Are all fund managers insiders?

Do all fund managers really have access to privileged information?

Samir Arora

What is common among terrorists, drugs-related offenders and fund managers?

These are the only persons for whom the provision 'innocent until proven guilty' under the law of the land does not apply.

Believe it or not, it is the first time in the history of capital markets anywhere in the world that a fund manager has been hauled up for violation of insider trading regulations without establishing that he had access to unpublished price-sensitive information and used such information to make personal gains.

How is that possible? It is possible because of a small change that was effected in February 2002 in the definitions of 'insider' and 'connected persons' under Section 2 (e) and 2 (h) of the Insider Trading Regulations. And this is what Sebi used to nail Samir Arora, the former chief investment officer and head of Asian emerging markets of Alliance Capital, in a case relating to Digital GlobalSoft (DGL).

On March 31, 2004, Sebi wholetime director T M Nagarajan passed the final order banning Arora from dealing in securities on the Indian bourses for five years on three key charges - thwarting Alliance Capital's plans to sell its India operations, making inadequate disclosures and violating insider trading regulations in Digital GlobalSoft.

Section 2 (e) defines an insider as any person who is (or was) connected with a company, or is deemed to have been connected with the company and is expected to have access to unpublished price-sensitive information about the company. The enumeration of persons deemed to be connected with the company, as given in Section 2 (h), includes intermediaries, investment companies, trustee and asset management companies or employees of stock exchanges and clearing corporations.

This clearly means that mutual funds and their officers are indeed covered under the definition.

However, till recently, it was assumed that the wider ambit of the definition of 'insider' will be applied less in practice, with the focus being on direct insiders - those who work for the company in various capacities, and their relatives.

The Arora case is the first instance of a fund manager being hauled up for insider trading charges despite not having a board seat or any direct official connection with the company. If Arora did indeed have access to any inside information on Digital GlobalSoft, it was not because of any official position in the company.

Normally, to prove insider trading, Sebi would have to prove how Arora got price-sensitive information, and how his use of it was malafide. But an amendment made to the insider trading regulations in February 2002 dropped some crucial words in section 2 (e). Earlier, an insider not only had to be connected or deemed to be connected with a company, but had to have access to price-sensitive information "by virtue of such connection." Dropping the words "by virtue of such connection" makes it easier for Sebi to level charges without a firm degree of proof.

Observes Siddharth Shah, senior associate, M&A and funds practice at law firm, Nishith Desai Associates: "Legally, all persons mentioned in Sebi regulations 2 (e) and 2 (h) qualify as insiders and Sebi can charge them for violation of insider trading regulations in case they leverage unpublished price-sensitive information for personal gains. The burden of proof, in such cases, would rest with the fund managers or any other affected party."

Sebi's final order in the Arora case says as much: "It is not material whether Arora was providing any service to DGL. The factual position was that the entities managed by Arora, at some time or the other, held as much as 10 per cent of the paid-up capital of the equity capital of DGL, which was next only that of the controlling holder - Compaq. He and his analysts were maintaining contact and close interaction with the management of DGL. I find that Arora was indeed an insider within the meaning of insider trading regulations. The requirement for Sebi to show that any other insider has shared unpublished price-sensitive information with Shri Arora does not arise."

Industry players, academics and a section of lawyers believe that Sebi's logic of having an all-encompassing definition for the term insiders without having to establish how and from whom a market participant got such information is completely flawed. "This is a way to circumvent the idea of having to prove violation of insider trading because it is difficult to prove," says Jayant S Varma, former Sebi executive director and now professor at the Indian Institute of Management, Ahmedabad.

An official with a leading law firm in the country who preferred anonymity says Sebi's definition of 'insider' was not in consonance with regulations in some foreign countries. A representation to Sebi regarding this was made a year-and-a-half ago, but no alterations were made in this respect, he adds.

How far from reality is the presumption that fund managers are insiders? "Not very," says a fund manager. It is a fact that fund managers around the world keep close contact with company managements. It is no different in India.

Fund managers on conditions of confindentiality do admit that they meet managements of investee companies regularly and get insights and information that may or may not be in the public domain. It will be naive to think that these management meetings are to discuss published financial results or any other publicly available information. Why would anyone want a private meeting if one is not expecting something that has already been said? Now the issue here is what is this unsaid part that fund managers and analysts look for.

Some fund managers say it is critical to assess the credibility of the management before taking big stakes. Some others say they meet managements to get a better understanding of the industry environment and the company's future plans which help them understand and appreciate information that is already in the public domain.

Reasons may be varied, but the common string is the fact that none of this information/insight is available to the public anyway. And much of this could have a bearing on stock prices, no matter to what extent.

Can a retail investor holding a few shares in a company ever hope to get a meeting with the company management? Forget that. Even journalists do not get entry into analyst meets hosted by many companies.

