I have a piece in today’s Economic times, linked here, where I argue that extending insider trading regulations to mutual fund units would be a disastrous idea -akin to killing mosquitoes with nuclear weapons - with massive collateral damage on the innocent. The entire piece is copied below:
SEBI has come out with a consultation paper on extending the insider trading regulations to mutual fund units. At first blush, it sounds like a logical extension of insider trading prohibition. After all, in two instances SEBI has caught a registrar and key management persons selling units of about to blow up schemes before the blow up had become public knowledge. Clearly, they exited at more favourable terms than the hapless investors. That sounds a lot like insider trading, though there is no listed company involved. And it definitely sounds wrong. Yet, the proposal is wrong and must not be adopted for multiple reasons.
First, the offence is one of front running and not insider trading. Front running is the offence of trading ahead of your client, putting the client at a disadvantage. A classic case is that of a broker placing her own order ahead of punching the client’s order.That may sound like legal semantics and mere differences in nomenclature, but it is important. You can’t prosecute forgery by altering the definition of theft, even though both are offences. Such convulsions in the language have consequences.
Second, such acts are already prohibited both by six SEBI circulars since 2001 and by the anti-fraud regulations of SEBI. If more clarity is required, both can be amended to make front-running in mutual fund schemes clearly prohibited.
Third, the definitions create several burdens, which as we will see, create problems for the honest and the ‘connected’. Unpublished price sensitive information in the paper includes several routine changes in a mutual fund like ‘change in accounting policy’. Similarly, a vast swathe of people are ‘deemed’ connected that allows such person to access unpublished price sensitive information. We will see shortly why this is a problem too.
There are three classes of people, who are impacted by this proposal. First is those who work inside mutual funds including its key managerial persons. Second are those who work with mutual funds whether as service providers or professionals. That would include lawyers like me who advice funds and their mangers. Third would be those unconnected to mutual funds but who choose to invest in equity solely through mutual funds, so as to avoid even an allegation of either impropriety or insider trading. This category would include big accounting firm members, judges, CXOs of listed companies to name just a few, who would like to avoid direct purchase of single stocks.
For the first class of people, there are already six circulars and one regulation which prohibit the action SEBI is seeking to prohibit. So there appears little difference except certain reporting duties about trades in mutual fund units. For the second class, and to a lesser degree for the third class this will be catastrophic. For professionals like me, this mutual fund carve out was extremely important because the current insider trading laws define price sensitive information broadly. So if I provide some legal advice to a listed company about whether a contract had an enforceable arbitration clause, the advice would make me deemed connected and any purchase of shares in the company would open me up to criminal charges if the company came out with good quarterly numbers (of which I had no idea). Once connected to a company in some remote and irrelevant fashion, the trade by itself would make me a criminal, and I would be obliged to rebut the presumption that someone tipped me off about the financial numbers. As it is impossible to prove the negative, in the absence of a camera on my head 24X7, I would find it nearly impossible to dis-prove that I’m not a criminal. For this reason, I have not traded in stocks for the past nearly 15 years. Mutual funds give me the immunity from such charges because purchasing funds breaks the causal chain. SEBI has exempted them from the definition of securities in the insider trading regulations for that very reason. The proposed amendments would make me a rebuttable criminal even if I purchase mutual fund units given that I occasionally advise mutual funds, though I have never once advised any fund about to get into trouble.
The proposal would seriously hurt the 2nd class named above which even occasionally works with funds and would jeopardise millions of transactions a year by that class of people. When only a few schemes blow up every decade, and SEBI has only shown 2 known cases of such front running, this is a disproportionate remedy which will primarily hurt honest people like me. When only a handful of schemes blow up every decade, it is fair to ask why it would jeopardise millions of transactions instead of just a handful surrounding sales before large blowups. The answer is that the rebuttable presumption of guilt attaches to a person only in hindsight. By that I mean that I advice mutual funds occasionally, with no knowledge of any trouble, and unknown to me one of them indeed blows up. In such a case, any sale before such event would factually make me a violator, and unable to rebut the allegation as I can’t disprove the negative, I would not invest in the markets at all. This cannot be the outcome SEBI wants for honest people who wish to invest in the markets without even the remotest possibility of inappropriate behaviour. The proposal should therefore be abandoned in its current shape. What needs to be done in its place is just a small addition to the anti-fraud regulations making this kind of front running a specific form of fraud. In fact, it is probably already covered in regulation 4(2)(q) of the anti-fraud regulation of SEBI.
While all laws impose a cost on the honest, there is no basis of imposing such massive costs on tens of thousands of honest people to catch 1 person every decade who commits mischief, who in any case can be caught with existing provisions. It is important to recall that blow ups in schemes are very rare events, and people misusing that information about a potential event would be even more rare. Using nuclear weapons to eliminate mosquitoes is not a good idea.
No comments:
Post a Comment