Mutual Funds and Insider Trading Rules: A New Era Begins

Summary: SEBI’s recent amendment to the Prohibition of Insider Trading (PIT) Regulations, which will come into force on November 1, 2024, extends insider trading restrictions to mutual fund units. The regulations introduce several key compliance measures for asset management companies (AMCs). Mutual fund units will now come under the definition of “insider information”, which prohibits trading where unpublished price sensitive information (UPSI) is available. The UPSI may include changes in liquidity, regulatory actions or any material event affecting the net asset value (NAV) or units. AMCs are now required to maintain a Structured Digital Database (SDD) to track UPSI sharing and report quarterly on properties of nominees and immediate family members. In addition, prior authorization will be required to trade in mutual fund units, except for certain types of funds such as ETFs and overnight schemes. AMCs must implement a code of conduct, establish trading restrictions during closed periods and impose penalties for violations. These changes aim to improve transparency and prevent insider trading, but also require significant procedural updates for AMCs to ensure compliance.

In July 2022, the Securities and Exchange Board of India (SEBI) proposed significant changes to the SEBI (Prohibition of Insider Trading) Regulations, 2015, through a consultation paper specifically targeting the applicability of these regulations to the ” mutual fund units”. After more than 2 years, in July 2024, SEBI notified the amendment of the regulations and fixed 1 November 2024 as the effective date for Chapter IIA and Annex B1 of the regulations CHEST. This article delves into the implications of these changes to AMCs’ compliance requirements, providing information on the upcoming changes and their potential impact.

Summary of the Changes to be implemented from November 1, 2024.

1. The definition of “Insider” now applies to mutual fund units and no insider may deal in mutual fund units when holding a Unpublished Price Sensitive Information (‘UPSI’)¹.

UPSI for the purpose of mutual fund units may be defined as material changes in the liquidity position of a mutual fund scheme, significant regulatory observations/notices or any other event that may have a impact on the net asset value.² or unitholders of the mutual fund scheme, read more about the different types of UPSI related to mutual fund units in the footnote.

2. Maintenance of Structured Digital Database (SDD) for mutual fund units will also now be required to efficiently track UPSI holding and sharing. UPSI may be shared internally or externally for various business reasons.

3. The AMCs will have to inform the stock exchanges quarterly of the aggregate holdings of their designated person or persons and their immediate relatives in regimes managed by them to the stock exchanges on the specific platform created for that purpose. .

Any transaction carried out by the designated person(s) or their immediate family members in the units of the own mutual fund schemes must be reported to the AMC Compliance Officer within of 2 working days and the compliance officer in turn will inform the dedicated platforms of the stock exchanges for this purpose within 2 working days of the notification of the designated person or persons.

2. The AMC shall have an institutional mechanism to prevent insider trading that includes the formulation of a written policy or procedural documents to investigate the leak or suspected leak of UPSI and the review of compliance with the provisions of the SEBI PIT Regulations by the AMC Audit Committee, at least at one time. annual basis

2. The code of conduct should be formulated in accordance with Schedule B1 of the PIT Regulations, which includes rules such as closing commercial windows, Chinese wall procedures, etc.

3. The AMC Compliance Officer will define the lock-in period during which the Designated Persons are expected to have access to UPSI and no trading in units of the relevant mutual fund schemes will be permitted during this closing period

During the scenarios listed in the footnote, the Compliance Officer will have to impose a lock-out period and a PAN-level freeze will be implemented so that the designated person or persons do not transaction during this closing period. This freezing of PAN level can be done with the help of RTA³which may refuse to process such transactions if the designated person or persons do so during a lock-out period.

1. Trading in Mutual Fund Shares shall be subject to prior authorization by the Compliance Officer of the AMC, a threshold shall be prescribed for such transactions by SEBI. However, the pre-authorisation requirement will not apply for trading in overnight schemes, index funds and exchange traded funds (ETFs)

2. Against Trade⁴ The duration of the restriction has been prescribed at two (2) months for mutual fund units.

3. The Code of Conduct may prescribe internal sanctions and disciplinary actions, such as wage freeze, suspension and termination, etc.

Potential and actionable impact

While the implementation of PIT regulations for mutual fund units is a welcome move and will help prevent insider trading that may happen in mutual fund units, it also requires a mechanism robust and enhanced within AMCs to meet new prescribed reporting and compliance obligations.