Having said that, market experts argue that there is a very thin line between what can be considered as having access to insider information and sheer interpretation of information that is not private. Fund managers and brokers suggest that they often take calls by watching company managers' body language and reading between lines. These enable fund managers to take calls ahead of the market. So if a fund manager gets out of a management meeting and decides to sell shares of the company, does it necessarily mean that the management whispered something in the fund manager's ears? Or could it be just that the fund manager was intelligent enough to gauge the manager's body language correctly. But would both qualify as insider trading?

Besides, fund managers say managements often speak with vested interests. Though it is common to find managements leaking privileged positive information to potentially large investors to drive up stock prices, they are quiet on negative information like the one Arora is alleged to have access to.

A fund manager who manages one of the best-performing equity funds in the country says the ability of company managements to forecast the environment is very limited. He argues that managements fail miserably in assessing the environment dispassionately and hence are often off the mark when it comes to predicting the future. That includes even the best companies such as Infosys - the company ended the year with double the earnings growth projected in the beginning of the year. However, that does not make their inputs any less important to the whole process of assessing the worthiness of a stock.

No one disputes that fund managers don't derive their edge due to effective access to company managements alone. But the fact remains that not all shareholders get the same level of information. There is disparity in information sharing even within the community of analysts and fund managers. Large investors do get a privileged treatment.

Yes. Some managers ask, why not? The higher your stakes are, the more vulnerable you are to the performance of that investment. Hence, the need for more explanations and insights. Also, is it fair to expect that a person working full time on managing investments be treated on par with someone for whom equity investing is only a peripheral activity?

Right or wrong, meeting managements and keeping track of developments on all fronts are a fund manager's job. Investors do expect fund managers to know it all. For any retail investor, a good fund manager is one who delivers great returns. Ask a fund investor on the street why he takes the mutual fund route (though it is difficult to find one very easily!), the answer will be pretty much clear: People come to mutual funds because they realise that they do not have what it takes - time, expertise and approach to keep pace with the stock markets. A fund manager is expected to be clued in every sense of the term.

Needless to say, having access to inside information is just one thing. The ability to use such information to make the right calls is quite another, and perhaps a more important one. Small retail investors lack both. Fund managers, by virtue of being caretakers of small investors' money, supposedly act in their interest, although it is also in their business and personal interest to make the fund grow and prosper. In fact, most fund managers have their personal investments deployed in fund schemes they manage as there are far too many restrictions on buying and selling of securities on their personal accounts.

In an earlier interview with The Smart Investor, a CEO of a domestic mutual fund said small investors should not be allowed to participate in the stock markets directly and should be compelled to enter only through mutual funds. Why? Because, they lack understanding of the markets (take that with a pinch of salt as it comes from the CEO of a domestic mutual fund!).

Some fund managers say that the regulator should try and correct the asymmetry in information dissemination in order to curb insider trading. The genesis of such asymmetry lies in the fact that regulation does not deter fund managers or analysts from meeting up with company managements privately. Also, company managements are not made responsible for any possible leak of information.

This point has only got accentuated after the Arora case as Sebi has taken for granted that the fund manager is expected to have information by definition. This boils down to the fact that the regulator recognises that large investors/fund managers are expected to have access to unpublished price-sensitive information though he is not allowed to act on such information. Now, why should a fund manager meet managements if he cannot use such inputs in order to manage his funds effectively? After all, the paramount duty of a fund manager is to act in the best interest of unitholders.

Sebi's interpretation, if it holds in the higher court, will only make life difficult for fund managers and large market participants. Such interpretation will leave too much discretion in the hands of the regulator, which can lead to abuse of such powers, fear market participants. It absolves company managements of any responsibility whatsoever to treat small and large shareholders alike.

