[2022]

141 taxmann.com 533 (Article)

[2022] 141 taxmann.com 533 (Article)

Date of Publishing: August 30, 2022

Mutual Funds to be Included Under Insider

Trading: An analysis of SEBI’s Proposals

SEBIN SEBASTIAN P.M AJITH N KALE

Introduction

By the end of 2020, regulated open-ended mutual funds boasted nearly

$56.92 Trillion worth of assets invested worldwide, with an estimated
177000 regulated mutual funds managing these assets. The mutual
fund (MF) market in India too, has been part of this enigmatic growth,
ever since its inception with the UTI mutual fund scheme all the way
through to its anomalous rise even through a rather crippling
demonetization policy in 2016. A catalyst to this growth has been the
inconsistent yet persistent trust in the mutual fund market over the
years, and a slow yet significant regulatory reform in the sector which
started in the 90s following scams such as the Morgan-Stanley Black
Market Scam1 and the CRB MF scam. Mutual funds have thus grown as
a safe and easy way of investing for various classes given their
structure and hands-free nature; with a large majority of MF
advertisements even emphasizing the general populace's lack of
technical understanding of the market as a reason for them to step in.
However, this is not to say that Mutual Fund operational efficiency is
not affected by the ills of the investment market; defects such as front
running and insider trading have significantly affected investor trust
over the years. Professor Paddy Ireland highlights one of the significant
components in the growth of the stock market and its shift from
traditional to liberal outlook as the rentier class's desire to have
constrained liability investments. The steady growth of the market is
dependent on the ability of the market to instill confidence in new
investors and maintain confidence in existing investors, especially of
the rentier classes, to invest their savings in the market. In light of
certain events that came to the attention of the SEBI, involving the
mala fide activities of a registrar and transfer agent of a mutual fund,
the SEBI, on the 8th of July 2022 published its consultation paper
proposing to include the previously explicitly excluded Mutual Funds
under the ambit of the SEBI 2015 insider trading regulations.

Regulatory background

As it stands presently mutual funds generally have been treated

differently in the Insider Trading Regime. Under the SEBI Act, 1992,
section 12A Clause (d) and (e) "any person" who directly and indirectly
exchanges securities while in possession of UPSI or in any manner
communicates such information to any other person, stands in
contravention of the provisions made in the act unless legitimate
reasons prove otherwise. However, in 2015 the SEBI eased insider
trading norms for mutual fund investors, holding price-sensitive
information given that the investors are unaware of the exact
investment portfolio and underlying securities. Additionally, the SEBI
had also included provisions under the mutual fund regulations and
prevention of fraud and unfair trade practices (PFUTP) rules, to
strengthen the fiduciary framework around mutual funds and their
investors.

In a circular dated October 28, 2021, employees, board members of

trustees, directors of AMCs, and along with access persons were also
denied from transacting in any scheme while in possession of UPSI.
However, specifically with respect to transactions by employees of
AMCs/Trustees in Mutual Fund units, the circular inter-alia mandated
reporting of such transactions to the Compliance Officer and
additionally sets certain limits on duration during which such
employees cannot transact in the units of concerned Mutual Fund
schemes.

2020 Franklin Templeton case study

While the SEBI has not named the two incidents that prompted the
discussion, persons familiar with its operations have identified one of
incidents to be the Franklin Templeton case as the precursor to the
discussion paper given the outline of facts the consultation paper
provides. On April 23, 2020, Franklin Templeton had closed 6 debt
mutual fund schemes with a combined AUM of 25,000 crores citing
high redemption pressure from investors and lack of liquidity in the
bond market. Subsequently in a big relief plan to over 300,000
investors affected by the fund, the Supreme court directed SBI Mutual
Fund to oversee the wind-up and transfer funds to investors as the
recovery progresses. As of April, 2022, a sum of 26,098 crore had been
distributed in eight tranches to the unitholders and the Supreme Court
had directed SBI Mutual fund to hold back on the next tranche of
payments to investors of the fund for the time being, after the
foundation of Independent Financial Advisors (FIFA), an NGO
comprising of 1,400 distributors moved to court, seeking payment of
distributor commissions as was accrued in the winding up process of
the schemes after April 2020 and were transferred to SBI mutual Fund
to add to the investors' pool. A breach of fiduciary responsibility was
however observed in the process wherein the top executives at
Franklin Templeton and connected entities (relatives of the executives)
were identified to have redeemed mutual fund units worth 56 crores
between March and April 2020, prior to the asset manager's
announcement of the closure of the six debt mutual fund schemes for
redemptions on April 23, 2020, this ultimately motivated the SEBI to
propose a change in the existing framework and bring transaction or
exchange of mutual fund units into the ambit of Insider trading
regulations.

