Supreme Court Widens Powers of SEBI – Penalties Now Even More Easier to Levy

Background

The Supreme Court in SEBI vs. Kanaiyalal B
Patel (2017) 85 taxmann.com 267 has held that `front running’ by any person
(and not merely intermediaries as provided by a specific provision) is in
violation of the SEBI Regulations relating to fraud and unfair trade practices.
By holding that SEBI is right in taking penal action against a person who is
`front running’, the Supreme Court has increased the penal powers of SEBI even
where the letter of the law is found wanting. However, the reasons given by the
Court have created a precedent that will have far reaching implications. It extends
the scope of `front running’ to almost every case of tipping. It makes it easy
to levy penalties with a lesser level of proof. It also broadens the definition
of ‘fraud’ to include even cases where there is no deceit. It would allow SEBI
to act even when there is a private
wrong between two parties and even if public/securities markets are not
affected. Finally, the Supreme Court holds that proving mens rea is
not required for levy of penalty in case of fraud.

Some parts of this ruling make it easier for
SEBI to take action against persons who indulge in fraudulent acts which are
not covered by the strict letter of the law. The decision makes the law
dynamic. Some parts of the judgement cover acts that shouldn’t at all be the
business of SEBI even if the actions were wrong. Finally, some parts of the
ruling overly broaden the scope of the law to convert some actions which are
neither wrong nor irregular into an offence. Instead of actually reading down
certain overly broad wordings of the Regulations, the ruling takes them
literally, it is respectfully submitted, that this creates absurd results.
Hence, this decision has far reaching effect beyond the specific offence of
`front running.’

What is front running?

`Front running’ is recently being found to be
a common practice in the securities market, considering that several cases have
been detected. Essentially, it is abusing of trust/confidence placed usually in
a market intermediary by a client, but it can happen in another context too.
`Front running’ is not only not defined – but the term is not even used in the
Regulations/Act. The Supreme Court has cited several definitions. Taking the
example of a stock broker, the gist of the definition is :

–   A client may place an order for a large
quantity of shares with a stock broker. The stock broker knows that as soon as
he places this large order, the market price will move up. To profit from this,
at the cost of his client and hence unethically, he would place the order of an
identical or lesser quantity of shares for himself (or he may tip some
friend/relative to do so). The price of the share would rise. He then would
place the order in the name of his client and simultaneously offer for sale at
the higher price the shares he had earlier bought. The result would be that he
would make a profit from the difference and his client would end up paying a
higher price. He may act similarly in case of a large order of sale.

–    There can be variants as was seen in the
cases in appeal before the Supreme Court. There may be a mutual fund
intermediary who seeks to buy a large quantity of shares and the employee who
is authorised to place such an order, tips off a friend/relative. A portfolio
manager may seek to buy and the manager/employee may do the same. Indeed, even
an employee of the client who is planning to buy such number of shares may do a
similar act.

In each of such cases, it is seen that the
person goes in front of such order and places his orders first. Hence the term
?front running.’

Background of the decision – front
running – law, SEBI and SAT decisions and amendments

The decision of the Supreme Court is in
appeal against five decisions of the Hon’ble Securities Appellate Tribunal (“SAT”)
in relation to `front running.’ In each of these cases, certain persons got
tipped off of large orders in shares. They thus bought ahead of such orders
(hence the term ‘front running’) and sold when these large orders actually
materialised, making a handsome profit. In each of these cases, SEBI had taken
penal action against persons found guilty of `front running.’ In the earlier
two of these cases, SAT held the SEBI Regulations applied only when an
intermediary did such front running ahead of its client’s large orders, not
when a person tipped off by an intermediary’s employee and did front running
ahead of the intermediary & its client’s large orders. The reasoning
offered was that the relevant regulation – 4(2)(q) of the SEBI (Prohibition of
Fraudulent and Unfair Trade Practices relating to Securities Market)
Regulations, 2003 (“the Regulations”) – applied only to intermediaries and not
to others. The principle applied was “expressio unius est exclusio
alterius”, i.e., when something specific is expressly mentioned, others in
the same class are excluded.

In later decisions, however, the SAT took a
different view. It held that the general provisions in the Regulations relating
to fraud were wide enough to cover front running even by non-intermediaries.

