Mutual funds are preferred by many investors in our country as a mode of investment. Depending upon individual preferences, an individual can select the kind of mutual fund that suits their portfolio. Investors’ interest is put at risk whenever they make a decision to invest in a market-linked scheme. Performance-based risk is always expected, but what happens when the mutual fund house itself is under the radar for some kind of irregular behaviour? Mutual fund irregularities have been in the headlines these days.
India’s seventh-largest mutual fund house, Axis Mutual Fund is in news for suspending two of its fund managers. The fund house has undertaken an investigation of irregularities in the funds handled by them. You must have read the terms ‘front-running’ and ‘insider trading’ while reading many headlines about the latest incident. The investigation is going on to get details revealing the exact nature of the violations.
In this article, we will try to understand these terms and also the impact of such orchestrated activities on the functioning of mutual funds.
The Recent Case of Axis Mutual Fund
On Friday 6th May, Axis Mutual Fund issued a public notice removing and replacing two of its fund managers, Viresh Joshi and Deepak Agarwal from seven of its schemes namely, Banking, Technology, Consumption, Nifty ETFs and Axis Value, Quant, and Arbitrage Funds. The fund managers have been removed on the ground of ‘potential irregularities’ and there has been an investigation going on with the help of external advisors. There has been no express allegation of any front-running charges by the Axis Mutual Fund. The independent inquiry is said to have started in February 2022.
Viresh Joshi was the chief trader and equity fund manager responsible for overseeing Axis Arbitrage Fund, Axis Technology ETF, Axis Banking ETF, and Axis Consumption ETF. He joined the fund house in 2009. Axis Mutual Fund was set up in 2009. MD & CEO Chandresh Nigam and Viresh Joshi were part of the original team. Deepak Agarwal was the assistant equity fund manager for Asix Quant Fund and Axis Consumption ETF. He was part of the house since 2015.
According to the Mutual fund insiders, the lavish lifestyle of one of the fund managers, who drives a limited-edition Lamborghini and owns several houses in Mumbai raised the concern. The fund house got suspicious and it started investigating the underlying facts. Rumours got spread that there is a scam involving Rs. 1000 crore in a large mutual fund owned by a leading private sector bank and it involved front-running by fund managers and dealers. In fact, the fund manager is said to be on the payrolls of brokers and had accumulated small and midcap stocks on behalf of the mutual fund. He was behind the boosting of the small and midcap stocks and placed them with the mutual fund once they crossed a certain size.
The audit conducted by SEBI revealed fraudulent and unfair trade practices-barring intermediaries and individuals with direct or indirect access to non-public information regarding big client orders or pending mutual fund trades in 2017-2019. SEBI was scrutinising all the transactions of these two senior executives over the past two years together with the transactions of other team members.
All the fund houses have an isolated area known as the dealing room where only the dealers and fund managers are allowed to enter. The trading activities are executed all day long in the dealing room. The access to the dealing room is strictly controlled as most mutual funds have strong control measures in place. Even mobile phones are not allowed inside the dealing room.
When the fund manager decides what he wants to buy or sell, he informs the dealer who is responsible for executing the trades on behalf of the fund house. This being a piece of very sensitive information is likely to be misused so all conversation takes place on recorded lines. Declarations need to be made of personal holdings and for those who are defined as relatives. Preclearance is required when trading in shares in a personal account takes place or it takes place in the accounts of relatives. Now, this is possible only when everything happens in the premises of the fund house. But due to the ‘work from home’ condition, it is not possible to trace whether all the dealings are followed in letter and spirit despite the calls still getting recorded. But the person who does the dealing, sits in his own premises and their movement cannot be controlled or supervised. This gives rise to a possibility that misuse of the information must have taken place during the work from home period.
The Axis Fund has holdings in 81 shares and assets under management are worth around Rs. 2.60 lakh crore. Axis Bank Ltd., the third-largest private sector bank in India holds a 74.99 percent stake in Axis MF, along with Schroder Singapore Holdings Pvt. Ltd holding the rest. A primary investigation by the SEBI detected Rs.170 crore scam of front-running of nine scrips by the two fund managers.
This is not the first case involving mutual fund irregularities. SEBI has detected cases of front running even before among foreign portfolio investors and other known mutual funds. As per SEBI’s Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market Regulations, 2003- front running is characterised as a fraudulent and unfair practice. Not only that SEBI has from time to time invoked this section to pass orders against those guilty of front-running. It is quite likely that this kind of mechanism could be part of the system in the Indian Mutual Fund industry and needs a serious redressal formation.
Front-Running
Front-running is trading stock or any other financial instrument/asset by a broker who has inside knowledge of a future translation that is likely to affect its price to a greater extent. It is illegal and unethical because it involves market-moving on the basis of some information that is not yet made public. Though it is different from insider trading, the orchestration is aimed to make money on the stock market by trading in a company’s shares.