Currently, AMCs maintain a restricted list, which includes all securities owned by their mutual fund schemes, and no designated person is permitted to trade (buy/sell) these securities, but these restrictions are not they apply for trading in own investment fund units, a designated person or persons are currently authorized to trade in own investment fund units without obtaining an approval. This will change from November 1, 2024 when AMCs would have to build necessary systems to facilitate approval of trading in units of the mutual fund itself by the designated person or persons.

AMCs will now have to adhere to two different sets of regulations for reporting and compliance, one for equity securities and one for trading in proprietary investment fund units, each with requirements for different fulfillment For example- Against The trading restriction for a variable income security would be 6 months, while the same for own investment fund units would be 2 months (currently 1 month).

In addition, AMCs will also need to maintain a structured digital database and actively track all possession and sharing of UPSI within and outside the organization.

Actionable for AMC

Amend the Code of Conduct to introduce the new changes related to the following:

1. Definitions to reflect the applicability of the PIT Regulation for investment fund holdings.

2. Prior liquidation requirement for investment funds’ own shares

3. Transaction information and quarterly information requirements

4. Against commercial restrictions

5. Disclosure and management of the UPSI

6. Penal provisions including disciplinary actions for violation of the Code of Conduct

7. Restrictions on the closing period

8. AMCs shall implement the necessary infrastructure to implement the above changes and sign agreements with ACRs, depositories and stock exchange(s) whenever necessary.

9. AMCs shall write policies and procedures to investigate any leakage or suspected leakage of UPSI.

10. The AMCs will have to acquire the necessary tools/software for the maintenance of the SDD

In conclusion, while the new change regarding investment in proprietary investment fund shares is intended to enhance monitoring against insider trading in an AMC, it also requires the establishment of additional policies and mechanisms for effective implementation. This may result in the designated person or persons refraining from investing in their own mutual funds, except as prescribed by SEBI for “Alignment of Interest of Designated Employees of Asset Management Companies with Unitholders of mutual fund plans”, and choose to invest. in regimes of other investment fund houses.

Footnotes

1. UPSI (Unpublished Price Sensitive Information) in perspective of mutual fund units may include the following scenarios:

1. Change in accounting policy

2. Material change in the valuation of any asset or class of assets

3. Restrictions on Scheme Reimbursements

4. Liquidation of scheme, liquidation of scheme(s)

5. Creation of a segregated portfolio

6. Activation of the swing price framework and the applicability of the swing factor

7. Material change in the liquidity position of a MF scheme(s).

8. Default on underlying securities material to MF Schemes

9. Fundamental attributes change

10. Merger of schemes

12. Changes in the personnel of the AMC, which are likely to materially affect the interest of investors or materially affect the NAV

13. Change in the ratio of total expenses in those situations that may materially affect the interest of investors or materially affect the NAV

14. Activation of the business continuity plan in those situations that may materially affect the interest of investors or materially affect the NAV

15. Audit observations that may materially affect the interest of investors or materially affect the NAV.

16. Regulatory observations that may materially affect the interest of investors or materially affect the NAV

17. Significant events in a material investee company.

18. Declaration of dividends in the scheme

19. Change in fund management responsibilities

2. The NAV (Net Asset Value) of a mutual fund is the total value of all assets owned by the fund divided by the total number of shares outstanding. It represents the value per unit of the fund’s investments.

3. RTA (Registrar and Transfer Agent) is a financial intermediary responsible for maintaining records of mutual fund shareholders, processing transactions such as purchases, redemptions and transfers, and ensuring compliance with regulatory requirements.

4. Contra Trade means a transaction or transaction involving buying or selling any number of shares of a company/mutual fund units within a period of 6 (six) months or 2 (two) months (in the case of the units of investment funds) of negotiation or operate in a reverse transaction of sale or purchase of the shares bought or sold, as the case may be. Basically, Contra Trade is an opposite trade that is executed after a buy/sell transaction.

5. SEBI Regulations (Prohibition of Insider Trading), 2015

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Disclaimers: The opinions expressed in this article are solely my own and made in a personal capacity and do not necessarily reflect the opinions of any other person or organization.