[By Avantika Sud & Suhani Sanghvi]
The authors are students of National Law University Odisha.
Introduction
In July 2022, SEBI released a Consultation Paper that MFs would be covered under the ambit of the SEBI (Prohibition of Insider Trading) Regulations 2015 (PIT Regs). In August 2024, SEBI circular announced that all Asset Management Companies (AMC) were directed to establish frameworks to curb front-running and fraudulent security transactions. India’s Mutual Fund Association (AMFI) has plans to step up surveillance by enacting institutional mechanisms and strict actionables for identifying and preventing front-running by AMCs. This article sketches some high-profile cases of frontrunning at mutual funds (MFs), how the new SEBI directions may curb further episodes, and its shortfalls in taking preventative action.
The Current Position on Frontrunning
The Hon’ble Supreme Court (SC) in N Narayana v. Adjudicating Officer, SEBI, discussed the raison d’être of securities law being the protection of the integrity of the market and to prevent abuse and protect investors, and businessmen, and ensuring market growth is regulated. These goals assigned to the securities regulator hinge upon free and open access to information– and how and when this information is provided. Any action antithetical to this principle results in market manipulation and the creation of an artificiality.
While frontrunning has not been defined by the Securities and Exchange Board of India (SEBI) in any legislation, rule, regulation, it has been done in the 2012 circular CIR/EFD/1/2012 as usage of non-public information to either directly or indirectly trade in securities prior to an impending substantial transaction where a change in prices of the securities is to be expected when the information about the occurrence of the transaction becomes public. The abovementioned is prohibited under Regulation 4(2)(q) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations 2003 (PFUTR). Frontrunning may be of three kinds: either someone with knowledge of an impending transaction trades for their own profit, or tips a third party who conducts the trade (‘tippee trading’), and where an individual takes trading decisions based on the knowledge of their own impending transaction (for example, an individual shorting a stock that they own before selling substantial portions of it to profit off of the drop in price.) This is known as self-front-running.
The SC in SEBI vs. Shri Kanaiyalal Baldevbhai Patel (Kanaiyalal) acknowledged interpretations where frontrunning was the usage of non-public information that would affect share prices in a predictable way by brokers and analysts. Regulation 4(2)(q) also provided that intermediaries were prohibited from engaging in such trades. However, the court finally ruled that the provision was applicable to anyone, including individual traders who traded on the basis of tips given by people privy to non-public information. The court laid importance on public interest and legislative intent of the PFUTR over the letter of the law.
The second ingredient of frontrunning per the circular is the existence of a substantial transaction. In this aspect the SEBI in the Final Order in the matter of Front Running Trading activity of Dealers of Reliance Securities Ltd. and other connected entities has taken a holistic approach and has not assigned a particular value to what would count as a substantial value – it would depend on a host of factors, one of them being the general economic condition of the country.
SEBI, like the SC, has interpreted the regulations such that it would not be pigeonholed by its own set limitations – as discussed in Kanaiyalal and Reliance Securities – to prevent the formation of any creative loopholes by the disingenuous.
Frontrunning in Mutual Funds
In June, SEBI conducted raids on suspicion of frontrunning at Quant Mutual Funds, a fund with more than ₹90,000 crores of Assets Under its Management (AUM). There has been a detrimental impact on its portfolio presumably due to investor panic already.
Viresh Joshi, the chief dealer at Axis Mutual Fund (at the time the seventh largest asset manager), created a network of broking houses in the country and in Dubai to conduct his frontrunning activities. All dealers at Axis were provided with Bloomberg terminals to allow dealers to work from home during the pandemic, and on one instance, it was using this terminal that Joshi negotiated a trade on behalf of both Axis and one of his noticees. Motilal Oswal Securities, the other party, was under the impression that the entire order was for Axis Mutual Fund. Despite two years having passed since the market manipulations came to light, aftershocks are still observable in Axis’s consistently underperforming equity schemes.