In the meantime, SEBI amended Regulation 4.
As noted earlier, Regulation 4(2)(q) treated front running by intermediaries as
a specific case of fraud prohibited by the Regulations. Some other clauses in
this Regulation too applied only to intermediaries. Apparently, to overcome
this, an explanation was introduced in 2013 to this Regulation which was stated
to be clarificatory and which, for this context, effectively said that the
clauses were not restricted to acts of intermediaries. The intention of the
amendment also appears to give it a retrospective effect and thus would apply
even to past cases including the ones decided by SAT.

Apart from the technical issue of whether the
specific provision that prohibits `front running’ only by intermediaries, there
was another issue involved.  The tipping
by an unregistered intermediary (and other parties) or its employee to an
outsider which results in front running does not necessarily mean that the
capital markets or the public are thereby harmed. The harm is caused to the
intermediary privately and/or its clients. To take an example, say a closely
held company seeks to place a large order of purchase  of 
shares  in  a particular company. An employee of the
buyer company tips a friend who then buys the shares and then sells the shares
to the buyer company at a higher price. Now in this case, the company ends up
paying a higher price, but the public who sells shares to the friend do not
lose since they would have otherwise sold the shares directly to the company at
the same price. Hence the loss is caused only to the company, by paying a
higher price, then it is arguable that the interests of the public/capital
markets are not affected. Indeed, it is also arguable that even if the orders
were placed on behalf of a client, the harm is caused by the intermediary to
the client and thus, the intermediary may need to compensate the client and
also otherwise face action for allowing such things to happen. The question
thus is whether wrongs that are private between parties and not affecting the
public/capital markets should be dealt with by SEBI?

Decision of the Supreme Court

The Supreme Court thus essentially had to
face certain basic questions. First question is, whether the specific
provisions relating to front running by intermediaries meant that front running
by others were not prohibited by the Regulations? Or were the general
provisions relating to fraud were wide enough to cover all types of front
running. The Court held that the rule that specific excludes the general does
not apply here. Several other issues were raised which were answered and also
certain reasoning and ruling of law/interpretation were provided which need
consideration.

The Court (reading together the separate
judgement of each of the two Hon’ble Judges) effectively held as follows:-

1. The definition of fraud is very wide. It includes every act
that induces another person to deal in shares.
Importantly, it is not necessary that such inducement should be with a
malafide intention of deceit or the like.

2. The act whereby the
tippee engages in front running is in breach of the understanding and law
relating to confidentiality of information and thus is an act that is violative
of the Regulations.

3. The general provisions of
Regulation 3 are wide enough to cover front running. Effectively, it is thus
not necessary to refer to Regulation 4 that refers to front running by
intermediaries.

Note: In
the author’s view, taking the ruling to its logical end, the specific
provisions relating to front running by intermediaries become redundant!

4. The Court held that
proving mens rea – guilty mind – is not necessary. It is sufficient if
the violation is proved by preponderance of probabilities and not beyond
reasonable doubt.

Note: This observation
lowers the bar of proof required to find a person guilty and subject to penal
action.

5. Any tipping by a
person to another is in violation of the Regulations. Effectively, this would
thus include
insider trading where insiders share unpublished price sensitive information
with third parties. `Front running’ thus is one of the types of such irregular
tipping.

Note:
This again may result in many provisions of the SEBI Regulations relating to
Insider Trading being redundant. This would extend the provisions of the
Regulations beyond what is expressly provided in the regulations.

Implications

As stated earlier,  we 
now  have a  broad and 
widely interpreted definition of fraud by the Supreme Court that gives
SEBI wider powers to catch and punish persons who directly or indirectly take
advantage of the securities markets. However, we have an earlier decision of
the Supreme Court in Shriram Mutual Fund ((2006) 131 Comp Cas 591 (SC)) that
has resulted in SEBI taking a view that penalty has to automatically follow
every violation. This decision goes many steps ahead and even effectively
endorses poorly drafted law, albeit mentioning in passing that current law
needs an overhaul. While one can hope that SEBI will not apply in practice the
definition of fraud which says deceit is not required. One also hopes that SEBI
exercises restraint whilst despite the wider powers provided by the Court.
However, it still remains an area of concern since parties will find it
difficult to meet allegations, which are not serious and will suffer larger
amounts of penalty, etc. whether before SEBI or even in appeal before
SAT. It is humbly submitted that this decision needs reconsideration. _