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Arora's case diary

• April 2003 : DGL board appointed a committee of independent directors to finalise the de-merger of the ISO division of Hewlett Packard (HP) with DGL.
• May 2, 2003 : DGL appointed Bansi S Mehta & Co to suggest a de-merger ratio for the ISO division of HP and DGL. DGL had informal discussions with BSM on the valuation issue before the assignment was given through a letter.
• Som Mittal, president and CEO of DGL, met Bansi S Mehta before the assignment was given and, thereafter, had regular discussions on the projections and estimates of the company.
• BSM completed the valuation and arrived at the merger ratio in three-four days based on interactions with DGL only.
• May 5, 2003: Arora in an interview with Business Standard talked positively about the DGL scrip. He mentioned that the proposed merger is going to immensely help DGL due to the additional projects it is going to get from HP.
• May 7, 2003: BSM submitted the de-merger ratio to DGL. Hemant Soonawala of BSM submitted the valuation report in a sealed envelope to DGL.
• May 8, 2003: The Economic Times carried positive reports about the prospects of DGL post-merger.
• CLSA Emerging Markets research analyst Aniruddha Dange and Bhavtosh Vajpayee downgraded DGL to 'sell'.
• Alliance internal analyst Bhaskar Laxminarayan recommended reducing position in the stock.
• ACMF sold 119,000 shares of DGL while ACM sold 2,18,400 shares.
• Arora noted "price has rallied nicely - taking profits" as the reason to sell shares.
• May 9, 2003: DGL told BSE that following the global merger between HP and Compaq, the future business and operating structure of DGL was under consideration. However, no decision was taken.
• ACML sold 334,562 DGL shares while ACM sold 250,000 shares. The reasons as noted by Arora when he took the decision to sell DGL shares: "Event risk in Digital is too high - getting nervous. Reducing exposure."
• May 11, 2003: The merger ratio was to be discussed/approved at the board meeting scheduled to be held on May 12 in which the results for financial year 2002-03 was also to be finalised. DGL did not inform the stock exchange about the agenda for the de-merger.
• May 12, 2003: Results for the March quarter was approved and the valuation submitted by BSM was accepted by the board. No final decision was taken.
• ACMF sold 334,562 DGL shares while ACM sold 250,000 shares. The reasons noted by Arora: "Event risk from tomorrow's announcement/results is too high. Bipolar situation, but we do not like to take such risks post very high volatility in technology stocks around results/corporate issues."
• May 13, 2003: DGL announced Q4 results in line with market expectations. ACM sold 211, 478 DGL shares.
• May 30, 2003: DGL appointed Deolitte Haskins Sells for a fairness opinion. DHS affirmed the fairness of the de-merger ratio recommended by BSM.
• June 7, 2003: DGL announced de-merger ratio which was perceived as unfavourable by the market. Stock fell 26 per cent.

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 Some legal experts believe that any fund manager buying or selling shares ahead of a material event, including quarterly result announcements, can be hauled up for violation of insider trading regulations, without establishing that he did indeed have access to unpublished price-sensitive information.

Even independent buy or sell decisions based on intuition could be termed as insider trading, if they happened to be timed before a material event. And then, it is a lot more difficult for a fund manager to prove that he was not in possession of information than for the regulator to prove otherwise.

What can be a good solution? Should private meetings be banned? Sure, it sounds like the best solution to ensure an egalitarian set up. There are companies such as Nestle which do not entertain private meetings. The company management meets the investing class just once a year and it is upto investors to ask as many questions as they want and make their own conclusions. But that is not a solution that will go down with fund managers' and, more importantly, with analysts' very easily.

The other option could be to put the onus on company managements to ensure evenhandedness in information dissemination. Firstly, is it easier to govern companies because they are far less in number than the investing public. The logic is that regulating companies should be a lot simpler than chasing every single investor on the street.

However, some market participants argue it may not be a great approach either because price-sensitive information can come from various sources, not just companies alone. Recall how bank stocks went up and down due to announcements of government officials on the issue of return of premium by banks to the government. Besides, such information can be used intelligently to circumvent the law.

Consider this case: Financial results of Infosys set the direction for the entire gamut of IT stocks on the Indian bourses. Now, take a market participant who knows ahead of the public announcement that the result/guidance is going to be poor - he could choose not to invest in Infosys stock and play all other IT stocks instead. Would his action qualify as insider trading?

But what the heck, no regulation can ever ensure fair practice. We all know that it is the intention to be honest that brings in fair practice.

Any ideas on how to make people more honest?

Sebi's Contentions

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• Arora sold all of Alliance's holdings in DGL in four days flat (May 8-13), a day after the valuation report was submitted by Bansi Mehta & Co to DGL management.
• Entities managed by Arora held 10 per cent of (in September 2002) DGL's equity capital which was next only to the controlling holder - Compaq. Thus, Arora was by definition an insider.
• Sebi is not required to show that any other insider shared unpublished price-sensitive information with Arora.
• Sebi has not found any evidence against other persons like Bansi Mehta and CEO of DGL, Som Mittal.
• POINT TO PONDER
• How can a fund manager be assumed to have legitimate access to information if he does not hold an official position in the company?

Arora's defence

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• When a merger is talked about widely, the convening of a board meeting itself leads to speculation and uncertainty.
• CLSA analysts put out a 'sell' recommendation on DGL on May 8. The report was significant since CLSA Emerging Markets was rated India's No 1 FII broker.
• If Arora had inside information he would have known that the ratio would not be disclosed on that date and there would be no urgency to complete the sale before May 12.
• None of the Alliance fund managers or analysts including Arora met DGL officials in 2003
• Being second largest holder cannot lead to the presumption of having unpublished price-sensitive information.
• POINT TO PONDER

  Can an event force a fund manager to wipe out his top holdings in four days flat?

(The Smart Investor had detailed discussions on the subject with several fund managers, brokers and analysts. However, none of them have been quoted here as they spoke on conditions of anonymity.)