Front-running is the illegal use of advance information leaked to brokers by mutual fund staff. Tips on impending purchases give the trader an advantage over others and is a sure-shot way to make big money (see graphic). Leveraged buying can yield even bigger gains. But this game is not as easy as it may sound.
The dealing rooms of mutual funds and brokerages are high security areas with strict confidentiality rules. Dealers aren’t allowed to carry personal phones and must use recorded phone lines. In the past two years, these rules have got diluted due to work-from-home. Also, the stringent rules cannot stop an individual from leaking the information after office hours. So, although fund houses and market regulator Sebi keep a tight watch, the human element in the equation means they can’t completely stop front-running.
Though front-running works well in the mid-cap and small-cap stocks, it does not yield too much in the large-cap segment. If a mutual fund places a large purchase order of Rs.20-30 crore, it can make a big difference in the price of a stock with a market cap of Rs.2,000-3,000 crore. But a large-cap stock with a market cap of Rs.50,000-60,000 crore may not get affected. At the same time, some momentous development like the merger announcement of and can make even large-caps zoom. Derivative buyers would have made a killing the day the merger news came out. That the move was kept a closely guarded secret is an indicator of the corporate governance norms followed by the HDFC group.
While front-running is both unethical and illegal, it does not really hurt the common investor in stocks and mutual funds. Yes, the advance information is very potent and brokers have made millions using this illegal market practice. In 2019, two entities coughed up Rs.10 crore to settle a front-running case.
However, purchases by front-running racketeers are not big enough to make a difference to the stock price. The front-runners make big money, but not at the expense of mutual fund investors. Sellers from whom the front-runners buy are possibly the only ones who lose out. They are not aware that a large purchase order will push up the stock the next day.
Hall of Shame
Front-running, insider trading and stock price manipulation–instances of malpractices are common in the investment world. Here are some recent cases:
Two fund managers of Axis Mutual Fund—Viresh Joshi and Deepak Agarwal—were suspended after an investigation by the fund house. They allegedly shared information about investment decisions with brokers in Gujarat in return for kickbacks. The two had assets disproportionate to their known income. Sebi is still investigating.
Deutsche Mutual Fund fund manager Akash Singhania and his parents paid Rs.5 crore to settle a case of alleged front-running. As the fund manager of Deutsche Mutual Fund, Singhania had knowledge of impending orders of the fund house. He opened four trading accounts in the names of his parents—Ashok Kumar Singhania and Premlata Singhania—who bought the scrips before the fund house placed orders and sold them when prices rose. Sebi says they made more than Rs.1.4 crore profits.
Just before Franklin Templeton shut its six debt mutual funds on 23 April 2020, some senior functionaries and their relatives reportedly redeemed almost Rs.30 crore worth of investments in the troubled schemes. Sebi termed this as misuse of non-public information and imposed a cumulative penalty of Rs.7 crore on Franklin Templeton director Vivek Kudva, his wife Roopa Kudva, and other relatives. The Kudvas have challenged the Sebi order.
Sebi barred three individuals from accessing the capital market for running a front running racket. Rakesh Shah, a dealer with
Mutual Fund, Anita Shyam Mhatre, who had a trading account, and Sanjay Parekh, a dealer with a brokerage firm Anugrah Stock & Broking teamed up to run the racket. As a dealer with Reliance Capital Mutual Fund, Shah knew about impending large trades. He passed that information to Parekh, who used Mhatre’s trading account to purchase securities. The three made around Rs.8.87 lakh in profits.
TV anchor Hemant Ghai, his wife and his mother were barred from accessing the capital markets after Sebi found them guilty of price manipulation. Ghai used to recommend scrips in his TV show. He had opened trading accounts in the name of his wife and mother. The shares were bought one day before the recommendations were made and sold when the stock price went up after the show. According to Sebi, Ghai made an estimated Rs.2.95 crore this way.
Four entities were fined Rs.2 crore for front running at HDFC Mutual Fund. The equity dealer of the fund house, Nilesh Kapadia used to tip off Dharmesh Shah about impending orders at HDFC Mutual Fund. Both were fined Rs.50 lakh each, while brokerage firm
& Investments was fined Rs.60 lakh and Ashok Nayak was fined Rs.40 lakh. The four were also barred from the capital markets. Sebi estimated they made Rs.1.75 crore from front running.