INSIDER TRADING IN MUTUAL FUNDS: A CATCHALL CHANGE

Introduction

The mutual fund industry in India has grown rapidly in the past few years, with more investors opting for mutual funds as a means of investment. However, the growth of the industry has also resulted in an increase in cases of insider trading and fraudulent practices. One such incident that shook the Indian mutual fund industry was the Franklin Templeton Mutual Fund closure, which was prompted by a severe liquidity crunch in the Indian bond market due to the COVID-19 pandemic, and a sudden outflow of investor money from the schemes. Later, in a Securities and Exchange Board of India (“SEBI”) enquiry, it was found that some of the key personnel of the fund house had redeemed their investments before the announcement of the closure of the scheme, i.e., before the value of the mutual fund dropped on account of its closure. In another infamous case, the Axis Mutual Fund case, the fund manager and the chief dealer were held for front-running, where shares forming the portfolio of the mutual fund were traded in before the execution of the mutual fund order that raised the share price.

In both these instances, non-public and price-sensitive information was used for personal gain by those in proximity to the fund without regard for the investors' interests. To this, the regulatory response was two-pronged. Firstly, SEBI issued a circular dated October 28, 2021, whereby employees and board members of an asset management company (“AMC”) and board members of trustees of mutual funds, including access persons, were not to transact in any scheme while being in possession of certain non-public information that could materially alter the net asset value (“NAV”) of the scheme. Secondly, SEBI released a consultation paper , which led the way to an amendment to SEBI (Prohibition of Insider Trading) Regulations 2015 (“PIT Regulations”) on November 24, 2022. The amendment, which integrated insider trading in mutual funds in the PIT Regulations, introduced measures, primarily of widening its net of individuals subject to insider trading regulations, towards filling the gaps that previously allowed for unfair practises in the realm of mutual funds.

This paper will examine the aforementioned regulatory changes and their potential impact on the mutual fund industry and various professionals, including lawyers.

Erstwhile Regime

Under Section 12A of the SEBI Act, 1992, the PIT Regulations apply to dealings involving securities. However, before the recent amendment, mutual funds were excluded from the definition of securities under Regulation 2(i) of the PIT Regulations. Consequently, mutual funds were not subject to the said regulations. Instead, mutual funds were governed by SEBI (Mutual Funds) Regulations 1996, SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations 2003, and directions and circulars issued by SEBI from time to time.

Regulatory Changes

The SEBI issued circular, and the subsequent amendment to the PIT Regulations introduced regulatory changes in a consistent and progressive manner. The circular served as a precursor to what we see, more expansively, in the PIT Regulations.

Circular

The circular identifies various positions within an AMC that are likely to have access to non-public information about the mutual fund. Non-public information, in this context, refers to any information related to the mutual fund that is not available to the general public or the unit holder and could materially impact the NAV of the mutual fund or interests of the unit holders in the form of the financial results of the mutual fund. The circular prohibits individuals in these positions from trading in the units of the mutual fund when such non-public information has not yet been communicated to the unit holders.

The circular goes on to outline the factors that may change the NAV, such as information about the mutual fund, including situations like the winding up of the fund, as in the Franklin Templeton Mutual Fund case or information about the underlying securities.

Further, to curb the practice of front-running, the circular imposes compliance requirements for purchasing shares. This aims to prevent the purchase of shares from personal accounts before executing a mutual fund transaction, which can increase the share value, as was seen in the Axis Mutual Fund case.

Apart from these provisions, the circular also covers various aspects such as code of conduct, disclosures, and other requirements, making itself nearly exhaustive.

PIT Regulations

As previously stated, mutual funds were excluded from the definition of securities. However, the recent amendment has eliminated such exclusion. As a result, mutual funds now come under the ambit of securities, to which the PIT Regulations are applicable.

A new chapter, i.e., Chapter IIA, has been added to the PIT Regulations, which is solely dedicated to mutual funds. While the regulations follow a similar framework as the circular discussed, with some added comprehensiveness pertaining to restrictions, communications etc., the scope has been expanded to include a wider range of individuals who may have access to unpublished price-sensitive data (“UPSI”), as laid down by Regulation 5B(1)(b) of the PIT Regulations.

While the circular focused on key persons within an AMC, the mutual funds chapter in the PIT Regulations applies to anyone who may have or has had any affiliation with the mutual fund or AMC two months before the concerned act, which majorly targets various professionals, including lawyers.

This expansion of the PIT Regulations was necessary due to the practice of using mutual funds to circumvent insider trading regulations. Professionals who have a diverse clientele may serve both companies and AMCs or mutual funds. According to Regulation 4(1) of the PIT Regulations, they are prohibited from trading in a company's shares while in possession of UPSI obtained in their professional capacity towards such company. However, because of their added access to the portfolio of mutual funds they work for, they could invest in mutual funds that held shares in the same company. This could effectively legitimize gains made from the UPSI of the company.

The amendment addresses this issue through two methods. Firstly, it includes information affecting the NAV of the mutual fund in the definition of UPSI under Regulation 5B(1)(f) of the PIT Regulations, which among other things, extends UPSI to information about the underlying securities of the mutual fund. Secondly, it widens the net to include individuals who may have access to such information about the underlying securities.

Way Forward

As mentioned, mutual funds were previously governed by various regulations, including the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations 2003, which under Regulation 3, prevented insider trading in mutual funds through the prohibition of trading in shares when in possession of UPSI of the mutual fund or its portfolio, i.e., front-running. However, these regulations failed to prevent insider trading in mutual funds through the route alternate to trading in shares, which is trading in units of the mutual fund itself.

Therefore, this amendment primarily pertains to the circumvention of insider trading when purchasing units of mutual funds while in possession of UPSI of the mutual fund or its underlying securities. The amendment has also facilitated a consolidation exercise for existing regulations, including front-running, thereby improving accessibility and eliminating confusion.

While the expansion in the scope of UPSI and individuals affected has been considered a welcome change in preventing the discussed circumvention, concerns remain regarding the restrictions this amendment poses for professionals who, at almost all times, possess the UPSI of some underlying security or another, due to the diverse portfolio of a mutual fund. To address this issue, the author suggests a regulatory change that examines the percentage of the mutual fund that the company(s), of which UPSI is held by individuals associated with the mutual fund, form. Individuals should not be barred from trading in the mutual fund unless this percentage crosses a certain threshold and significantly affects the NAV of the mutual fund. Such a change would strike a balance between preventing insider trading and ensuring that professionals are not unfairly restricted in their trading activities.