Axis Mutual Fund, the country’s seventh-largest fund house, has suspended two of its fund managers (one of whom was also its chief dealer), and is investigating irregularities in the funds handled by them. While the investigation is yet to reveal the exact nature of these violations, domestic mutual funds have come under scrutiny for instances of front-running.
Front-running is a bit different from insider trading, although in both the cases, the perpetrators aim to 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 or even a share broker takes advantage of his knowledge of the orders that the mutual fund has lined up for the day and tries to profit from them.
Let’s look at the subtle differences between these two practices.
How is a front-running fraud orchestrated?
Once the fund manager decides what he wants to buy or sell, he informs his dealer, whose responsibility it is then to execute the trades on behalf of the fund house. Every fund house has an isolated area called the dealing room, in which these trades are executed, all day long. Only dealers and fund managers are allowed entry here.
And here’s where the crime can take place. If the dealer wants to profit, he enters the market minutes before he punches in the order of the fund house. Mutual funds usually place large orders in the stock market. Such orders can sharply move the price of a stock.
Here, the dealer buys or sells the stock minutes before a mutual fund places its trades, buying or selling the stock.
The idea is to profit from the big investor’s moves, either by buying or selling shares.
What is insider trading?
Insider trading, on the other hand, is when a company insider, an official, employee or a senior executive, takes advantage of unpublished price-sensitive information (UPSI) to trade in the company’s stock and make profits from such transactions.
As the name suggests, insider trading is done by a company’s employee aiming to profit from dealing in the company’s shares. Front running can be done in just about any stocks or sectors by unrelated people, who have knowledge of how some large investors plan to trade in the markets.
Impact on shareholders, mutual fund unitholders
Insider trading is bad because it gives an unfair advantage to someone on the basis of non-public information. SEBI (Prohibition of Insider Trading) Regulations clearly define the ‘insider’ and what constitutes ‘unpublished price-sensitive information’.
Public shareholders like mutual funds are at a disadvantage as company insiders have access to UPSI, and can take undue advantage from it. Insiders can use accounts of their associates to execute such trades.
SEBI has put in place certain checks and balances to prevent insider trading. For example, 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.
Returning to front-running, if the dealer benefits, how do his actions harm the unitholders of the fund house?
When the mutual fund’s dealer knows that the mutual fund is going to buy a certain stock, he can build a position immediately in another account. And as the price of the stock rises with the mutual fund buying it in large quantities, he can sell the stock and make a quick profit in this trade.
Similarly, when the dealer knows that the mutual fund is going to sell a stock, he can start selling or shorting the stock right before the mutual fund’s trade. And when the mutual fund’s selling starts, he can square off his position to make a quick profit in intra-day trade.
When such an activity takes place, the mutual fund scheme is deprived of a market-driven price. Because of the presence of one or more participants who have already taken positions in the market, the stock price already gets impacted. When the fund house finally enters the market, the stock price is already manipulated.
A one-off incident doesn’t materially impact a stock’s price. But when a dealer repeatedly front-runs a large investor, he can make lots of money. Worse, if the buying by the dealer is large enough, it can create a large jump in the stock price. So, when the mutual fund is buying the stock, it is buying it at a higher price than it would have had bought it otherwise.
Similarly, when the dealer is shorting or selling the stock, especially in large quantities, this will pull down the price of the stock. So, when the mutual fund starts to sell, the selling price it will fetch on the stock would be lower.
Remember, the dealer would not execute these fraudulent trades in his own account, but through his associates and their accounts, to avoid getting caught. These accounts are called mule accounts in stock market parlance.
Front-running also impacts other stock market investors, as the latter trade at prices manipulated by the dealer for his own gain.
‘Work from home has made it difficult to keep controls’
Most mutual funds have strong control measures in place to make sure that instances like front-running don’t take place.
For example, the access to dealing room is strictly controlled. Surveillance cameras keep an eye on the dealing room. No mobile phones are allowed inside the dealing room.
All conversations take place on recorded lines. Further, declarations need to be made of personal holdings as well as those defined as relatives. Pre-clearance is needed when trading in shares in personal account or in those of relatives.
However, all these controls are possible within the premises of the fund house. Industry executives say that work from home has made it difficult to ensure that these controls are followed in letter and spirit. "Calls would still get recorded, but who is the individual interacting with in his own premises, that can't be controlled," said chief executive officer of a fund house, requesting anonymity.
How has SEBI dealt with front-running cases in the past?
When SEBI has found violations, it has imposed monetary penalties. Usually, the dealers, fund managers and the outside brokers with whom they have worked in collusion- get penalised. In rare instances, the CEO of the fund house is also made to pay a monetary penalty. Unlike US SEC, it is all the more rare in India to penalise or debar a CEO of an Asset Management Company. Depending upon the gravity of the securities fraud, SEBI is also known to pull up the fund house’s trustees and the Board of Directors.
Sometimes, proceedings get settled through the consent mechanism of SEBI, also known as settlement process. A consent mechanism is where the institution under investigation, settles the case with SEBI in lieu of payment of monetary amount and voluntary restrictions. In one of the first cases of insider trading that came to light in public domain, a large fund house’s head had to pay a Rs 15 lakh fine, as part of SEBI’s consent proceedings. The fund house and its trustee board had to pay Rs 20 lakh each.Sumit Agrawal, founding partner, Regstreet Law Advisor and former SEBI officer says a consent mechanism is usually of two types; one where the fund house neither admit nor deny the findings of fact or conclusion of law, and the second category where there is admission. “If the institution doesn’t admit or deny allegations made by SEBI, then the penalty amount is higher in comparison to the cases where fund house admits the charges,” says Agrawal. And how is the consent fine decided? Here, SEBI relies on the formula prescribed in the Regulations where it takes into account the size and nature of the offence, its impact on the market, the corporation and the conduct of the culprit during the proceedings and so on.