The proposed Amendments to the SEBI (PIT) Regulations 2015:

An analysis

The SEBI at the very outset insists that its approach is meant to be
neither too lax nor too onerous for investments. In its discussion paper,
the SEBI proposes various changes to the existing framework bringing
a greater amount of responsibility on persons identified as Designated
Persons and restrictions on trading on persons further understood as
insiders, which include connected persons and persons possessing
unpublished price sensitive information relating to the scheme.

Significantly in its maiden attempt to regulate insider trading in mutual

funds the SEBI, in its proposed amendments to the PIT regulations
annexed to the paper, advances the removal of the previous explicit
exclusion provided for mutual fund units within the definition of
securities in the PIT regulations and prescribes that, with respect to
dealing in the mutual funds only Chapter IIIA, V and a newly inserted
Chapter IIA is to apply. The new Chapter IIA inter alia presents a new
and expansive definition of Connected persons vis-a-vis a mutual fund
scheme and which includes a host of persons who are inherently
deemed to be connected persons, these connected persons who
constitute an 'insider' as per Amendment along with other persons
possession UPSI relating to the scheme are prohibited as per the
proposed Chapter IIA from communicating such unpublished
information and utilizing them for the purpose of trades. The proposed
amendments also put forth a code of conduct to be followed for
designated persons by the fund, along with disclosure and reporting
requirements of holdings of such designated persons in the mutual
fund.

The SEBI, in bringing about these changes, has made marked shift
away from the existing framework governing trustees and AMC
officials through its circulars up to the 28th of October 2021 in light of
bringing a clear framework of definitions and obligations for the
effective litigation of insider trading incidents. In doing so, it has, as
aforementioned, also included professionals, such as legal advisor and
consultants, in its long list of connected persons, which given the
Mutual Fund Market in India creates a pool of a rather large number of
professionals who are affected by the effective proscription from
investment in Mutual Fund Units. Many persons associated with the
market in response to this move have proposed a compromise to
proscribe only, those actors in a direct fiduciary relationship with the
investors while enforcing disclosure requirements with the rest of the
persons listed; as the proposed amendments in status quo would only
prevent legitimate investment opportunities, given the presumption of
the possession of UPSI relating to the scheme, and further makes the
process of identifying genuine circumstances of Insider trading far
more onerous for SEBI.

However, the above discussion regarding the list of connected persons,

while one of significance, is but only an ancillary argument in the
discussion as to whether mutual fund units should be included under
the ambit of Insider trading at all. It is worth taking note in this regard
the decision of the US Court of appeals of the 7th circuit, which
furthers the underlying principles of this question, holding that trading
in mutual funds would not violate the traditional theory of insider
trading; a leading rationale for this conclusion was that the value of
mutual fund units are not derived from the units themselves but rather
from the underlying securities. Therefore, any information regarding
the mutual funds by and of itself would be immaterial to the trade, but
would nevertheless leave open the possibility of a breach of fiduciary
responsibility. The insignificant control over the investment portfolio
serves officials in status quo (now proposed to be covered under the
meaning of connected persons), who would otherwise find it onerous to
buy and sell stocks directly, an easy route to invest in the stock market.
Therefore, an outright proscription is likely to be strongly resisted.

Conclusion

The extension of Insider trading to mutual funds, while largely

considered a welcome move in principle, suffers from restrictions and
the lack of a clear case being made out in the discussion paper by the
SEBI as to why the extension of fiduciary responsibility within the
existing framework along with additional reporting requirements for
connected persons would not serve the same purpose. Insider trading
has been proven, from an economic standpoint to reduce trust in the
market; however, overarching regulations to rid this evil may not
necessarily be the answer as well. Nonetheless, given that various
stakeholders have flagged such concerns to the SEBI in the form of
public comments to the consultation paper, how the SEBI will respond
to these concerns remains a much-awaited matter.

■■

1. DR. SUDHANSHU KUMAR & ALOK VERMA, GUIDE TO

CAPITAL MARKET AND SECURITIES LAW, PAGE 270 1ST
ED Thomson Reuters (2021).