The Securities and Exchange Board of India (SEBI) recently expanded the scope of the ‘Prevention of Insider Trading’ regulations to extend to mutual funds.
This decision aims to prevent insider trading by ‘connected persons’ related to mutual funds and protect the interests of the unit holders, with units being the listed securities in questions.
We discuss the key aspects of these new regulations, their impact on the mutual fund industry, and the challenges they may pose for asset management companies (AMCs) and ultimately their Trustee Companies
Insider trading rules in India have traditionally applied to dealing in securities of listed companies (or those that are proposed to be listed) whenever in possession of UPSI (i.e. Unpublished Price Sensitive Information).
Mutual fund units were earlier specifically excluded from the definition of securities under these rules.
We assume that one of the main impetus to include mutual funds under the ambit of SEBI PIT regulations was the Franklin Templeton episode is which executives were accused of redeeming their holdings ahead of the six debt schemes shutting for redemption.
Regardless of the background, the rules are now in force. Let’s review the changes.
PIT Framework for Mutual Funds
In July 2022, SEBI published a Consultation Paper on the applicability of its Prohibition of Insider Trading (PIT) Regulations 2015 to mutual fund units. Following this, the November amendment has brought within its fold all types of mutual funds, whether listed or unlisted.
There are certain exclusions for exchange-traded funds (ETFs) and relaxations to Systematic Investment Plans (SIPs) that constitute a critical mode of investment for many.
Connected Persons and UPSI in Mutual Funds
Connected persons include the board of directors and key management personnel of the sponsor of the mutual fund, banker of the mutual fund or AMC, the stock exchange officials, the employees of fund accountants, registrars and share transfer agents, custodians and valuation agencies of the mutual funds. Moreover, the immediate relatives of these people are also scoped in.
UPSI in itself is a vast term (which SEBI is looking to enlarge further) and includes instances when there is likely to be a change in the accounting policy, a material change in the valuation methodology, restrictions on redemptions, wind ups, segregations of portfolio, material changes in the liquidity position of the concerned mutual fund schemes, default in the underlying securities material to the concerned mutual fund scheme.
Trading Restrictions for Mutual Funds
Under the new rules, no insider is allowed to trade in the units of a mutual fund scheme when in possession of UPSI that may have a material impact on the net asset value of the scheme or may have a material impact on the interest of the unit holders of the scheme. There is a blanket ban on trading in mutual fund units when in possession of UPSI or during the closure period.
Structured Digital Database for Mutual Funds
Maintenance of Structured Digital Database (SDD) where the board of the AMC is further required to ensure maintenance of SDD and making of an entry in the same each time there is an instance of sharing of UPSI, relating to every scheme, internally or externally. The SDD, maintained internally by the AMC, should have a feature of audit trail, time-stamping and preservability for 8 years. This would demand increased compliance requirements for ensuring controls on manner of determination of UPSI, capturing flow of UPSI and requires the vaunted SDD to be created in a manner and method that makes capturing flow of UPSI in SDD quick and compliant alongside several other controls and easements.
Trading Plan Differences
Amongst minor differences, there are variations between the trading plan allowances for mutual funds and listed shares. Under the mutual fund PIT framework, the tenure of the trading plan is six months, whereas for listed shares, it is 12 months. Additionally, the trading plan must be intimated 60 days before trading commences for mutual funds, whereas for listed shares, this is a period of six months in advance.
Contra-trade Restrictions For Mutual Fund Employees
Contra trade means entering into an opposite transaction within a prescribed deadline. Designated persons (DPs) are restricted from entering into opposite transactions within two months of the previous transaction. For example, if a DP purchases the units of a mutual fund scheme, they cannot sell the units for the next two months. The contra-trade curbs are also applicable at the scheme level so for it to be applicable, only redemptions and purchases in the same scheme will amount to a contra trade.
Reporting and Disclosure Requirements
Under the new rules, asset management companies (AMCs) will have to disclose the details of holdings in the units of its mutual fund schemes, on an aggregated basis, held by the AMC, trustees, and their immediate relatives on the platform of stock exchanges. Furthermore, details of all transactions in the units of their own mutual funds executed by designated persons of the AMC, trustees, and their immediate relatives must be reported by the concerned person to the compliance officer of the AMC within 2 business days.
Insider Trading; Code of Conduct and Compliance Requirements
SEBI has prescribed a minimum standard of code of conduct for designated persons in line with provisions of existing insider trading rules. Moreover, the compliance officer of the AMC is responsible for determining the closure period during which a designated person cannot transact in units of the mutual fund.
To ensure compliance with these new regulations, SEBI mandates that the Chief Executive Officer (CEO) or Managing Director (MD) of an AMC, with the approval of the trustee or equivalent of an intermediary or fiduciary, put in place adequate and effective systems of internal controls to prevent insider trading. These internal controls include identifying all employees who have access to UPSI as designated persons and ensuring the confidentiality of all UPSI.
This rule mandates investment of a portion of salary in schemes of one’s own fund house. This could add difficulties for mutual funds to attract talent. Investing in one’s own fund house may be complicated, as redemptions will require regulatory clearance.
The inclusion of mutual funds under the ambit of insider trading regulations is a significant development for the Indian mutual fund industry. While these new rules aim to protect the interests of unit holders and maintain the integrity of the market, they also pose challenges for asset management companies and their employees. The earlier mentioned Structured Digital Database for Mutual Funds becomes critical. Employee Trading and Tracking becomes more complex and difficult. And management of Designated Persons and their relatives takes on an entire new meaning in this context. Take for example, the fact that fiduciaries or intermediaries that work with mutual funds (such as brokers, custodians, banks etc who are primarily execution-only service providers for specific purposes) do not have any specific carve-out. SEBI has left it to institutions to justify their compliance roadmap, making the designation process and the evidentiary trail backing it to be even more critical.
State-of-the-art systems like Affinis developed for management of Insider Trading compliance based on international best practices become a must-have, especially given that the requirements of Mutual Funds are far more complex (closer to the needs of Intermediaries in complexity than they are of Listed Entities).