Industry needs to raise the bar for ethical conduct
On 7June, the Securities Exchange Board of India (Sebi) fined a senior executive of Franklin Templeton his spouse for acting on insider information to redeem their personal investments. Regardless of the final outcome, the case has highlighted ethical issues, even what constitutes insider trading material non-public information.
But 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 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 the proportion of AAA-rated securities falling from 5-8% at the end of February 2020 to less than 1% by end of March.
These two pieces of information were non-public, but were they material? Yes. The executive argued that he based his decision on macroeconomic conditions in March pointed to redemption pressures elsewhere. A piece of information is material if it would significantly alter the total mix of information, something investors would want to know before making a decision. There was significant selling pressure in corporate bonds last March, but, as the Sebi order noted, no other fund house wound up their debt schemes due to illiquidity redemption pressures. Even with the benefit of hindsight, the knowledge of dwindling opportunities to redeem was crucial at the time allowed the insiders to exit before the gates were forced shut.
Executives who manage money on behalf of clients owe a fiduciary duty to them. In general, it means putting the needs of their clients before their own. In this instance, it means giving priority to clients’ transactions, or an opportunity for them to redeem before their personal transactions. To that extent, the ethical violations are clear. But what is different in this instance is the nature of insider trading material non-public information. Until now, the traditional view of insider trading has been limited to individual securities, non-public information in the fund context 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 need to be cautious about redeeming their personal investments in the schemes they manage, or should Sebi come out with more guidelines? The question is pressing, given that Sebi is also planning to introduce skin-in-the-game rules for mutual fund executives. But 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 their personal investments. What the order means is fiduciary duty is contextual cannot be the exclusive purview of compliance regulations. All asset management firms already have a code of conduct, but what is needed is a proactive approach to implementation.
There are three steps to mastering ethical conduct—awareness, analysis action. First, ethical dilemmas are more common than we think, we are not always aware of them. In many instances, we let go of issues that are really ethical dilemmas.
The second step is analysis. We need an ethical decision-making framework to help us resolve ethical dilemmas. The framework must be reasonably abstract to be applicable to most issues uncover potential blind spots in decision-making. Case studies (including this one) help in learning. However, merely reading them doesn’t help. Therefore, in the final step, individuals teams must confront these situations select the right course of action in their own context, with all its attendant risks constraints, learn from them.
While individuals have a responsibility for good behaviour, firms have a greater influence on conduct. The main challenge to ethical conduct is situational influences, where ethical individuals can be influenced to act in an unethical manner, due to factors such as obedience to authority, conformity with others, or as a response to incentives. Senior leaders have a disproportionate influence on ethical conduct in the rest of the organization, must not only 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 quickly effectively.
Sebi has raised the threshold of what it considers acceptable executive behaviour. It is up to the rest of the industry to exceed the lofty standards.
Vidhu Shekhar (CFA, CIPM), is country head – India, CFA Institute.
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