By Jayant M. Thakur
Chartered Accountant
Front running is a serious problem in capital
markets. It is very similar to, and as serious as, insider trading. But unlike
insider trading, which has a full-fledged law devoted to it that makes it
easier for SEBI to prosecute wrong-doers, front running has to be established
by a long and arduous procedure. The difficulty was compounded till now because
whether front running was a prohibited practice or not was itself questioned in
law till the Supreme Court ([2017] 144 SCL 5 {SC}) and an
amendment to the law settled it. Fortunately, as a recent case (order dated 4th
December, 2019 in the matter of various entities of Fidelity Group)
demonstrates, SEBI has shown creativity and initiative in the matter to
establish front running by persons and then taken fairly quick action.
WHAT IS FRONT RUNNING?
Front running, as the term may indicate, is similar to a person running
in front of you to take unethical and illegal advantage of you; for example,
you ask your assistant to buy 1,00,000 shares of X company for you. Now, it is
known that buying such a large quantity of shares at one stroke could result in
an increase in the price of such shares. So your assistant is tempted to first
buy shares for himself in his own name or in the names of nominees / friends.
Thereafter, he starts buying shares for you while he or his nominees / friends
are selling shares. Thus, he has bought shares at a lower price and he will
sell you shares at the higher ruling price after his purchases. So you
end up in a loss since you paid a higher price for your shares. The same thing
could happen if you wanted to sell a large quantity of shares, except that the
trades would be opposite.
Such unethical and dishonest practices could be carried out not just by
one’s office staff, but even by one’s stock brokers. Or, as in the present case
as discussed in detail later, by authorised traders in mutual funds. In such
cases, the investors in such funds end up bearing the loss. SEBI has, even if
by fits and starts, been increasingly taking action against such front runners
and has progressively amended the law.
HOW ARE FRONT RUNNING AND INSIDER TRADING SIMILAR?
Both involve some confidential information that a person has and that is
given generally on trust to a deputed person. Such information in both cases is
valuable in the sense that such a person can exploit it for his own illicit /
unethical profit at the expense of the other.
An insider, for example, may be a Chief Financial Officer of a company.
He may have access to the latest financial performance of his employer company
that has not yet been made public. If such results are very positive, he may
buy shares before disclosure of the results and then sell when the price rises.
This in a sense causes loss to those people who were deprived of the
information and also leads to loss of credibility of the company and the stock
markets in general.
A front runner may well be a stock broker. A client comes to him and
places an order for a significant quantity of shares which will almost
certainly move the price in a particular direction. The stock broker exploits
this order information and places an order for himself first. Then, while he is
executing the client’s order, places a counter order for himself. The client
ends up suffering a loss.
HOW ARE FRONT RUNNING AND INSIDER TRADING LAWS DIFFERENT?
Firstly, there is a separate and comprehensive set of regulations
dealing with insider trading. The SEBI Act too has specific provisions dealing
with it. Insider trading and even front running are both notoriously difficult
to establish. However, the Insider Trading Regulations are fairly detailed and
have several deeming provisions to help establish the guilt. These provisions
may result in a whole group of persons to be deemed as insiders. Certain types
of information are deemed to be price-sensitive. Many other presumptions, some
rebuttable, are also made.
In comparison, till recently front running was not technically even an
offence, unless it was by intermediaries. Thus, for example, there were two
views on whether an employee of a mutual fund who trades ahead of orders of
mutual funds could be said to have engaged in front running. The Supreme Court,
however, finally held that even that was front running. But front running still
does not have the helpful deeming provisions as do insider trading related
regulations. Hence, the already difficult task of proving such cases is made
even more difficult.
So, in this context, the latest order of SEBI is worth a read. The fact
that SEBI used market intelligence and some out-of the-box methods to establish
guilt makes the order even more interesting.
BRIEF FACTS OF THE CASE
The discussion here is academic and hence is on the presumption that the
findings of SEBI are correct. It is possible that these prima facie
findings may be wrong as it is only an interim order and the parties may
provide evidence to the contrary which may result in the SEBI order being
modified.
The case presents a typical scenario of front running. There were
certain funds belonging to the ‘Fidelity Group’ that dealt in shares. The
relevant dealings were, as expected, in large quantities. And there was this ‘trader’
who placed orders on behalf of the mutual fund with brokerage houses.
SEBI has stated that this trader had two relatives
– his mother and his sister – and the three engaged in front running in
concert. How SEBI found out about this relation is an interesting aspect that
is dealt with separately. SEBI found that these relatives made significant
trades that were similar to the orders placed by the fund through the trader.
