The regulator's case against the star fund manager may not be as strong as SEBI, India’s securities regulator would have us believe.
Article previously published in the BNA International publication World Investment Regulation Review Vol 2, Number 9.
The Securities and Exchange Board of India (Sebi) passed an interim order on August 9, 2003, debarring Samir Arora, the chief investment officer of Alliance Asset Management Company in India, from participating in the securities markets.
Another order, passed on September 24, 2003, confirmed the first one, resulting in the continuance of Arora's bar from the securities industry until further orders.
The order is based on several erroneous applications of the law, and is not logically consistent. At best, it does nothing for the markets in terms of setting the regulatory tone and, at worst, penalises Arora's superstardom rather than a wrongdoing.
The first order was riddled with inconsistencies and failed to fully state the facts. The second one fills in some of the gaps in the logic and facts of the first order but still falls short of proving its case emphatically. This piece critically analyses the salient parts of the order.
Facts: Sale of AMC
Alliance Capital Management, United States (Alliance, United States) owns an asset management company (AMC) in India which manages mutual fund schemes.
Alliance, United States, sought to sell its Indian AMC by an offer to select bidders.
Samir Arora, the fund manager of the AMC, told the management that he would continue working with the AMC only if it were bought by one Henderson Global Investors. Arora had a contract with Henderson for a substantial equity stake in the proposed entity.
AUM erosion Vs NAV erosion
According to the regulator this proposal created panic in the markets and the assets under management (AUM) of the AMC fell, enabling the Henderson/Arora group to acquire the company at a discount to the original market value.
The first hole in the argument of the regulator is equating the AUM with the net asset value (NAV) of the fund. The order seems to suggest that unitholders of the mutual fund are somehow hurt by large-scale redemptions.
Nothing could be farther from the truth. People liquidated their units of various schemes because of the value they put in the brand equity of its fund managers.
Thus instead of staying invested in Alliance, they chose to liquidate their investment at the then current NAV. It is likely that they put the money in some other equity scheme.
This view was, in fact, empirically supported for several days after the episode when, despite the negative news and the fact that the fund saw above normal redemptions, NAVs of Alliance Capital schemes did not show any significant erosion.
In the absence of an erosion of the NAVs of the mutual fund units not related to market movements, a fall in the AUM cannot be termed as hurting interest of the unitholders.
This reasoning seeps into other aspects of the ruling, too.
For instance the order states: "It was the paramount responsibility of Shri Samir Arora to enhance the AUM of the mutual fund for the benefit of unitholders. However, in contrast, in his role as a bidder, his interest would have been to acquire the fund at the cheapest possible price. From the subsequent events it is observed that by his actions/inactions, Shri Samir C Arora has let the AUM fall, knowing that the valuation of the AMC depends on the AUM, so as to achieve his selfish objective of acquiring the fund along with Henderson at a lesser price and, in the process, he has compromised his position of fiduciary responsibility with unitholders and the sponsor".
It is certainly not the job of the fund manager to increase the size of the AUM. His job is to increase the value of the assets that are given to him to manage.
It is also not possible for unitholders to get any advantage out of a larger AUM (if at all the converse is usually true). Thus the argument that the AUM of the MF affects the AMC's value is correct but the converse does not hold - that a larger value of the AUM would result in any benefit to the unitholders.
In the order, the NAV movement is compared with two high performing mutual funds during the same period.
However, the correct comparison would be with the index and also with, say, a set of 20 or 30 mutual funds with a similar composition. To call the returns abnormal the same should fall outside at least 95 per cent of such funds.
A cursory look at the benchmark shows negative returns for the index in the December 2002 to January 2003 period. Absent a more scientific analysis, the conclusion of Sebi cannot be sustained.
Conflict of interest
The order goes on to quantify the gain that Arora would make with the deal and calls him 'selfish' and acting in self-interest. Now, with due respect to the regulator, it is not per se illegal to be selfish.
Is Arora expected to say "no, thank you, but to preserve the market integrity I will not change my job".
Well that is the crux of the weakness of the order. Not only is the order violative of basic rights of a person's choice of employment, it also goes against the grain of the Indian Contract Act which prohibits fetters on a person's choice of profession.
It is no secret that the value of a fund management company is often a function of the value of its managers and analysts. And Arora, like any other employee, is trying to make the best deal he can for himself.
Unfortunately for him, the reason of his popularity is also a reason for people associating success with his funds (however unreasonable or wrong that might be of the investors).
It is improper for the regulator to limit the rights of a fund manger from changing his job. Not every conflict of interest is prohibited by law.
The order finds that one of the bidders quoted $42-50 million while the Henderson/Arora group made a bid for $30-33 million. Here the order mixes up the mutual fund with the AMC. It was the AMC which was up for sale. Whether it gets a fair price or not is for the seller to determine.
The AMC is a subsidiary of the American company and its sale has no impact on the unitholders of the mutual fund.
Whether the price was adequate or not is purely a contractual issue between Alliance, United States, and the bidders. Being privately held, the sale of the AMC has no public interest element or any impact on the mutual fund.
The order also makes some observations of 'insider trading' by Arora. There are damaging findings of Arora making a positive public statement about Digital GlobalSoft and then, within a week, of his liquidating the entire shareholding in the company on behalf of all the funds under him.
Unfortunately, there is no factual enquiry reflected by the order, no phone records, no meetings with insiders and no basis for stating that he entered into prohibited trades after getting inside information.
Based on circumstantial evidence alone, the regulator has brought charges of insider trading. Whether this form of circumstantial evidence will suffice to stick charges remains to be seen.
Lastly, the order holds Arora responsible for not making takeover code and insider regulation disclosures (similar to the Schedule 13F disclosures in the United States).
These are, of course, quantifiable wrongs and the fact that purchases and sales were made without the correct disclosures for crossing acquisition limits would ipso facto create a wrongdoing without any further proof though there is no resultant takeover code and insider trading violation (only a disclosure violation).
Here again there is an infirmity in the order. The order is directed against Arora who is only an investment officer. Such a violation is appropriately directed against the company and the mutual fund trustees who have committed the wrong.
The apportionment of the blame would probably fall on the head of the compliance department of the company or such other officers who are entrusted with the job and only incidentally on the investment managers.
While the previous order placed no blame on the company and the mutual fund's board of trustees, the recent order recognises the role and responsibilities of the company and trustees in the violations.
A part of the blame, of course, falls on Arora because it seems that he was the only person who knew the collective holding of various mutual funds (including other funds) and the violations arose only on an aggregate basis.
Of course, it is the job of the compliance officer to find out all collective holdings in a company by the AMC and its group companies.
The failure highlights the need of respectable Indian mutual funds and financial institutions to have internal controls in place.
Other funds and financial institutions should take this as a cue not only to improve internal audit but also to introduce something necessary, though alien, to the Indian financial industry: a periodic annual legal audit by an outside law firm.
It is likely that the order would not stand up to the scrutiny of the often critical Securities Appellate Tribunal which is the appellate body.
And absent a very tangible proof of insider trading, not much of the blame will survive against Arora. What case there might be against the company is a different issue altogether.
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