IIFL AMC case: Should you be worried when a fund house staff is caught while front running shares?

On October 1, the capital market regulator Securities and Exchange Board of India (SEBI) issued an ad interim ex parte order against a dealer (Santosh Brijraj Singh) of IIFL Asset Management Company (AMC) and a former sub-broker (Adil Suthar) of Angel Broking for colluding with one another and front running. Now, front running is a corrupt stock market practice that involves a market participant – usually a dealer or a broker – entering the equity market minutes before a large institutional investor (typically a mutual fund) transacts in the same set of scrips that the institution trades in. The aim is to make profits with the information available, of what the institution would buy or sell. When large institutions buy or sell shares, price movements are generally substantial, given the large quantity of stocks involved. The 70-page SEBI order says that apart from IIFL AMC, there were five other alternate investment funds (AIF) on whose trades Singh and Suthar benefitted from. What really happened at IIFL AMC? Like all equity investors, Singh wanted to profit from the stock markets. So, he chose to mimic IIFL AMC’s trades in such a way that he could benefit from the share price movement that happens when such large institutions buy and sell in the market. Whenever a fund house buys or sell its securities, its in-house dealers execute the trades. Fund houses appoint a panel of brokers with whom the dealers stay in touch. The dealer’s job is to get the trade executed; he doesn’t buy or sell himself. The fund house’s brokers actually buy and sell shares. If the volume of shares is high, it can move the prices sharply, especially if it’s a small or mid-sized company with low liquidity. This is the opportunity that front runners such as Singh and Suthar kept an eye on. Minutes before IIFL AMC entered the markets to buy shares, Singh bought the same company’s shares, knowing fully well that the firm’s share price would go up. After IIFL AMC bought those shares, Singh would sell the shares on the same day and make a profit. Since he was an employee of IIFL AMC with access to information, he knew exactly what the fund house was going to buy. Similarly, when the fund house went to sell a large quantity of some of its underlying shares, Singh sold the same shares from his own personal kitty, then waited for IIFL AMC to sell its own shares of the same company, see the prices drop and then buy the same company’s shares at lower prices. Singh and Suthar had opened multiple demat, bank and trading accounts for ensuring the smooth travel of proceeds from the front-run shares. They didn’t buy and sell these front-run shares using their own personal accounts. These are called mule accounts, in stock markets parlance, if front runners use them without the real owners’ knowledge. To further cover up their trails, they repeatedly deposited cash in the bank accounts to be used for buying shares and also withdrew the cash profits from ATMs, instead of using online banking transfers. Between the two of them, they did front running through four such sets of accounts that belonged to four different and mostly unrelated people, whose access SEBI says could have been obtained illegally. In fact, one of the bank accounts used in this operation had received a small sum as part of chief minister’s welfare scheme meant for below-poverty-line people, indicating that the demat, bank as well as trading accounts were fraudulently opened in other people’s names. SEBI noted that Singh and Suthar made a total profit of Rs 58.1000000 in front-running IIFL AMC trades, between December 1, 2019 and August 10, 2020, in as many as 107 companies. After receiving alerts from market surveillance systems about two demat accounts doing front running trades of IIFL AMC, SEBI’s hunt led them to Singh. and to confirm who operated the mule bank accounts, SEBI relied on mobile phone locations procured from phone companies as well as security cameras at various ATMs from where cash was withdrawn. Does front running impact mutual fund investors? When a market participant front runs trades of a mutual fund, the AMC may buy the stock a higher price than what it could have purchased at otherwise. While selling, the fund house may get lower prices. In either case, the scheme that transacts in such front-run stocks would clock lower gains. If the dealer sells a security knowing fully well that a large fund is about to sell a large quantity, the price of this security would mostly fall. However, the buyer who buys from the front runner doesn’t know this and ends up buying the security at a higher price. Had he waited till after the fund house sold its shares, he could have bought the same company’s shares at a cheaper price. What fund houses do to prevent front running SEBI strictly prohibits practices like front running under SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2013. In short, it bans people from trading using non-public information. Fund houses do their best to prevent such activities. Aside from limiting access of dealing rooms to only designated officials such as dealers and fund managers, there is a ban the usage of mobile phones. Only recorded landlines are used in the dealing rooms. Security cameras are fixed too, for monitoring. IIFL AMC too bans the usage and carrying of mobile phones in the dealing room, says a person close to the fund house. Yet, how Singh and Suthar spoke to one another over 168 times on phone during trading hours between December 17, 2019 and July 30, 2020 (as per SEBI’s investigation) remains a mystery and is still being looked into. Another fund house’s official says that a single company’s trades are usually split among multiple brokers to ensure no single broker gets an idea of the full quantity. The difference in the time taken for the dealer to place the order and the time taken by the broker to punch in, can give precious clues. If there’s a large gap, the broker could be positioning himself before he is ready to execute the fund house’s order. Another fund house’s chief investment officer says that fund house employees are encouraged to maintain an arm’s length with brokers; gifts from brokers, especially during festive seasons, are discouraged. Background checks are also conducted before hiring fund managers and dealers. What should you do? All their bank, trading and demat accounts have been frozen and they have been asked to deposit their gains within 15 days. “An internal investigation is being conducted and a report on the same will be submitted to SEBI,” says an IIFL AMC spokesperson. In the meantime, SEBI has asked the offenders to file their replies. SEBI is expected to pass a final order. As mutual fund investors, there’s nothing much that you can do. Even IIFL AMC found out about it only the morning after SEBI order came late night on October 1, 2020 – it being a long weekend. As we’ve seen in the past, front running can happen in large and reputed fund houses as well. The only comfort that you as a mutual fund investor can get is that the offenders have been caught.