By Jayant M. Thakur
Chartered Accountant
BACKGROUND
A recent order
of SEBI (dated 7th August, 2020 in the matter of dealers of Reliance
Securities Limited) on front-running is noteworthy on several grounds. Firstly,
it has been rendered in less than four months after the alleged front-running
took place. The transactions in question took place from December, 2019 to
April, 2020; SEBI completed the preliminary examination which, as we shall see,
involved numerous aspects and passed its order on 7th August, 2020.
Secondly, as the
order shows, a lot of detailed detective work has been carried out wherein the
alleged connections between more than 25 parties have been detected and
demonstrated. The connections are in various ways. They are through
transactions in bank accounts, they are through calls made to each other, there
are social media connections and also through family relations between the
parties concerned. SEBI then passed an interim order banning from the capital
markets the parties allegedly involved in the front-running and also ordered
them to deposit the profits made until a final order has been passed.
Front-running
cases, like insider trading, are notoriously difficult to detect. Investigation
and demonstration of guilt is even tougher. In view of this, the meticulously
detailed order at a preliminary stage is credit-worthy.
This order is in
the matter of certain dealers of Reliance Securities Limited in respect of
transactions by Reliance in their capacity as stockbrokers for Tata Absolute
Return Fund, a scheme of Tata AIF, a SEBI-registered Alternate Investment Fund
(‘Tata Fund’). The interim order finds these parties, along with various
associated persons, to have been involved in front-running and allegedly making
profits by trading ahead of the large orders of Tata Fund.
WHAT IS FRONT-RUNNING?
There have been
several cases of front-running in the past and in respect of which SEBI has
passed orders. However, earlier what amounted to front-running and even whether
it was a violation of securities laws, was in question. Indeed, the Securities
Appellate Tribunal had even held that front–running did not amount to violation
of the securities laws then existing [e.g., Dipak Patel (2012) 116 SCL
581 (SAT)], [Sujit Karkera (2013) 118 SCL 84 (SAT)]. However, the
Supreme Court decision in the case of SEBI vs. Kanaiyalal Baldeobhai Patel
[(2018) 207 Comp Cas 416 (SC)] laid the matter more or less to rest and
held that it was a violation of specified provisions of the securities laws.
Further, the relevant clause in the SEBI PFUTP Regulations has also been
amended to explicitly include front-running as it is generally understood.
Hence, today, it is more or less well settled that front-running is a violation
punishable under the securities laws.
However, there
is no specific definition in the Securities Laws of the term ‘front-running’. There
are clauses that do describe what is understood as front-running. There are
also several other dictionary definitions and also a fairly detailed
description in the decision of the Supreme Court. For guidance, although in a
different context, there is also a definition of front-running in a SEBI
Circular (dated 25th May, 2012).
Front-running is
also known as trading ahead. It essentially means that, armed with valuable
information of a proposed large transaction which would result in a change in
the price of a security, a person, in breach of trust, trades before such a
transaction takes place and makes personal illicit profits. To take an example,
a stockbroker has been given an order to buy a very large quantity of shares of
a particular company by his client. The experienced stockbroker knows that this
order will result in a rise in the price of that scrip in the market. He then
proceeds to first buy for himself these shares at the then prevailing price.
After doing this, he places the order of his client at the increased price.
Simultaneously, he sells the shares that he has just acquired, at this higher
price. The result is that his client ends up paying a higher price for the
shares – and the difference is pocketed by the stockbroker.
This is breach
of trust of the client. This also affects faith in the markets and its
integrity because, if permitted, there would be concerns that such malpractices
can happen on a regular basis and cause losses to the public. SEBI has alleged
in this case that front-running harms not just the client but the market and
the public in general.
Front-running is
thus similar to insider trading. In insider trading, a person in possession of
price-sensitive information which has been given to him in trust, abuses such
trust and trades and makes a profit for himself. So also in front-running.
However, interestingly, there are comprehensive regulations for insider trading
that define various terms, have several deeming provisions, etc. This, at least
in theory, should help inside traders to be caught and punished. It is another
thing that insider trading is still notoriously rampant and yet difficult to
catch. Front-running, in comparison, has just one specific provision under the
PFUTP Regulations. There are no definitions, no deeming provisions, no
explanations of how persons may be deemed to have been connected as insiders,
etc. In this context, the SEBI order in the present case is thus a good case
study for all on how the violation has been established, albeit by an
interim order.
WHAT ARE THE ALLEGED FINDINGS OF THIS
CASE?
As discussed
earlier, the Tata Fund used to carry out trades through its stockbrokers,
Reliance Securities Ltd. The orders were large and expectedly would result in a
change in the price of the ordered scrip. A large purchase order would thus be
expected to result in rise in prices, and vice versa in case of an order
of sale. The Fund also dealt heavily in derivatives where, again, the impact of
the orders would be similar.
