explicit knowledge of the fund’s portfolio or any influence on the decision of the working of the fund which could lead such person to benefit from the UPSI of a mutual fund. Additionally, it is pertinent to note that the UPSI associated with a mutual fund is only available to a small group of persons that are associated with the mutual fund, AMC, or a trust.
The definition of a ‘connected person’ suggested in the consultation paper is far too broad when considered in terms of mutual funds. The definition states that ‘any person’ who is or has during the two months prior to the concerned act been associated with the mutual fund, but it is important to note that everyone who is associated with the mutual fund two months prior to the act will not have access to the UPSI, that could potentially alter the NAV of the scheme. Moreover, the framework contained in the circular dated 28 October 2021, aptly deals with insider trading by ‘designated persons’ for mutual funds which include, key personnel of AMC, trustee company, research analysts, and heads of all divisions. The broad definition of ‘connected person’ will only lead to a increase the compliance burden over the members of the mutual fund scheme, as it would end up including a larger group of people who may have access to USPI relating to securities of a company but may not have potentially NAV altering information relating to the UPSI relating of units of a mutual fund scheme.
Additionally, the misfit occurring from the inclusion of mutual funds in the PIT Regulations leads to undue compliances from the modification being made to the definition of ‘securities’ which will now include mutual funds, thereby subjecting mutual funds to all the other pre-clearance compliances and monitoring mechanisms applicable to publicly traded securities. It must be clarified that units of mutual funds will be a part of the definition only for the purpose of the proposed chapters applicable to mutual funds and shall otherwise be excluded. Additionally, clarity is required on whether the PIT Regulations would be applicable to the underlying securities contained in the mutual funds as the definition of securities would now include both, units of mutual funds and securities present in the portfolio of the mutual fund or shall only be applicable to the broader units of mutual funds.
To tackle similar issues, and to hold mutual fund to the highest ethical standards, SEBI has on past occasions resorted to practices like adding a Code of Conduct, to the MF Regulations, thereby making the MF Regulations the sole statute that regulates mutual funds. This practice eliminates a lot of uncertainty and doubt regarding enforcement. Further, given that mutual funds are not traded in the same way as other forms of publicly traded securities, the PIT Regulations are not necessarily appropriate for addressing the problem of insider trading in mutual funds, as they are primarily directed towards directly traded securities. It could be argued that the incorporation of mutual funds from the perspective of inside trading, rather than being made to the PIT Regulations, would be more effective if made to the MF Regulations. This would make the adoption and enforcement of the modifications relatively straightforward, avoiding unnecessary complications, and adding uniformity to the regulation of mutual funds.
The definitions and concepts contained in the PIT regulations are aimed towards regulating publicly traded securities and not pooled investment vehicles. To make it an effective prohibitory mechanism, for insider trading in mutual funds, the modifications would have to go against the underlying legislative intent of the regulations. It is agreed that the move to address the issue of insider trading in mutual funds, is one in the right direction. However, due to the intrinsic disparity, of mutual funds, with other forms of security, and the pre-existence of the MF Regulations, it would be preferable to consolidate the pre-existing jurisprudence related to the prevention of insider trading of mutual funds, into the MF Regulations, to prevent future uncertainty regarding enforceability.