Fund houses on their own, lack data to be able to accurately detect frontrunning activities. SEBI, with its omniscient possession of raw data, uses algorithms to track abnormal trading patterns, for example, a spike in trades before a substantial transaction by a big client that would belabour an investor’s common sense would be flagged. The algorithm has been adapted to evolving ways of committing fraudulent transactions, and in recent months has also utilised artificial intelligence. It was using this method of flagging suspicious trades that the HDFC mutual fund frontrunning was uncovered. However, Joshi used Covid-19 work from home policies as well as social distancing protocols to his advantage since there was no supervision, and was able to communicate with noticees using his undeclared mobile number. His frontrunning was not detected by an algorithm, but by Axis Mutual Fund after a routine audit of all fund managers and the subsequent finding of a suspicious email.
Surveillance on Asset Management Companies
AMFI’s new directives will be implemented in a phased manner starting November 2024 on equity MFs with total AUM higher than ₹ 10,000 crores, and equity MFs with AUM less than ₹ 10,000 crores in February 2025. For all trades in schemes, the implementation would begin from May 2025 and for debt securities, August 2025.
The new directive says that CEO/MD of AMCs must immediately establish and ensure compliance with comprehensive Standard Operating Procedures (SOP) to monitor and address suspicious activities. This includes generating 3 tier level weekly alerts on potential market abuse, thoroughly examining suspicious trades, and reviewing all recorded communications linked to these alerts. The first set of alerts is based on participation volume and volume-weighted average of large, mid, and small-cap mutual funds. Following that, activities like suspicious price movements, scrip volume and block chains would be closely monitored.
To enhance security, biometric access to dealing rooms is now mandatory. AMFI also requires AMCs to maintain detailed entry logs of investment team premises, enforce mandatory leaves for fund managers to prevent continuous monitoring of trades, and take decisive action against brokers involved in market abuse with quarterly reporting to SEBI.
Additionally, AMCs are instructed to update employment contracts with strict anti-market-abuse clauses and ensure that all records of departing employees are thoroughly reviewed to prevent unresolved cases.
SEBI Expands Insider Trading Regulations to include Mutual Funds
Sebi in October 2024, by a Circular, included MFs in the PIT Regs for increased transparency. Firstly, AMCs shall abide by Reg 5 (E)(1) and mandatorily disclose on the Stock Exchanges, information about the MF holdings of their designated persons, trustees and immediate relatives every quarter. Pertinently, a Consultation Paper recently proposed to expand the definition of “connected persons” to include a broader range of “relatives” while the current “immediate relative” remains unchanged for disclosures under the PIT Regs.
Second, MF transactions over Rs 15 lakh in a quarter shall be reported to the Compliance Officer (CO) with 2 business days with specific application to the persons stated above, particularly probing large transactions. Furthermore, insiders as per the PIT Regs are to refrain from profiting from sale and purchase or purchase and sale of securities within 30 days, any breach shall be explained to the CO and be reported to the board and the trustees on review.
Conclusion
SEBI Chairman Buch has been proactive in increasing productivity and implementing better measures to protect the integrity of the securities market. Notably, Viren Joshi’s actions were not particularly novel – a secret phone, trading through his company terminal, and all this provided him with isolated areas to work in. And yet, his scheme was found not by SEBI’s sophisticated algorithms, or any other technology – but a matter of chance – a routine audit that found a strange email addressed to Joshi that incidentally, he had not deleted.
It is perhaps after Axis and Quant’s frontrunning fiascos that the market regulator brought frontrunning under the umbrella of PIT Reg, realizing the need for greater investor protection. Pertinently, while these regulations may serve as effective deterrents, their purpose is to increase the likelihood of detection and successful prosecution. Only the regulation requiring traders to be on 10 days’ leave is preventative in nature. However, wrongdoing is innovative and adapts to all measures taken, and it is in the nature of SEBI’s duty to keep plugging leaks in the tank after they have been discovered.