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Drishti Das*
I. INTRODUCTION
The Securities and Exchange Board of India (‘SEBI’) recently amended the SEBI (Mutual Funds) Regulations, 1996, requiring asset managers to implement institutional mechanisms against market abuse such as front running and insider trading through “enhanced surveillance systems, internal control procedures […] to identify, monitor and address specific types of misconduct […]” (the ‘Mechanism’) in the manner prescribed by SEBI. To this intent, it issued a circular dated August 5, 2024 (‘Circular’) prescribing the broad framework for the Mechanism. In line with the Circular, the industry self-regulatory body, Association of Mutual Funds in India (‘AMFI’) has specified detailed standards for the Mechanism, and the same is expected to be rolled out by the end of 2024.
This post explores how the aforesaid measures represent de-centring of market abuse regulation by introducing frontline regulation by a private party. With that perspective, the post examines whether, in the Indian institutional context, such a non-state regulatory process must be complemented with functional guidelines issued by the state, to ensure that it remains immutable, efficient and resistant to challenge.
II. BACKGROUND
Before exploring the purport of the Mechanism, the background in which it was introduced is relevant. SEBI had, in its Consultation Paper on “Draft SEBI (Prohibition of Unexplained Suspicious Trading Activities in the Securities Market) Regulations, 2023” dated May 18, 2023, highlighted the impediments in prosecuting the increasing market abuse due to insufficient evidence, even to meet a preponderance of probabilities standard, on account of abusers resorting to novel technologies such as data encryption. Separately, in its Consultation Paper on “Institutional Mechanism for Asset Management Companies for Deterrence of Possible Market Abuse and Fraudulent Transactions” dated May 20, 2023, it further suggested that asset managers put in place institutional internal controls systems for deterrence and detection of market abuse and taking action against market abusers to eliminate this vice at inception. These measures arrive at a critical juncture where domestic institutional investment has reached a record high of 25.85% in mid-2024, while SEBI simultaneously noticed an increase in market abuse – such as front-running – involving mutual funds, demanding increased scrutiny over market participants.
III. ROLE OF ASSET MANAGERS UNDER THE CIRCULAR
In this vein, the Circular, which has the force of law, requires asset managers to put in place surveillance and internal controls procedures to identify, probe and ultimately deter market abuse. In addition, asset managers are to “take suitable action upon becoming aware of any potential market abuse by its employees or brokers / dealers, including suspension or termination of such persons/entities.” These actions include suspension or termination and covers employees and external associates. The responsibility and accountability for the Mechanism has been reposed on asset managers. In this regard, AMFI’s detailed standards also enable asset managers to initiate action against suspicious brokers including termination of contract. Pertinently, asset managers are themselves regulated as constituents of SEBI and the Circular has been issued “to protect the interest of investors in securities and to promote the development of, and to regulate the securities market.”
IV. ANALYSIS
From the above, it can be said that asset managers have now been clothed with what some call “core regulatory attributes” over market abuse at the institutional level i.e., (a) regulation of a target through rule-making; (b) an imperative over such target to “adopt means or achieve ends”; and (c) rule enforcement through investigation and disciplinary processes. Thus, to the extent of the Mechanism, asset managers can be characterised as ‘frontline’ regulators of market abuse which function under SEBI’s nodal regulation. Traditionally, these are to be discharged by a state actor such as a market regulator or designated bodies such as market infrastructure institutions (MIIs). However, rapid proliferation of technology and digital advancements in the economy, has demanded a regulatory model which can not only influence industry conduct at a granular level, but also adapt to market dynamics on a real-time basis while functioning under the state’s broader umbrella.
A. Frontline Regulation in India
Frontline regulation of this nature by private parties is not new to the Indian regulatory landscape. For example, banks are empowered to conduct administrative proceedings and declare their borrowers as “wilful defaulters” under Master Circular dated July 1, 2015 (‘2015 Master Circular’) or as “fraud accounts” under Master Circular dated July 1, 2016 (‘2016 Master Circular’), both issued by the Reserve Bank of India, the money market regulator. However, non-state entities require guidelines on discharging such functions, to avoid arbitrariness. For instance, the 2015 Master Circular minimizes the scope of discretionary powers and lays down express guidelines for exercise of authority thereunder. This includes prescribing minimum expertise of officers that conduct the disciplinary process, incorporating the principle of audi alteram partem and requiring a reasoned decision, providing for an internal maker-checker system, and stipulating penal consequences. Even then, courts amplified the guidelines in 2015 Master Circular by reading into it a higher requirement of natural justice because the penal consequences therein have a direct and immediate impact on individuals’ fundamental right to do business, and the master circular must therefore, be construed reasonably. The 2016 Master Circular, which did not originally contemplate equivalent guidelines but had the same penal consequences, has been similarly interpreted by courts. MIIs, being private, for-profit entities set up under the Securities Contracts (Regulation) Act, 1956 (SCRA), also discharge duties of frontline regulation. They have the power to inspect/surveil and take disciplinary action against members including expulsion from membership. For this purpose, touchstones for discharge of a regulatory role, such as principles of natural justice and reasonableness, in are incorporated in their rules and byelaws, which are prepared in terms of the SCRA, modelled per SEBI’s draft, approved by the government and therefore have statutory character.
