Liability of Stock Brokers for clients’ frauds – Supreme Court Decides

Nevertheless, brokers
are routinely proceeded against. Their defences are often ignored or
dealt with as per varying/subjective standards. The fact that
allegations of frauds are serious in nature and hence require a higher
degree of proof is not fully appreciated. This is not of course to say
that brokers are necessarily and always innocent.

In this light,
a recent decision of the Supreme Court (SEBI vs.Kishore R. Ajmera
[2016] 66 taxmann.com 288 (SC)) is very helpful. It lays down several
parameters and guidelines as to how the role of the stock brokers would
be determined in such cases.

Before we discuss the relevant
facts of the case and the decision of the Court, it is worth
understanding some concepts involved here.

Basic concepts
The
following paragraphs discuss briefly some of the concepts relevant to
such frauds/manipulation. The background is that certain parties carry
out pre-determined trades on the stock exchange through the electronic
trading mechanism. Such automated mechanism does have some safeguards.
However, determined and coordinated efforts by a group of persons can
easily override them, particularly if the shares are relatively
illiquid. The objective of such efforts may be several but they usually
involve manipulation of price, volumes, etc. of the shares/securities
and thus present an artificial/fake impression of what is happening in
the stock market. In essence, the normal market mechanism of
price/volume determination is tampered with for various purposes.

Opaque electronic Stock Exchange mechanism
The
electronic stock market trading mechanism is opaque. This means that
the buyer does not know who is the seller or how many sellers are there,
and vice versa. He punches in his order, and the mechanism matches his
order with the best orders presently available from any person spanning
across the country. He may end up buying from several sellers or just
one. He may end up buying at several prices too, but obviously not
exceeding the price that he has keyed in. The defence of a person
accused of price manipulation is usually that he does not know, cannot
know, and in any case cannot control, who the counter party is.

Synchronized dealing
While
stock market trading mechanism is opaque, it is still possible for
determined persons to override this system. They ensure that in terms of
price, volume and timing, their trades are matched. Two or more parties
enter orders simultaneously by prior coordination at such price and
volumes and at such time that usually the whole or most of their trades
match. Person A may enter an order to buy 10000 shares at Rs. 31.30
which person B at the same time enters an order to sell at same price
and of same quantity. Unless the shares are quite liquid, their orders
will wholly or substantially match.

Price/volume manipulation
Usually
the objective of such exercise is to manipulate the price or volumes of
the shares in such a way that an artificial picture is shown. The
parties may carry out such synchronized trading to, say, progressively
increase the price of the shares. The parties may also carry out
continuous trading amongst themselves whereby a fake picture arises that
the stock is quite liquid. The public gets a wrong picture and may end
up participating, and may incur a loss.

No transfer of beneficial interest in securities
The
essential feature of such acts is that, on the whole, there is no
transfer of beneficial interest in securities outside the group. The
group may start with a certain quantity of shares and finally end up
with the same or nearly the same quantity of shares. The whole objective
is to circulate these shares amongst themselves. Of course, at certain
stages, the shares actually move within the group. For this reason,
trading without transfer of beneficial interest in shares is
specifically considered to be a fraudulent/manipulative act under
certain circumstances.

Facts of the case
The decision
gives a common ruling for appeals in matter of several stock/sub
brokers accused of price manipulation/ fraud and/or violation of Code of
Conduct applicable to them, on account of acts of their clients. In
each of such case, it appears that price manipulation/fraud was indeed
carried out. The question to be answered was how would the role of the
brokers be determined? The Court lays down certain guiding factors.
Thereafter, it applied such factors to the facts of each case and
determined the role of each broker.

The various levels of liability of brokers as determined by Court and tests therefor
The Court essentially laid down various levels of liability of brokers, which have been summarised as follows.

Firstly,
the Court divided the liability under law in two parts. First concerned
a civil liability that could result in a monetary penalty, suspension,
etc. on the broker. The second concerned a criminal liability that would
result in prosecution. The criteria to determine whether broker was
guilty would differ depending on whether the proceedings were civil or
criminal. Further, the allegation may be of having violated the Code of
Conduct whereby the broker may not have exercised due diligence/been
negligent. The allegation may also be of the broker having deliberately
allowed such trading for earning brokerage. Finally, the allegation may
be of having been actively involved in such price manipulation.

For
criminal proceedings, the Court observed that, “Prosecution u/s. 24 of
the Act for violation of the provisions of any of the Regulations, of
course, has to be on the basis of proof beyond reasonable doubt.”
(emphasis supplied).

For civil proceedings, the Court observed,
“While the screen based trading system keeps the identity of the parties
anonymous it will be too naive to rest the final conclusions on said
basis which overlooks a meeting of minds elsewhere. Direct proof of such
meeting of minds elsewhere would rarely be forthcoming. The test, in
our considered view, is one of preponderance of probabilities so far as
adjudication of civil liability arising out of violation of the Act or
the provisions of the Regulations framed thereunder is concerned”.

