[Shruti Rajan is a partner at Trilegal]
In Greek mythology, the gods condemned Sisyphus to an endless cycle of rolling a boulder up a hill, have it roll down and then start again. A parable of the interminable, eternal human struggle against the diktat of the gods, the fate of Sisyphus has long served as a metaphor for the repetitive and dogged demands of modern life and business.
Introducing a new legal regime and a host of Sisyphean compliances for both asset management companies (“AMCs”) as well as their “fiduciaries”, the Securities Exchange Board of India (“SEBI”) approved a proposal to amend the Insider Trading Regulations, 2015 (“PIT Regulations”) at a board meeting dated September 30, 2022, which was soon followed by a gazette notification dated November 24, 2022.
What Do These Amendments Do?
The amendments have been brought in to enable SEBI to utilise the insider trading blueprint for monitoring transactions in mutual funds as well as deploy the standards available under that regime for investigation and enforcement. Simply put, the amendments create an absolute equivalence between a listed security and mutual fund units, irrespective of whether the mutual fund units are listed or whether the AMC managing such funds is a listed company. It does so by extending both legal as well as compliance concepts under the PIT framework into the mutual fund universe, in the following manner:
Key legal changes
(i) It amends the definition of “securities” in the PIT Regulations to include units issued by a mutual fund and also introduces terms such as “redeem” and switch” into the definition of trading;
(ii) It amends the definition of “connected person” and expands on the list of “deemed to be connected persons” to include the following:
- Persons associated with mutual funds/AMCs or their trustees by virtue of a contractual, fiduciary, professional business or employment relationship as well as due to being in frequent communication with its officers, in a manner that would allow or be reasonably expected to allow, for direct or indirect access to UPSI;
- Immediate relatives of such persons;
- Sponsor of the mutual fund as the holding, subsidiary or associate company of the sponsor/AMC /trustees;
- Board of directors and key managerial personnel of the sponsor;
- Directors and employees of intermediaries that interact with mutual funds, such as registrar and transfer agents, custodians, banks, valuation agencies, lawyers, auditors, fund accountants, etc, where they have or can be reasonably expected to have access to the UPSI of a scheme or its units, in the course of business operations;
- Officials of self-regulatory organizations and stock exchanges;
- Any entity (incorporated or otherwise) where a director of an AMC, trustee or his immediate relative or a banker of the company, has more than 10% interest.
(iii) The term “unpublished price sensitive information” in the context of mutual fund units has been defined to include instances where there is a likelihood of the following, which would correspondingly materially affect the net asset value of mutual fund units (“NAV”) upon being generally available:
- a change in the accounting policy;
- a material change in the valuation of any asset or class of assets;
- restrictions on redemptions, winding up of scheme(s);
- creation of segregated portfolios;
- the triggering of the swing pricing framework and the applicability of the swing factor;
- material change in the liquidity position of the concerned mutual fund scheme(s);
- default in the underlying securities which is material to the concerned mutual fund scheme(s).
(iv) An explanation to the definition of ‘generally available information’ has been added, reiterating that AMCs and trustees must immediately disseminate all material information to unitholders. However, the term “likelihood” itself has not been defined.
Key compliance requirements
In addition to the changes in law, the amendments also introduce a host of new compliance requirements by importing the entire pre-clearance regime applicable to equities and other listed securities to AMCs and their “fiduciaries” and transplanting it for mutual fund units.
(i) Akin to the restricted list/grey list process being followed for listed securities, AMCs and their fiduciaries will now have to pre-clear all mutual fund transactions of designated employees and block those which are in schemes of fund houses that the organization or its personnel may/are likely to have unpublished price sensitive information (“UPSI”) on.
(ii) The amendments also require AMCs to frame a legitimate purpose policy for sharing information as well as formulate policies on investigation of UPSI leaks and whistleblower complaints (similar to what listed companies do now).
(iii) Both AMCs and fiduciaries who do business with them are also required to maintain a structured digital database, which is a master roster that tracks the what, who, when of each instance of UPSI shared within and outside of an organization. As is the case for listed companies currently, this database cannot be outsourced and has to be retained for eight years or until completion of SEBI’s investigation/enforcement, whichever is later. It is pertinent to note here that the law does not provide a statutory period within which investigations or enforcement proceedings must be completed, neither is there a process to confirm closure of an investigation.