B. Need for Procedural and Substantive Safeguards
On the other hand, the Circular espouses self-regulation over a prescriptive approach while requiring asset managers to “take action” against market abusers, which include third parties such as brokers and dealers, and does not provide asset managers with guidelines on the procedure to be followed in such a processes. The Circular is also unclear on the specific consequences or penalties market abusers stand to face pursuant to such a process, and only talks of an ‘inclusive’ list of consequences. Another factor which is not clearly spelled out is whether the actions taken by one asset manager against an employee, broker or dealer, would render him ineligible to do business with other asset managers. Additionally, the Circular does not contemplate separation of the asset managers’ business and regulatory functions, unlike the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2018 which mandates that MIIs’ regulatory departments must be kept separate from their business departments.
Considering the above, asset managers may have to exercise considerable discretion in designing and implementing their internal processes, which can be antithetical to the cardinal principle that administrative powers must be clearly defined and anticipated to avoid arbitrariness and inconsistency. This may lead to manifestation of one of the criticisms of a self-regulatory model, that the regulated regulators are unable to strike a balance between self-interest and the collective good. It must be mentioned here that SEBI retains the ultimate power to proceed against market abusers for securities market law violations. The Mechanism’s disciplinary “action” aims to sever the asset manager’s nexus with the recalcitrant individual by “taking decisive action” on suspicions of market abuse, presumably to safeguard institutional integrity. However, this can be distinguished from proceedings against typical organisational misconduct, given that they are aimed at curbing practices which have market-wide impact and therefore can potentially impact economic and reputational rights of individuals. Therefore, from an equitable perspective, functional guidance by clearly defining the procedure and specifying institutional penal consequences for market abuse within the law, may be desirable to rule out arbitrariness or inconsistency and promote efficiency. This is because administrative processes must inhere principles of natural justice and clarity on penal consequences, especially when economic and reputational rights may be directly and immediately impacted by the process. While these rights are not absolute, any fetter thereon must be “reasonable” i.e., the fetter must not be disproportionate or arbitrary, which can be achieved by incorporating procedural and substantive legal safeguards. This position is discernible from the courts’ views on the aforesaid master circulars, where in the Indian institutional context and in the absence of statutory prescription, interpretations which harmonised principles of natural justice with private administrative processes, were favoured to avoid procedural arbitrariness, promote transparency, and accord equal protection of law to all.
C. Review of Decisions
The Circular is also silent on where, if at all, an appeal will lie against orders of the asset manager. SEBI is a creature of statute without an appellate jurisdiction over its constituents’ disciplinary processes unlike the U.S. Securities and Exchange Commission (SEC), which hears appeals against decisions of frontline regulators. The Securities Appellate Tribunal, where appeals against orders of SEBI and MIIs are heard, is also a creature of statute and can only hear appeals which are contemplated by enactments of the legislature. At present, the law does not contemplate appeals against orders of asset managers before the appellate tribunal or SEBI. If such rights are contemplated, it will require amendments by the Parliament. Pertinently, although no statutory appeal mechanism was contemplated under the aforesaid RBI master circulars either, banks’ decisions thereunder are subject to judicial review in writ petitions before the jurisdictional High Court (constitutional courts). This is since banks have been made amenable to writ jurisdiction to this limited extent, on account of them discharging a “public duty” for the purposes of the aforesaid master circulars. In the absence of a statutory remedy, the question that must be answered is whether non-state asset managers in the aforesaid context also discharge a “public duty” and can therefore become amenable to writ jurisdiction.
D. Implications on Overall Efficacy
The above shows that the disciplinary process under the Mechanism may be vulnerable to challenge on three counts: first, that a non-state disciplinary process arising out of suspicions of market abuse when implemented with minimal legislative guidance, may lack procedural and substantive safeguards against arbitrariness; second, lack of legislative clarity on penal and other consequences may militate against doctrines of certainty, predictability and proportionality and lead to inconsistent outcomes in similar fact situations; and third, lack of clarity on the appeals process may render the process inefficient by leaving aggrieved persons remediless. For this reason, the lack of functional guidance in the Circular may be detrimental to the overall efficacy of the Mechanism.
V. CONCLUDING THOUGHTS
Market abuse is a serious violation which erodes market integrity and undermines public confidence and must be dealt with strictly. SEBI’s effort to curb market abuse by empowering asset managers at the grassroots is a step in the right direction and can be a key component in the regulator’s toolkit for achieving its objectives. However, the implementation of the same may not be bereft of teething pains in the absence of functional guidelines. As a starting point, these processes can be benchmarked against guidelines formulated by courts in respect of RBI’s master circulars. In addition, continuous and meaningful engagement between the regulator and the industry body can evolve the processes under the Circular to put in place procedural and substantive safeguards. Addressing these issues will contribute to ensuring efficient and speedy implementation of the Mechanism without technical objections, and aid SEBI’s overall goal of creating a free and fair securities market.
*Drishti Das is a Principal Associate at the Mumbai office Cyril Amarchand Mangaldas in the Disputes practice, focusing on regulatory, insolvency and commercial litigation. Views expressed are personal.
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