The Securities and Exchange Board of India (“SEBI”) in its 205th board meeting[1] held on April 30, 2024, has approved amendments to the SEBI (Mutual Funds) Regulations, 1996 (“MF Regulations”), to enhance the existing regulatory framework for Asset Management Companies (“AMCs”) for facilitating identification and deterrence of potential market abuse, including front running[2]. As part of the said decision, detailed in its press release dated April 30, 2024, AMCs would be required to put in place an appropriate institutional mechanism, consisting of enhanced surveillance systems, internal control procedures and escalation processes to identify, monitor and address various types of misconduct. Additionally, SEBI’s Board has approved amendments in the relevant regulations to enhance responsibility and accountability of the management of AMCs for the said institutional mechanism and also for AMCs to put in place a whistle-blower mechanism.
The amendments are significant since there is now: a) an obligation to have an institutional mechanism in place; and b) the responsibility and accountability of such an institutional mechanism would lie with the management. So, there is a clear attempt on the part of the market regulator to make prevention of market abuse practices, particularly front-running, a priority for AMCs.
The amendments have been made following SEBI’s consultation paper dated May 20, 2023, on Institutional Mechanism for Asset Management Companies for Deterrence of Possible Market Abuse and Fraudulent Transactions (“Consultation Paper dated May 20, 2023”) [3]. It may be recalled that SEBI had also come out with a consultation paper dated May 18, 2023, on draft SEBI (Prohibition of Unexplained Suspicious Trading Activities in the Securities Market) Regulations, 2023 (“Consultation Paper dated May 18, 2023”)[4], though these regulations have not yet been finalised. Both the consultation papers sought to inter alia prevent instances of front running.
Reasons for increasing regulatory compliance for AMCs
It is relevant to note that Regulation 18(23)(b) of the MF Regulations[5] requires mutual fund trustees to furnish a certificate every six months, stating that they are satisfied that there have been no instances of self-dealing or front running by any of them, or any of the directors and key personnel of the AMC. Thus, it is not as if measures are not in place to prevent such malpractices.
Hence, the question is what has triggered this renewed attempt by SEBI to mandate the enhancement of institutional mechanisms for prevention of practices like front running?
As per SEBI’s Annual Reports, in FY20-21 and FY21-22, SEBI had respectively taken up one (1) and seven (7) cases of front running for investigation. In contrast, in FY22-23, SEBI took up twenty four (24) cases of front running for investigation; indicating a clear surge in the number of front running cases taken up for investigation. Hence, it is safe to say that prevention of front running appears to be a key focus area for the market regulator.
A perusal of SEBI orders on front running shows that many such orders involved employees/ dealers of AMCs. In this regard, reference is made to the Interim Order passed by SEBI on February 28, 2023[6]. By way of the said order, SEBI has barred the former chief dealer of a prominent mutual fund, and nineteen (19) others from accessing the securities market for front running the trades of the mutual fund. As per the Interim Order, an alleged wrongful gain of INR 30.5 crore was made by these persons from front running activities. It is relevant to note that as part of the scheme to front run the trades of the mutual fund, the said dealer incorporated a company in Dubai. Also, the front running trades were not placed directly by him, but by entities connected to him. The connected entities referred to the dealer as ‘Jadugar’, to hide his identity. SEBI considered circumstantial evidence such as chat records, trading history and money trail, and held in its order that Jadugar was in fact the said dealer. One such fact that helped establish the identity of Jadugar was messages exchanged among the other entities regarding Jadugar’s birthday, which matched the date of birth of the dealer. It may be noted that in the absence of specific WhatsApp chats that came to SEBI’s possession, it would have been difficult to establish a connection between the persons involved in the matter.
As is evident, evidence collection and establishing connections and relations in such matters are difficult. Encrypted and disappearing messages make it even more difficult for SEBI to establish connections among entities suspected of engaging in manipulative trades. The Consultation Paper dated May 18, 2023, highlights the challenges involved in discovering/ investigating cases of market abuse, including front running. The said consultation paper also noted that matters were often not pursued due to challenges in gathering evidence. Hence, the new measures for institutional mechanisms within AMCs aim to ensure deterrence, detection and reporting of possible misconduct.
The way forward – some suggestions
SEBI has clarified in its press release that it will specify the broad framework of the institutional mechanism, but the industry body i.e., Association of Mutual Funds in India, in consultation with SEBI, would specify the detailed standards for such an institutional mechanism.