If the dealer wants to profit, he can enter the market and buy or sell stocks minutes before the mutual fund places its trades to buy or sell the stock. Mutual funds place large orders that are capable of moving the price of a stock incredibly. This way huge profits can be made from the big investor’s moves by buying or selling shares. As the mutual fund makes a big order, the fund managers who have the information about it, buy the same shares in their own accounts before this order is executed. When a mutual fund purchases in larger quantities, the price of the share will shoot up.
Front running though is not considered to be an offense, more particularly in the case of mutual funds. It is likely to occur where an employee, dealer, trader, or broker executing trades for any big investor gets advance information on big buy/sell orders. The big investor could again be anybody including a mutual fund, foreign portfolio investor, pension fund, insurer, or HNI.
But at the same time, front-running is illegal in India. It is a dubious market practice enabling a dealer, trader, or employee to misuse the details about a big order for buying or selling shares being placed by a fund or big investor and getting ‘In front of the trade’.
Front-running involves two parties carrying out the transactions. There is someone who gets advance information about the big investor’s orders because that person is either an employee, dealer, or trader for it. Then there is another party playing a role to carry out the actual trades. They could be an acquaintance, friend, or a relative of the former. The dealer would not execute the fraud in his own account, he will do it though his associates and their accounts. These accounts are called mule accounts.
What Can Be Done To Prevent Front-Running?
- Surveillance mechanisms of stock exchanges must be used to uncover front-running.
Surveillance software is capable of tracking down real-time trades in the market. They can find out trading patterns between big investors and individuals in a similar manner because such dealings are usually the very base for front-running.
- The surveillance data must be checked strictly by the stock exchanges and if they find any suspicious trades, they must be immediately reported to SEBI. This helps in preventing any big fraud by getting it unrevealed in the due course. The system has to be vigilant enough to alert the authorities at the right time.
- SEBI needs to consider making policies that prescribe strong actions against such front-runners and information carriers as such investigations are otherwise not easy to prove due to lack of evidence.
- There have to be stringent punishments as merely banning these entities from dealing in securities markets for a temporary period is not sufficient. Levying a low-key fine is also not acceptable nor is settling with the accused without admitting to the offense.
- SEBI’s code of conduct for listed companies states that trading restrictions on insiders can come into force from the end of every quarter till 48 hours after the declaration of the company’s financial results.
Until now, whenever SEBI has found violations, it has imposed monetary penalties. The dealers, fund managers and other outside brokers involved in the fraud also get penalised. But the CEO of the fund house is rarely made to pay a monetary penalty. In India usually it is uncommon to penalise or debar a CEO of an Asset Management Company. If the securities fraud is found to be more damaging, the trustees and the Board of Directors of the fund house have been pulled up by SEBI in a few instances.
There are settlement processes and a consent mechanism of SEBI works where the institution is under investigation and the matter gets settled. Such an institution has to pay a monetary amount and undergo voluntary restrictions. One of the first such cases involved a large fund house’s head paying Rs. 15 lakh fine and the funds house together with its trustee board had to pay Rs. 20 lakh each as part of SEBI’s consent proceedings.
A consent mechanism is of two types-
- The fund house neither admits nor denies the findings of fact or conclusion of law: In this case the penalty amount is higher as compared to the cases where it admits the charge.
- The fund house admits.
The SEBI decides the amount of penalty on the basis of the regulations made by it. It considers the size and nature of the offence, its impact on the market, the cooperation and the conduct of the wrongdoer during the proceedings etc.
Irregularities found in the case of Franklin Templeton Mutual Fund and Consequential Actions Taken by SEBI.
Franklin Templeton’s top executives have been alleged of irregularities in the past. The SEBI found major lapses and a breach of the regulator’s mutual fund guidelines more than a year after the AMC shut down its six credit risk schemes involving Rs. 26,000 crore. There were many irregularities found by SEBI impacting interests of unitholders.The Franklin Templeton AMC was barred from launching any new debt scheme for two years. And it was asked to refund Rs. 512.5 crore, the investment management and advisory fees collected from June 4,2018 to April 23, 2020 with respect to the sic debt schemes with simple interest @12% per annum. A penalty was also imposed amounting to Rs. 5 crore.
Debt scheme investors across fund houses were afraid when FT shut down six of its schemes in April 2020. There were huge redemptions in credit risk schemes of other mutual funds. Mutual funds are investing in illiquid instruments of unknown companies following FT’s modus operandi. The fund house did not exercise the exit option despite increasing liquidity stress during 2019-20. During this period there were eight instances of put options in the ultra short bond scheme that AMC had not exercised. The market value of the securities on the date of put option was around Rs. 900 crore.
