Sebi's regulation of mutual funds welcome but with caveats
Premium- Insider trading is easy to understand as a concept but difficult to pin down as an empirical fact
Sebi’s proposal to bring mutual funds under its Prohibition of Insider Trading Regulations 2015 is a welcome move. However, some classes of individuals associated with mutual funds, whose possession of price-sensitive unpublished information is hypothetical and not definitive, could be made to disclose their trades, rather than proscribed from trading.
It is in the interest of investors and of actively managed mutual funds themselves to bring mutual fund units within the ambit of the securities covered by the PIT regulations. Therefore, there is no reason to consider Sebi’s move just as a reaction to the Franklin Templeton episode, in which senior functionaries had sold their holdings prior to the Fund House’s decision to wind up six debt schemes in April 2020.
Passively managed index funds have predictable transactions, whereas transactions of actively managed funds depend on the expertise of the fund managers, which would differ from case to case. If investors have to stay with this latter group of funds, it would help them to be reassured that their funds are being managed with integrity and that fund managers or their associates would not leave them holding the short end of the stick when things go wrong.
Insider trading is easy to understand as a concept but difficult to pin down as an empirical fact. Nowhere in the world is the number of insider trading offences that are prosecuted successfully particularly high. But having norms against insider trading has the merit of the likelihood of prosecution hanging like the Sword of Damocles over the heads of would-be insider traders, however eminent, hirsute or bereft those pates might be. The US Securities and Exchange Commission (SEC) has nailed the likes of former head of McKinsey Rajat Gupta and celebrity chef and author Martha Stewart for insider trading, precisely because such norms exist and permit law enforcers to follow through on enforcement of those norms.
It would, therefore, be useful to have explicit insider trading norms that extend to mutual funds, their schemes and units as well. The proposed changes to the definition of trade to include “subscribing, redeeming, switching, buying, selling, dealing, or agreeing to subscribe, redeem, switch, buy, sell, deal, in any securities" is most welcome.
‘Any securities' can be too sweeping, and bring into the ambit of proscription the securities wholly unrelated to the insider information in question. However, there would be sense in not restricting prohibited trade to securities about which an insider has non-public information. In a recent case in the US, the SEC brought a charge of insider trading against an individual who, on learning about the as-yet unannounced takeover of the company he worked for, bought shares of another company that immediately became the next likely takeover target. The case has not been settled, but regulation must address what is termed "shadow trading".
Where the Sebi proposal goes too far is in defining too many classes of people into the ambit of "connected persons". It is proposed to expand the definition of connected persons to embrace "any person who is or has during the two months prior to the concerned act been associated with the Mutual Fund, AMC and Trustees, directly or indirectly, in any capacity including by reason of frequent communication with its officers or by being in any contractual, fiduciary or employment relationship or by being a director, officer or an employee of the AMC and Trustee or holds any position including a professional or business relationship between himself and the MF/AMC/Trustees, whether temporary or permanent, that allows such person, directly or indirectly, access to unpublished price sensitive information or is reasonably expected to allow such access".
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If this seems too dauntingly general, the consultation paper then makes specific categories, which could putatively include anyone who might have an indirect association with the mutual fund industry. This is arbitrary.
The solution is to make trade proscription applicable to those with direct fiduciary responsibility in a mutual fund and their close relatives, and bring the rest within the ambit of mandatory disclosure, not to any compliance officer but to the stock exchange and Sebi. If such disclosures are mandated, professional agencies, including rating agencies, would track the trades to figure out patterns that suggest a non-publicised material event in the offing. The law could penalize as insider trades all such trades that form a pattern suggesting prior access to material, price-sensitive information on the part of the traders.
To proscribe trading by anyone connected with a mutual fund in a professional capacity, on the hypothetical access they acquire to price-sensitive information before the investing public does, is to deny a whole class of professionals access to legitimate saving avenues. This would be unfair and counterproductive.
Regulation evolves, learning from mistakes. Learning by doing applies to regulation better than to most other activities. Sebi should go ahead and make PIT regulations applicable to the mutual fund industry, with the caveats outlined above, and make further changes, if required.
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