Securities and Exchange Board of India Raises the Bar for Ethical Conduct for the Indian Fund Industry
In April 2020, faced with growing redemption pressures and illiquidity during the height of the pandemic, Franklin Templeton’s Indian arm wound up six mutual fund schemes with a total assets under management of nearly $3.5 billion. One year later, following an investigation, the Securities and Exchange Board of India (SEBI) fined the company and its executives for lapses in ethics and risk management practices. This first article in a series of three explores the ethical dimensions of the case.
On 7 June 2021, the Securities and Exchange Board of India (SEBI) fined a senior executive of Franklin Templeton and his spouse for acting on insider information to redeem their personal investments. Regardless of the final outcome, the case has highlighted ethical issues as well as what constitutes insider trading and material nonpublic information.
What did the executive know? The executive knew that the six credit risk schemes, whose redemptions were restricted in April 2020, were facing high outflows and running out of options to meet them. The borrowing limits of the schemes were close to the regulatory limit of 20%. The schemes were selling down liquid assets, with a proportion of AAA-rated securities falling from 5% to 8% at the end of February 2020 to less than 1% by the end of March.
These two pieces of information were nonpublic, but were they material? Yes. The executive argued that he based his decision on macroeconomic conditions in March and pointed to redemption pressures elsewhere. A piece of information is material if it would significantly alter the total mix of information, and if it would be something investors would want to know before making a decision. Last March, there was significant selling pressure in corporate bonds, but as the SEBI order noted, no other fund house wound up their debt schemes as a result of illiquidity and redemption pressures. Even with the benefit of hindsight, the knowledge of dwindling opportunities to redeem was crucial at the time, and this information allowed the insiders to exit before the gates were forced shut.
Executives who manage money on behalf of clients owe a fiduciary duty to those clients. In general, this means putting the needs of their clients before their own needs. In this instance, it meant giving priority to client’s transactions or creating an opportunity for clients to redeem them before their personal transactions. To that extent, the ethical violations are clear. What is different in this instance, however, is the nature of insider trading and material nonpublic information. Until now, the traditional view of insider trading has been limited to individual securities, and nonpublic information in the fund context has meant front-running large client orders or advance knowledge of portfolio rebalancing events. That an early redemption of a scheme, based on advanced knowledge of portfolio-level attributes, could be the basis of an insider-trading charge is certainly novel, if not nuanced.
Does this mean that mutual fund managers should be cautious about redeeming their personal investments in the schemes they manage, or should SEBI release more guidelines? This is a pressing question, particularly given that SEBI is also planning to introduce skin-in-the-game rules for mutual fund executives. A blanket conclusion would be misplaced; an asset manager in a large-cap diversified fund faces a much lower threshold of materiality when it comes to personal investments. This order means that fiduciary duty is contextual and cannot be the exclusive purview of compliance and regulations. Although asset management firms already have codes of conduct, a proactive approach to implementation is needed.
The three steps to mastering ethical conduct are awareness, analysis, and action. First, ethical dilemmas are more common than we think, but we are not always aware of them. In many instances, we let go of issues that are really ethical dilemmas, and if we ignore them long enough, we eventually may land ourselves in trouble.
The second step is analysis. We need an ethical decision-making framework to help us resolve ethical dilemmas. This framework must be reasonably abstract to be applicable to most issues and to uncover potential blind spots in decision making. Case studies (including this one) help in learning. Merely reading them does not help, however. Case studies are stories that makes perfect sense in hindsight but that do not have the same impact as lived experiences. Therefore, in the third step, action, individuals and teams must confront these situations and select the right course of action in their own context, including all of its attendant risks and constraints, and learn from them.
While individuals have a responsibility for good behavior, firms have a greater influence on conduct. The main challenge to ethical conduct is situational influences, in which ethical individuals can be influenced to act in an unethical manner, because of factors such as obedience to authority, conformity with others, or responsiveness to incentives. Senior leaders have a disproportionate influence on ethical conduct in the rest of the organization, and they not only must lead by example but also create an environment of psychological safety, which allows people at all levels to raise potential ethical issues the firm can respond to quickly and effectively.
SEBI has raised the threshold of what it considers acceptable executive behavior. It is up to the rest of the industry to exceed these lofty standards.
This article first appeared in Livemint
Photo credit @ Getty Images / Nora Carol Photography