Quant MF incident may nudge mutual funds to expedite setting up internal fraud-detection mechanism

SEBI wants mutual funds to set up internal mechanism to detect fraud

Last week's search and seizure operations conducted by the market regulator Securities and Exchange Board of India in the offices of Quant Mutual Fund on possible charges of frontrunning are expected to expedite the framing of a formal internal mechanism that mutual funds will need to implement to curb market malpractices.

Also read: A Moneycontrol exclusive: SEBI suspects front-running in Sandeep Tandon-owned Quant Mutual Fund

In April, SEBI had decided to modify the mutual fund regulations to make it mandatory to put in place a structured mechanism to identify potential market abuse like frontrunning, insider trading and so on. “This has been a work-in-progress, but in light of recent events SEBI might ask us to expedite it,” said a chief executive officer of a fund house who did not want to be quoted.

Catching abuses from the inside

Typically, when market abuses such as frontrunning are caught, SEBI, armed with data, statistics and trends, initiates and conducts inquiries  that could point to a potential fraud. However, over the past year SEBI has been of the view that fund houses must have internal systems — more than what they already have at the moment — to prevent and detect market manipulations.

Watch: What should you do with your quant mutual fund holdings in the wake of front-running allegations

SEBI’s initiative is in a tradeoff for a relaxation of a phone tapping rule that fund houses had sought earlier. In 2020, SEBI had mandated that all communication (phone calls, face-to-face chats and so on) done by fund managers and dealers during market hours (including personal calls, out-of-office meetings, and so on) must be recorded. While recording phone calls made from within office wasn’t much of a problem, documenting verbal chats, especially those when fund managers are out on company visits and so on, was a challenge. The regulator, then, agreed to relax this rule, in exchange for fund houses setting up an internal mechanism to detect fraud.

To be sure, existing guidelines, too, put onerous conditions on fund houses to keep a vigil. For instance, aside from recorded phone lines that the fund managers and dealers must use during market hours, trustees are required to submit periodic reports to SEBI that there have been no instances of frontrunning activities by any of them, directors or key personnel of the fund house. Due diligence is also required before empanelling brokers and avoid giving too much business to one or a few brokers. SEBI, however, felt that existing guidelines are too centred around catching ‘rogue employees’ and do little to fix responsibility on the fund house when it comes to fraud detection.

This assumes significance in recent events when it was SEBI that got the information and initiated search and seizure on Quant MF instead of the fund house having detected it first. To be sure, SEBI’s investigation is currently on. The outcome is awaited.

More onus on fund houses

The intent of this mechanism is to put more onus on a fund house’s chief executive officer or managing director and the chief compliance officer.

SEBI has also asked mutual funds to put in place a whistleblower policy to encourage sharing of information and at the same time, has put the onus on the AMC to protect those who speak up.