The trades by these relatives preceded those of the mutual fund and when the fund
itself placed the orders, the relatives reversed their trades. Thus, to
illustrate, if shares of Company A were to be purchased by the fund, the
relatives purchased shares of A before the fund placed its order, and on the
same day. When the orders of purchase for the fund were placed, the relatives
sold the shares they had purchased earlier. In a short span of a few hours, the
relatives made substantial profits. This was repeated over a period of time and
in case of several scrips.
It was also found that trading / bank accounts of these relatives were
opened shortly before such trading. Further investigation found that trades
also took place online through IP addresses located in Hong Kong where the
trader was stationed.
Thus, by what clearly appears to be intelligent information gathering,
SEBI noticed these transactions. SEBI held that this was front running.
USE OF MATRIMONIAL SITES AND INTERNET TO ESTABLISH THE RELATIONS BETWEEN
THE PARTIES
SEBI has in the past, to check for possible
connections, used social media like Facebook. Social media and many
internet-based social sites can provide possible clues to relations between
parties. These may include being ‘friends’ or ‘relatives’ as per the personal
profiles of persons. Even interactions in the form of reactions on posts /
comments could provide some preliminary basis for further investigation.
In this case, a question arose about what was the
relation between the employee of the mutual fund who placed the orders and the
two persons who traded apparently ahead of such orders and made substantial
profits. SEBI checked a matrimonial site for the profile of the trader and
found that he had effectively mentioned one of the persons as his mother. The
surname of these three persons was also the same. SEBI further investigated
using PAN card, KYC, bank account and other details of the persons and held
that the two persons were the mother / sister of the trader. SEBI accordingly
concluded for the purposes of its interim order that they were related.
This investigative method may be used increasingly
in future. Countless people are on social media and similar sites, and interact
actively there, put up their profiles, etc. Such profiles of course have varying
degrees of ‘privacy’ and particularly ‘public’ profiles (i.e., those that can
be seen by any person) are easy to investigate. The law relating to accessing
private information is developing and can be an interesting study by itself.
But it is clear that this does provide an opportunity for establishing
connections and gathering information. The connection between parties is
relevant not just for front running or insider trading but even for other
matters in securities laws such as price manipulation, takeovers and other
cases where parties are connected in their actions without formal agreements.
FINDINGS OF SEBI
SEBI compared the trades of the funds (through the trader) and his two
relatives and their timings, prices and whether they reversed in a synchronised
manner. SEBI held that the trades were connected and there was no explanation
other than that this was on account of front running.
It also found other factors which supported this, such as financial
transactions between the parties, the timing of opening of broker / demat accounts by these relatives, etc. SEBI accordingly
held, by its interim order, that this was a case of front running in violation of the relevant regulations.
ORDER / DIRECTIONS BY SEBI
SEBI issued several directions through the interim order. It directed
the parties to deposit in an escrow account the profits of Rs. 1.86 crores made
through this alleged front running. Such a direction to deposit the profits is
usually a prelude to a final order of disgorgement – i.e., forfeiting such
profits, usually also asking for interest. SEBI also directed banks and demat
authorities of the parties to not allow any transactions till the amount was
deposited. They have also been debarred from dealing in, or being associated
with, the stock markets.
SEBI has given an opportunity to the parties to present their case
before it against these interim directions. If the offence is proved, it is
possible that the parties may face further penal action that could include
debarment, a financial penalty and a final order of disgorgement of the profits
with interest.
CONCLUSIONS
This order is a good example of how SEBI has tried to overcome the
problems of gathering information and evidence for difficult-to-establish
offences of front running and thus even insider trading.
Use of internet and social media for investigation and evidence is,
however, a double-edged sword. It does give prima facie clues for
further investigation. But social media connections can be misleading. People
may have thousands of ‘friends’ or followers, who are often made by merely
clicking a button once on a webpage. Many of them may be total strangers.
Information uploaded on such pages may be unreliable and even false, and in any
case not authenticated sufficiently to be usable for legal action. However, as
in the present case, it can provide clues to investigate further. The challenge
would be to access private profiles and this would require a careful balance
between the need for privacy and the needs of public interest.
Front running arises out of the classic conflict of loyalty / duty and
greed. There are endless opportunities for persons in organisations or for
organisations themselves to illicitly profit from persons who place trust in
them. It would not be surprising if there are numerous such cases. They cause
losses to investors and harm the credibility of both the intermediaries and the
stock markets. If more are being detected and caught, it is good news.
However, it is submitted that the law relating to front running should
be made more comprehensive.
