Cases of insider trading in companies often make headlines globally, but not been much debate around whether mutual funds (MFs) too must be subject to an insider trading regime. SEBI has, last week, floated a consultation paper suggesting that MF units be brought into the ambit of its strict Prohibition of Insider Trading (PIT) Regulations, currently applicable only to listed securities. Here are some top-of-the-mind questions for MF investors answered.

Why is insider trading a problem?

With many companies attracting talent through ESOPs (employee stock option plans), it is commonplace for insiders to buy or sell shares in the company they work with. There is per se nothing illegal about this. But insider trading becomes a market crime when company employees or others with privileged access to confidential information about a company, exploit their special knowledge (asymmetric information) to make profits at the expense of public investors who aren’t privy to the information. Take the example of an IT company CEO, who knowing that the company is going to report poor quarterly numbers this June, cashes out on his shares just before the results are officially out and tank the share. In this case, the CEO has offloaded his losses to a public shareholder who may be equally skilled at reading the IT sector, but doesn’t have advance information about the company’s results, as the CEO did. The fair functioning of stock markets rests on all investors having equal access to information that can affect a company’s profits or stock price and insider trading can sometimes violate that principle. This is why SEBI has such an elaborate mechanism of stock exchange filings in place, to make sure that companies immediately disclose all material events affecting their profits with shareholders on the BSE and NSE platforms.

What are tests to find out if trading by an insider is illegal?

There are three tests. One, the insider must be in possession of material information about the company that has not yet been made public. Two, this information must be important enough to impact the company’s profits or move its stock price. Three, the insider must have dealt with listed securities in the company while being in possession of this information. Under Indian laws, it isn’t necessary for insiders to personally profit from trading on unpublished price-sensitive information (called UPSI) to be hauled up by the regulator. Even unnecessary sharing of UPSI with outsiders, who stand to make profits or avoid losses in trading because of it, is illegal.

Given that the NAV of an MF may not move up or down with material events, is an insider trading regime necessary for MFs?

The NAV of an MF scheme usually does not move up or down with material events. But there can be situations in which the fund’s NAV or assets are set to get a boost or a dent in future from a material event. Debt funds are generally more susceptible to such NAV-denting events. For instance, unknown to the fund’s investors, a debt fund may be facing liquidity issues while selling bonds in the portfolio, delayed repayments by issuers, a planned write-down or write-back of a bond it holds or a proposed carve-out of its NAV to create a segregated portfolio. While debt funds are more susceptible to such issues, equity funds are not immune to them. Even in the case of an equity fund, insiders can get advance information of an imminent merger or winding up of the scheme, unusual redemption pressures, the exit or entry of a skilled fund manager or a proposed change in manager or mandate, and cash out ahead of other investors. In all such circumstances, fund insiders who get wind of these events before the AMC publishes an official addendum intimating unit-holders, can redeem their units (or add to them) ahead of others, to make an unfair profit or avoid losses.

In its discussion paper, SEBI cites an instance of a registrar and transfer agent of a fund redeeming all its units in a scheme after it got wind of sensitive information. After Franklin Templeton announced the unprecedented winding up of its six debt schemes, it came to light that top executives had redeemed part of their holdings in these schemes just ahead of the winding up announcement. In these cases, insiders holding UPSI would have got an exit at a higher NAV than other fund investors.

Doesn’t SEBI have any regulations, right now, to prevent insider trading in MFs?

It does. It has issued several circulars over the years that require key officials of every AMC to refrain from dealing in units during material events and to internally report such transactions. In October 2021, after the FT saga, SEBI issued a circular that said that employees of the AMC, Board of Trustees, and Board members of AMCs and a list of access persons (key employees in a fund who have access to top management) should not buy or sell any units in a scheme from the fund house, when there is material unpublished information relating to a scheme. Where there is no unpublished information, MF employees and officials are free to buy and sell units, provided they informed the compliance officer within seven days of their transaction. Now, instead of enforcing insider trading rules on MFs via these circulars, SEBI is seeking to include MFs within the scope of its stringent PIT regulations, so that both enforcing the rules and imposing penalties will be easier.

Know the rule
At the end of every quarter, top employees of the AMC and trustees will be required to share details of their holdings across schemes

Who are fund insiders to be covered by the new rules?

Under the proposed regulations, there are two classes of people who will be considered ‘insiders’ in an MF. First, there are ‘designated’ employees of the AMC such as the CEO of the AMC, directors of the AMC, Trustees, CIOs, COO, Chief Risk Officers, fund managers, dealers, research analysts etc. Two, there’s a whole new set of ‘connected persons’ who will be deemed insiders. This set consists of employees in registrars and transfer agents, valuation agencies, credit raters, fund accounting firms, lawyers, AMFI officials and employees of the sponsor or holding company of the AMC. For good measure, any other person who has been associated with the MF, AMC or its trustees in the two months prior to a material event has any contractual or professional relationship with the fund and can access or has accessed UPSI will be deemed insiders.

What are rules for these insiders when dealing in MF units?

Generally, all insiders – whether fund employees or connected persons – are barred from trading in the units of a scheme when in possession of UPSI. There is also a proposed bar on any insider communicating or allowing access to UPSI to any other person, except for ‘legitimate purposes’. What is a legitimate purpose is to be decided by the AMC’s Board. Ahead of predictable material events or when AMCs are internally in possession of UPSI relating to a scheme, the compliance officer will declare an official closure period during which none of the designated employees of the AMC can transact in the scheme’s units. Even at times when there’s no closure period in place, designated employees and their relatives need prior permission from the compliance officer to trade in their units.

SEBI also plans to require all MFs to share more information on legal insider transactions on a common platform (yet to be set up). At the end of every quarter, top employees of the AMC and trustees will be required to share details of their holdings across schemes. All transactions above ₹10 lakh by these insiders will also be reported on the common platform within 48 hours. However, these rules will come into effect only if the consultation paper is written into law, without changes.