The Securities Appellate Tribunal has held that front running by investors and others (who are not intermediaries) is not in violation of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003 (hereinafter referred to as “PFUTP Regulations”). This is in the case of Shri Dipak Patel vs. SEBI (Appeal No. 216 of 2011, decision dated 9th November 2012).
What is front-running? Though widely discussed in press and earlier here in this column, a quick review of this term is made here. It essentially is using information about major trades by a person and in anticipation of price movements owing to such orders, the front runner himself carries out such trades first. Carried out by an intermediary such as a broker, it takes usually the following form. An investor wants to, say, buy a large quantity of shares of a particular listed company. It is expected that such purchase itself will result in increase of the market price of those shares, at least in the short run, taking various factors such as available liquidity in the market etc. The investor places this order with his broker. The broker, savvy about the implications in the market, places his own orders of purchase first. Say, the ruling market price is Rs. 100. So he buys a large quantity of shares at Rs. 100. This purchase results in the market price moving up to, say, Rs. 102. Then he places the order of his client at, obviously, Rs. 102. He sells his shares in the market and these sales expectedly go mainly to the investor. Thus, the broker is richer by Rs. 2 per share and the investor pays a higher cost of the same amount. The broker thus runs in front of the investor’s orders.
The reverse can also be done when the investor wants to sell shares, where again the broker will gain at the cost of the investor. Of course, it is not only the broker who may do this. Any person who comes to know about the proposed trades of such investor may do it – whether the employee or advisor of the investor, an employee of the broker. Indeed, the broker himself may disguise his trades by use of other names.
Front running is in a sense similar to insider trading since in insider trading too, an insider takes advantage of price sensitive information. However, front running, unlike insider trading, causes a direct and often quantifiable loss to the investor.
There have been a few earlier orders of SEBI of instances of front running, where such front runners were punished and such orders were upheld by the SAT. However, the SAT has sought to make an important distinction in this particular case. SAT has effectively said that front running is punishable only if carried out by an intermediary and not by other persons. Thus, in this case, an employee of the investor who, having come to know of its proposed trades, allegedly carried out front running. SAT held – on grounds discussed herein – that such employee could not be punished.
The facts, as narrated in the SAT order, are simple enough. An employee (“D”), who was designated as a portfolio manager of a certain foreign institutional investor (FII), came to know of certain proposed large trades by such FII. He organised with his cousins in India to carry out their own personal trades ahead of such trades. The next step was to reverse them when the FII itself came to trade. Considering the size of the proposed FII trades, it appeared that if D traded first, he would be able to move the price in a particular direction. This movement, coupled with the trades of the FII, would help them make a profit in the reverse transaction he would carry out with such FII. He (along with his cousins) allegedly made, and consistently too, such profits amounting to approximately Rs. 1.50 crores.
SEBI compiled in great detail the trades of D and the FII in such scrips. It collected information about the trades of the FII and then compared them with the trades of D. The comparison was made in both quantity and timing. The telephonic records of D and his cousins were also examined and allegedly the contacts and its timings supported the view that there were contacts between them during the time of these trades. The financial transactions between D and his cousins were also examined and similar supporting evidence was allegedly found supporting the view that D helped facilitate such transactions. It was also stated that the cousin of D who carried out such trades consistently made profits on such trades which SEBI said was rare and unbelievable in the present facts. And thus, such trades pointed out to illegitimate and illegal use of information to profit, at the cost of the employer FII.
The Adjudicating Officer thus held that these transactions were in violation of Regulation 3(a) to 3(d) of the PFUTP Regulations. Penalties aggregating to Rs. 11 crores were levied on D and his cousins. On appeal, the SAT reversed the order of the AO on two grounds.
Firstly, it took a view that front running was made a specific violation of the PFUTP Regulations and it referred to front running by intermediaries only. It compared the present Regulations with the PFUTP Regulations of 1995 which, according to SAT, covered front running by “any person”. Since D and his cousins were not intermediaries, SAT held that this clause could not apply to them.
In the words of SAT, “In the absence of any specific provision in the Act, rules or regulations prohibiting front running by a person other than an intermediary, we are of the view that the appellants cannot be held guilty of the charges levelled against them.”.
Secondly, it held that front running at best amounted to a fraud by D on his employers. It was found that the employer FII had indeed carried out an internal investigation report. Certain findings of this report were referred to by SAT. It was also noted that the employer had punished him by, effectively, making him resign. However, it did not, SAT held, amount to a manipulative practice or a fraud on the market. Hence, first, the provisions of Regulations 3(a) to 3(d) which were held to be violated by D as per the order of the Adjudicating Officer, could not apply to the present facts. What is even more interesting is that, the SAT held that in the absence of any specific provision in law, the acts could not be punishable under any other provision either.
As the SAT observed, “The alleged fraud on the part of Dipak may be a fraud against its employer for which the employer has taken necessary action. In the absence of any specific provision in law, it cannot be said that a fraud has been played on the market or market has been manipulated by the appellants when all transactions were screen based at the prevalent market price.”
The decision raises several concerns and questions. There is surely a valid point in SAT’s view that unless there is a manipulation in or fraud on the market, a purely private wrong cannot be punished by SEBI unless there is a specific provision prohibiting it. However, the question still remains that when such a wrong is carried out in the market, how private does it indeed remain? And if it remains unpunished, whether it will affect the credibility of the market?
The question also arises whether the decision was arrived at because the charges were framed too narrowly, limiting it to specific clauses in the PFUTP Regulations. Or whether the decision has a broader scope and that such decision would apply generally leaving SEBI with no powers – either under the other clauses of the PFUTP Regulations or under the Act – to deal with such acts.
There is another point that the SAT made which with due respect does not seem to be correct. It held that the 2003 PFUTP Regulations made a departure from the 1995 PFUTP Regulations. The 1995 PFUTP Regulations, as per SAT, prohibited front running by any person. The 2003 PFUTP Regulations, however, prohibited front running by intermediaries only.
SAT observed, “We are inclined to agree with learned counsel for the appellants that the 1995 Regulations prohibited front running by any person dealing in the securities market and a departure has been made in the Regulations of 2003 whereby front running has been prohibited only by intermediaries.” (emphasis supplied)
The relevant Regulation 6 of 1995 PFUTP Regulations does start with the phrase “No person shall…”. However, clause (b), which seems to be the relevant clause to which SAT refers to reads as follows:-
“(No person shall) on his own behalf or on behalf of any person, knowingly buy, sell or otherwise deal in securities, pending the execution of any order of his client relating to the same security for purchase, sale or other dealings in respect of securities.
Nothing contained in this clause shall apply where according to the client’s instruction, the transaction for the client is to be effected only under specified conditions or in specified circumstances;” (emphasis supplied)
Thus, while the prohibition is on any person, the prohibition applies provided such dealing is “pending the execution of any order of his client ”. In other words, even in the present facts where D did not apparently deal “pending the execution of any order of his client”, the 1995 PFUTP Regulations could not have applied.
Having said that, it is also clear that the present facts and decision was not with reference to 1995 Regulations but the 2003 Regulations and they do refer specifically to intermediaries. Still, this distinction sought to be made appears to be erroneous.
It seems certain that, considering the nature of the transaction, and the amounts involved and the other cases of a similar nature, SEBI will appeal this case before the Supreme Court. Perhaps, SEBI may also take an initiative and amend its Regulations, to introduce specific provisions prohibiting such transactions.