Some of the measures that may be a part of the institutional mechanism for preventing front running are:
- Robust monitoring protocols: Effective surveillance systems and internal control procedures must be put in place.
- Structured processing of alerts: Every alert that is generated must be examined thoroughly through a standard operating procedure before it can be determined to be either actionable or non-actionable. While examining an alert, care should be taken to look at all available information, including recorded communication, trading activity, etc.
- Action in case of determination of misconduct: A policy document should be framed, enumerating actions to be initiated/ imposed based on the nature of the misconduct/ wrongdoing. In case, an examination of an alert proves to be actionable, reference should be made to such policy document while levying any punishment. Also, contracts of employment should state the existence of such policy document, and the likelihood of action in case of determination of misconduct.
- Constant and effective reporting of misconduct: All actions taken by an AMC, pursuant to an examination, should be periodically reported to the Board of Directors of the AMC, trustees of the mutual fund and SEBI.
- Review and updating of systems and procedures: Audit Committees and Boards of Directors of AMCs should periodically review the systems in place for deterrence and reporting of possible misconduct to verify if such systems are adequate and operating effectively. In case, any deficiencies are found, the same should be corrected and the systems appropriately updated.
- Whistle-blower mechanism: The SEBI press release dated April 30, 2024, notes that pursuant to amendments in the MF Regulations, AMCs are required to have a whistle-blower policy in place. In view of the above, AMCs could adopt a vigil mechanism/ whistle-blower policy, incorporating necessary procedures to ensure adequate protection of the whistle blowers.
- Continuous employee engagement: Employee engagement within AMCs must be holistic and should ideally encompass both training and sensitisation regarding market abuse, fraudulent/ unfair trade practices and laws relating to the securities market. Also, such engagement should be carried out at regular intervals to engender the development of a culture of legal and ethical conduct.
- Consultation with legal and external experts: Necessary consultation with external and legal experts to develop an institutional mechanism that ensures a balance between regulatory compliance and mitigation of risk on the one hand, and operational efficiency on the other, may be considered.
The practice of front running, at its core, undermines the integrity of the securities market by allowing a person to unfairly profit basis non-public information. In light of this, SEBI’s decision to enable the creation of a framework that emerges from the industry is a step in the right direction, and would foster effective and relevant practices for regulatory compliance by AMCs.
For further information, please contact:
Vasudha Goenka, Partner, Cyril Amarchand Mangaldas
vasudha.goenka@cyrilshroff.com
[1] PR No.: 8/2024 dated April 30, 2024 available at https://www.sebi.gov.in/media-and-notifications/press-releases/apr-2024/sebi-board-meeting_83115.html (last accessed on May 9, 2024).
[2] Front running refers to the buying or selling of securities prior to a large order to benefit from the subsequent price move (as defined in Major Law Lexicon by P Ramanatha Aiyar (4th Edition 2010)). Such an activity is prohibited under securities laws, with Regulation 4(2)(q) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 specifically providing that – “any order in securities placed by a person, while directly or indirectly in possession of information that is not publicly available, regarding a substantial impending transaction in that securities, its underlying securities or its derivative.”
[3]https://www.sebi.gov.in/reports-and-statistics/reports/may-2023/consultation-paper-on-institutional-mechanism-for-asset-management-companies-for-deterrence-of-possible-market-abuse-and-fraudulent-transactions_71440.html (last accessed on May 9, 2024).
[4]https://www.sebi.gov.in/reports-and-statistics/reports/may-2023/consultation-paper-on-draft-sebi-prohibition-of-unexplained-suspicious-trading-activities-in-the-securities-market-regulations-2023_71385.html (last accessed on May 09, 2024).
[5] “(23) The trustees shall furnish to the Board on a half-yearly basis,—
(a)…
(b) a certificate stating that the trustees have satisfied themselves that there have been no instances of self-dealing or front running by any of the trustees, directors and key personnel of the asset management company”.
[6] Interim Order-cum-Show Cause Notice in the matter of Front Running of the Trades of Axis Mutual Fund, February 28, 2023, https://www.sebi.gov.in/enforcement/orders/feb-2023/interim-order-cum-show-cause-notice-in-the-matter-of-front-running-of-the-trades-of-axis-mutual-fund_68546.html (last accessed on May 06, 2024).