The applicability of insider trading laws to mutual funds has been a matter of much debate and well covered in an interesting post on this Blog last year. The concept of insider trading, when looked at from the vantage point of market efficiency, has little relevance to unlisted mutual fund units where investors do not operate within a single market to exchange these goods at discovered prices; rather in mutual fund transactions, the counterparty is the AMC itself. However, when understood as a tool to neutralise the information asymmetry advantage, insider trading laws are an elegant theoretical device in the world of mutual funds.
For some time now, SEBI has been keen on introducing a sterner regime around mutual fund transactions and had issued a consultation paper outlining this objective, back in July 2022. The mutual fund industry itself is no stranger to regulations around its key employees’ transactions in units of the entity’s own schemes as well as in other listed securities, across both the primary and secondary markets, For decades, SEBI has had fetters around trades by “access persons” to prevent conflict of interest and many fund houses even opt to put in pre-clearance stipulations for all trades in their schemes. Specifically, SEBI’s rules also mandated employees of an AMC, its board members/trustees to not place orders for units in any mutual fund scheme if in possession of non-public, NAV altering information; a list of examples set out in those circulars is in fact, identical to the modified definition of UPSI, now introduced in the amendments.
Therefore, the heart of the amendment’s impact lies not in changing the law or introducing a new regime for AMCs – these are already in existence today – but in transforming the receptacle that contains it. The amendments now arm SEBI with an almost match-point advantage of reversing the onus of proof on the insider/connected persons of fund houses, by requiring them to rebut the presumption of guilt, a benefit not available to it thus far, when taking action under the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 or the mutual fund framework. By shifting the regulatory basis of trial and the evidentiary burden, SEBI has reconstructed its enforcement pitch for violations going forward, such that in cases where access persons of mutual funds undertake transactions in their schemes, the onus will be on the persons/entities under question, to demonstrate that they were not in possession of UPSI while doing so.
Hence, while the appeal of such an amendment from a legal standpoint is obvious, the need for the corresponding, accompanying army of compliance requirements is not quite as easy to comprehend. This is especially true for fiduciaries or intermediaries that work with mutual funds. A number of such entities such as brokers, custodians, banks are primarily execution-only service providers, who are empanelled for specific purposes and rarely serve as advisers or consultants who are likely to be privy to sensitive information regarding the schemes they deal with. But by not providing a specific carve-out for such businesses, and failing to distinguish them from other services that may actually have a finger of the fund house’s pulse, SEBI has left it to institutions themselves to create their roadmap for satisfactory compliance. To comply with SEBI’s mandate under the amendments, fiduciaries will now have to pre-clear all mutual fund purchases, switches and redemptions by designated persons within their organization, to ensure that transactions in fund houses they work with, are sifted out. Depending on the nature of their businesses and the size of the organization, the time, scale and costs involved in operationalising such an exercise, will be significant.
Maintaining a digital database will also be a steep learning curve for these entities, given the subjectivity that surrounds terms such as “likelihood” of a “material impact” on the NAV and in practice, intermediaries will likely rely on the AMC to decide on the trigger point for identifying such information as UPSI on their databases. If not possible to accurately estimate, at least a ballpark empirical assessment (within the constraints of available information) of the cost benefit ratio involved in such an intensive industrywide compliance re-haul, would have been useful prior to introduction. Appraising the likely costs of compliance against the likely incremental advantage that such databases allow SEBI during investigations, should be treated as a necessary line item of regulatory design.
Another issue that merits consideration is the burden this places on an already beleaguered body of compliance officers of AMCs and other intermediaries, who will need to implement and man these complex databases, policies and pre-clearances. Unforced errors may be many, especially in the initial years of roll out and hence, senior manager and compliance officer liability should be read down considerately. The real impact of these amendments will be felt only when it is used for timely enforcement against those violating its spirit, rather than letting it spawn a quire of show-cause notices to organizations or their officers, for not conforming with the peripheral compliances, policies and databases. This will only trigger an avoidable, futile cycle of litigation and settlements, without addressing the primary delinquencies, for which it all came to pass.
– Shruti Rajan