Will SEBI’s Forensic Audit on Mutual Funds Pull More Skeletons Out of the Closet?

February 17, 2023 Mutual Fund

All are guilty unless found innocent seems to be the undertone of SEBI’s latest actions. Recently, SEBI released an advertisement inviting Expression of Interest (EoI) from forensic auditors to conduct audits of mutual funds.

Now you might think I am blowing this topic out of proportion. No, I am not, given the context of these developments.

In its advertisement, the capital market regulator has outlined the nature of work its potential forensic auditor might perform at mutual fund houses. The market regulator has stated that the potential applicant should be experienced in performing digital forensic work for acquisition, extraction and analysis of digital evidence from mobile, computers, tablets etc., on an ongoing basis.

This provides us with a marker or short demo of perhaps what’s coming.

Following some high-profile fiascos in the mutual fund industry over the last few years, SEBI seems to have decided to dig deeper and uproot all practices that may be detrimental to the interest of investors at large.

For instance, Axis Mutual Fund sacked two of its fund managers over controversies sparked by front-running cases. The charges against two fund managers of Axis Mutual Fund are extremely serious and include-front-running and receiving kickbacks from brokers in exchange for passing on confidential information and teaming up with them for illegal order execution. What’s been more worrisome is the modus operandi the ex-fund managers of Axis Mutual Fund adopted to fly below the radar.

For those who don’t know what is front-running-it is a practice of performing trades based on confidential information about future trades that may vastly affect the stock prices.

The whole episode is now unfolding in a quite dramatic manner. One of the sacked fund managers of Axis Mutual Fund leaked vital information about planned but unexecuted trades of Axis Mutual Fund to brokers in his nexus, who then accumulated the stock in advance. The ex-fund manager happened to buy those securities from them in mutual fund schemes at a higher price and received kickbacks for doing these favours. He recently even admitted in a regulatory probe that he shared confidential information with two brokers, who then remotely placed orders from Dubai from their personal accounts and the accounts of their clients.

This practice helped them dodge the surveillance systems and stricter scrutiny. So, for the records, those trades appeared as though punched from India but were actually initiated in Dubai.

The Income Tax Department has already attached Fixed Deposits (FDs) worth Rs 57 crore of the accused fund manager. Needless to say, these have possibly been the proceeds he received from illegal trades. He then used Kolkata-based shell companies to route the unaccounted cash to legit bank accounts of his family members. Besides, the sacked fund manager owns 6 flats in Mumbai, of which two are in the premium Lower Parel area and the remaining four in the flourishing suburban area of Ghatkopar.

Axis Mutual Fund took suo moto action against its former fund managers facing allegations after conducting an internal inquiry.

In response, interestingly, the sacked fund manager cried wolf and slapped a notice on his former employer, i.e. Axis Mutual Fund, for his so-called “unlawful termination”, seeking Rs 54 crore in damages.

At a time when the markets are still to put NSE’s co-location scam completely behind, high-profile front-running cases affecting investors’ interest come as a shocker. A slight extension of what Axis Mutual Fund’s fund managers did would have translated into circular trading and a series of front-running aimed at jacking up prices.

Such episodes of wrongdoing put questions on the adequacy of internal checks and balances. Imagine an instance where officials of a broking company offering Portfolio Management Services (PMS) collude with their counterparts at a mutual fund scheme of the same group AMC. Won’t there be instances of PMS investors (mostly HNIs) benefiting at the expense of mutual fund investors (largely retail investors)?

At worse, how about two fund managers of different fund houses having worked with the same organisation in the past colluding for personal benefits?

SEBI’s final order on the Axis Mutual Fund matter is awaited, but the fact is that story doesn’t end here.

If you remember, the confidence crisis in the system started with investors losing money in debt funds following the IL&FS and DHFL debacles. Later Franklin Templeton Mutual Fund abruptly shut six of its debt schemes, leaving investors in the lurch.

It is possible that there may be many more such skeletons in the closet at the fund houses that have unnoticed, or no one has bothered to show the courage to whistle blow.

Currently, it remains to be seen how diligently mutual fund houses handle the hard-earned money of investors in actively managed equity funds with exposure to Adani Group companies.

Against the backdrop of aforesaid instances, SEBI’s search for forensic auditors to conduct an audit of mutual funds, asset management companies (AMCs), trustee companies and board of trustees, is very welcome and would prove to be in the interests of investors.

Besides, to have an independent review mechanism for the decisions of AMCs from the perspective of unitholders across all products and services, SEBI on February 10, 2023, has proposed “a “Unit Holder Protection Committee (UHPC) should be constituted by the board of AMC.”

Although there are adequate provisions on paper to create a Chinese Wall and ring-fence specific business operations to protect investors’ interest, the firm resolute of SEBI to grill mutual fund houses (whenever necessary) and forming UHPC, suggests that the market regulator wants to pull all the stops out to protect investors. I believe this would bring in more accountability and potentially make the internal control systems at fund houses robust.

As you must be aware, some sections of the media have already started questioning the efficiency of SEBI despite it being, as they call, perhaps the most powerful regulator in the world. But then, the series of scams also highlights the need for further reforms in market surveillance. If the market regulator decides to put all such topics to rest, it might come down very heavily on market participants that it finds playing foul in its planned extensive forensic audit.

At present, while genuine investors and market participants use technology to attain greater speed, accuracy and convenience; devious minds may be exploiting the loopholes in digital systems for making personal gains. With forensic audits and improved surveillance, SEBI will go after all such audacious participants.

But with it, in the coming days, to avoid misdoings, fund houses shall also become stricter with respect to compliance and governance norms, which for you, the investors, would be rather reassuring.

This article first appeared on PersonalFN here