To determine what, if at all, the role of the broker was, the Court laid down the following factors:-

“The
conclusion has to be gathered from various circumstances like that
volume of the trade effected; the period of persistence in trading in
the particular scrip; the particulars of the buy and sell orders,
namely, the volume thereof; the proximity of time between the two and
such other relevant factors. The fact that the broker himself has
initiated the sale of a particular quantity of the scrip on any
particular day and at the end of the day approximately equal number of
the same scrip has come back to him; that trading has gone on without
settlement of accounts i.e. without any payment and the volume of
trading in the illiquid scrips, all, should raise a serious doubt in a
reasonable man as to whether the trades are genuine. The failure of the
brokers/sub-brokers to alert themselves to this minimum requirement and
their persistence in trading in the particular scrip either over a long
period of time or in respect of huge volumes thereof, in our considered
view, would not only disclose negligence and lack of due care and
caution but would also demonstrate a deliberate intention to indulge in
trading beyond the forbidden limits thereby attracting the provisions of
the FUTP Regulations. The difference between violation of the Code of
Conduct Regulations and the FUTP Regulations would depend on the extent
of the persistence on the part of the broker in indulging with
transactions of the kind that has occurred in the present cases. Upto an
extent such conduct on the part of the brokers/sub-brokers can be
attributed to negligence occasioned by lack of due care and caution.
Beyond the same, persistent trading would show a deliberate intention to
play the market. The dividing line has to be drawn on the basis of the
volume of the transactions and the period of time that the same were
indulged in. In the present cases it is clear from all these surrounding
facts and circumstances that there has been transgressions by the
respondents beyond the permissible dividing line between negligence and
deliberate intention.”

It can be seen that, the Court also
highlighted a difference between liability of negligence / lack of due
care and caution under the Code of Conduct and liability for frauds/
manipulation under the Regulations.

The type of evidence to be gathered by SEBI to determine liability of the broker
The
Court then discussed the type of facts that SEBI would have to gather
and place on record to determine the liability and nature thereof of the
broker. As discussed above, where proceedings are civil in nature and
also considering that liability has to be determined by preponderance of
factors, direct proof may not be available nor needed. The Court
observed:-

“It is a fundamental principle of law that proof of
an allegation levelled against a person may be in the form of direct
substantive evidence or, as in many cases, such proof may have to be
inferred by a logical process of reasoning from the totality of the
attending facts and circumstances surrounding the allegations/charges
made and levelled. While direct evidence is a more certain basis to come
to a conclusion, yet, in the absence thereof the Courts cannot be
helpless. It is the judicial duty to take note of the immediate and
proximate facts and circumstances surrounding the events on which the
charges/allegations are founded and to reach what would appear to the
Court to be a reasonable conclusion therefrom. The test would always be
that what inferential process that a reasonable/ prudent man would adopt
to arrive at a conclusion.” (emphasis supplied).

Finally, the
Court laid down the following specific facts as relevant to determine
the liability of broker in each case. Whether the scrip was illiquid? It
has to be considered whether “the scrips in which trading had been done
were of illiquid scrips meaning thereby that such scrips were not
actively traded in the Bombay Stock Exchange and, therefore, was not a
matter of everyday buy and sell transactions. While it is correct that
trading in such illiquid scrips is per se not impermissible, yet,
voluminous trading over a period of time in such scrips is a fact that
should attract the attention of a vigilant trader engaged/engaging in
such trades.” Whether the Stock Exchange has issued any caution in
regard to the dealing in the scrip? Dealing in such scrips thus needs
greater attention by the broker.

Whether the clients who deal
through the broker know each other and such fact is known to the broker?
If such clients deal with each other through the broker, that should
surely attract concern from the broker. Whether the volumes in illiquid
scrips was huge, as was found in a case?

Whether the gap in time
of matching of the trades was too short (between 0-60 seconds in the
case before the Court)? Whether such trades were very frequent?

It
also emphasised that while the point relating to opaque screen trading
was relevant, this does not always rule out manipuation/frauds where
offline prior meeting of minds could be demonstrated by other factors.

Decision of the Supreme Court
The
Court applied the guiding factors to the facts of each case and
depending on individual facts, it either confirmed the adverse action
against the broker or set it aside.

Conclusion
This
decision should help make the law clearer and should be also helpful to
brokers in laying down systems and procedures to ensure that
frauds/manipulations by their clients do not take place and make them
liable for negligence or otherwise. Decisions by SEBI and the Securities
Appellate Tribunal will also thus become consistent and based on
certain pre-decided specific factors.