Then there were 15 instances of interest rate reset wherein the scheme had not exit despite the security becoming illiquid amounting to Rs. 4708 crore. In the low-duration scheme, there were four instances of put option that were not exercised amounting to Rs. 315 crore. This, as per SEBI, was an arrangement of lending money to the issuer for the pre-decided time or until the issuer paid. The decision was made to remain invested in those illiquid securities.
FT had invested in illiquid securities without proper due diligence. FT was served a notice on the ground that it was running the inspected debt schemes like credit risk fund schemes and had not disclosed to investors its strategy of investing in high yield securities with low credit rating. It gave incorrect maturity dates leading to an incorrect valuation of the securities. It had not disclosed the change in terms of investment immediately to valuation agencies and credit rating agencies and had made incorrect disclosures of the monthly portfolio of securities.
Director of FT AMC Vivek Kudva, his wife Roopa Kudva and mother Vasanthi Kudva sold units worth Rs. 30.70 crore just before it shut down the schemes on April 23,2020. Vivek Kudva had the information about the same including redemption, concentration and liquidity risk pertaining to the stress in the impugned debt scheme, which the public was not aware of.
Though Vivek Kudva denied the charges made against him, the assets under credit risk funds plummeted by Rs. 36,000 crore to Rs. 25,656 crore from February 2020 to May 2021 due to this huge scam. He said that his personal transactions in the two schemes under winding up had been in good faith and with no intent to gain unfair benefit. SEBI fined Vivek Rs. 4 crore, Roopa Rs. 3 crore, and they were banned from the markets for one year. According to SEBI, it all amounted to unfair trade practice in the securities market and a fraud on the other unsuspecting unit holders of said debt scheme who were not privy to such confidential information and therefore could not redeem their investments.
The Effect on Investors
The investors do not have any knowledge about such activities and they suffer due to the manipulation as the prices go up and down according to the purchase and selling strategy of an insider.
The mutual fund industry is shaken once again due to the actions taken against Axis Mutual Funds’ fund managers. This hoax has however prevented the mutual fund company from the consequences of being non-compliant and helped to maintain the trust of its unitholders as it has taken quick actions.
Since such practices give is an unfair advantage to someone SEBI has made rules to put such irregularities under its scanner.SEBI regulations define the term ‘insider’ and also the meaning of ‘unpublished price-sensitive information’ or UPSI. Insiders have the knowledge about UPSI and they can use accounts of their associates to execute such trades.
As a dealer already knows that the mutual fund is going to buy a certain stock, he can accordingly plan his moves in another account. Once the price rises with the mutual fund buying in large quantities, he can sell the stock and make profit instantly. The same applies in case of selling when he can make a quick profit in intraday trade. The Mutual fund in such a case is deprived of a market driven-price. But as the individuals with advanced knowledge about the move have decided to trade in a particular way, the stock price is already manipulated.
A single transaction of that nature does not affect much. When it becomes a pattern,the dealer can make huge profits. If it is done in bulk quantities, there will be a huge effect on the stock price. A mutual fund ends up buying a stock at a price higher than it would have bought it otherwise. Contrary to this when selling takes place, the price of the stock will go down and the price which it could have fetched, cannot be fetched as the selling takes place in large quantities. Naturally an average investor pays up high while buying the stock and shall receive less price by selling them.
The Axis Mutual Funds’ managers have been changed by the fund and that will have an impact on the performance of the respective funds. Investors are advised to evaluate their investment in these funds once a quarter just to be sure about their consistency. If the performance is not up to the mark when compared to the category, they can shift their funds to other funds with better performance. Until that time, they should stay invested and wait.
The names of the new managers for different funds are as under.
The fund managers who are now responsible to manage or co-manage have a good performance record in the long term.
How Front Running is Different From Insider Trading?
Both these terms are different though they are interchanged because of the fact that in both the cases, the perpetrators make money on the stock market by trading in a company’s shares.
In front-running, a dealer within an institutional money manager like a mutual fund takes advantage of his knowledge of the orders that the MF is about to trade for the day and books profit from them. The fund manager decides what he wants to buy or sell, then he tells the dealer to execute the trades on behalf of the fund house. So the dealer buys or sells the stock minutes before a mutual fund places its trades for buying or selling the stock. Front-running is done in any stocks or sectors by unrelated people who take advantage of having knowledge of large investors planning to trade in the markets.
In the case of insider trading, there is a company insider like an official, employee or a senior execurite who takes advantajge of unpublished price-sensitive information to trade in the company’s stock and makes profits from it. It is done by a company’s employee so it is known as insider trading and it is from dealing in the company’s shares.
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Bhoi Smrutirekha Dharanidhar