Front-running in
such a circumstance, as the order also explains in detail, follows two
strategies. In case of a purchase order, it is the Buy-Buy-Sell (BBS) strategy.
In case of a sale transaction, it is the Sell-Sell-Buy (SSB) strategy. If the
Fund had placed a buy order, the front-runner would buy ahead, and then place
the order of purchase for the Fund. Against such purchase order of the Fund,
the front-runner would sell the shares bought by him earlier.
SEBI found
through its surveillance that transactions suspiciously of the nature of
front-running were taking place. An analysis of the data followed and the
various parties who allegedly did the front-running were investigated. Their
connections with the dealers of the stockbroker who had executed the
transactions of the Fund were looked into by checking the bank transactions,
inquiry with the brokers, their phone records and even their Facebook accounts.
Personal connections and relations were also looked into. It was established
that three such dealers had connections directly or indirectly with various
parties who had actually traded ahead of the orders of the Fund. This was seen
in the equity segment as well as the derivative segment. The timing of these
orders and how they matched with the orders of the Fund were analysed. Analysis
was also done of the volume of trading of such persons, particularly in the
derivatives segment before and during the period when such alleged
front-running took place. It was alleged that a significant proportion of the
transactions of such parties matched with those of the Fund and a large amount
of profit was made in a short time by these parties.
In view of these
findings, SEBI passed an interim order and prohibited the parties from dealing
in or being associated with the securities market.
SEBI also
ordered these parties to deposit the profits allegedly made from front-running
– of nearly Rs. 4.50 crores – pending further investigation, a hearing to the
parties and a final order. The parties have been required to deposit this
amount within 15 days of the order. Their assets have also been frozen.
SOME ISSUES IN THE ORDER
As stated
earlier, the order is credit-worthy on several grounds. It has detected, even
in an interim way and through an ex parte order, a difficult case of
front-running. Not only this, the speed of detection and investigation is indeed
very fast. It is expected to act as a warning to those who indulge in such
activities.
However, there
are some concerns, too. To begin with, the connections alleged are on
relatively flimsy basis. A few phone calls between the dealer and the alleged
front-runner have been held sufficient to establish a connection. Transfers of
funds of relatively small amounts between parties have also become the basis of
the connection. What is surprising is that even being a Facebook friend is seen
as a connection. While checking the Facebook profiles of persons is surely good
use of modern technology to go behind the scenes, it is also unrealistic. It is
very common for people active on social media to have hundreds or even
thousands of so-called Facebook friends. Facebook, Twitter and even LinkedIn
are generally used for exchange of information and ideas and do not necessarily
mean that there is also an off-line connection between the parties.
Interestingly,
this is not the first time SEBI has used online connections to allege
‘connections’. In another case of alleged front-running, SEBI had noticed a
‘connection’ through a matrimonial site and passed an interim order (dated 4th
December, 2019). There have been other cases, too, where a Facebook connection
has been relied upon to allege ‘connections’.
The connection
alleged on account of the calls made between parties may also not be sufficient
to uphold such serious allegations. Unless the calls are timed with the
transactions it may be difficult to say that this meant such a connection that
parties are engaged in front-running together. In this case, of course, SEBI
has also tabulated the data of transactions and alleged that the timing also
matched.
Then there is
the connection alleged on account of financial transactions. Being an interim
order, it appears that no further information has been collected as to the
reason for entering into such transactions. It may be possible that such
financial transactions may be for genuine reasons having no connection with
front-running and also not establishing any connection sufficient for
front-running.
Nevertheless,
all these parties have been debarred even in the interim by this order. They
have been made to deposit a very large sum of money being alleged profits of
front-running. Their assets are also barred from sale, etc.
There is another
angle here. As stated, at least on first impression, the basis for alleging
connections is shaky. What is possible is that in the future such parties may
ensure that even such connections are not there, or not evident. After all,
these are white-collar crimes committed by educated people having a level of
sophistication. Indeed, if such flimsy connections are relied on, it may mean
that many persons perpetrating front-running would not come under the radar.
To conclude,
being an interim order, it may happen that the explanation given by the parties
may result in it being set aside either wholly or in part. Nevertheless, this
order is a wake-up call and a warning to persons operating the markets that
SEBI by its market surveillance collects and analyses information that may
throw up white-collar frauds. The fact that such white-collar frauds have been
tackled in a timely manner should make one hope that other less sophisticated
orders would also be caught in larger numbers.
Do not wait; the time will never
be ‘just right.’
Start where you stand and work with whatever tools you may have at your
command, and better tools will be found as you go along
—
George Herbert
