By Jayant M. Thakur, Chartered Accountant
Background
SEBI has passed an order on
8th May 2018 in a case of front running in the matter of Kamal
Katkoria. On the face of it, there is nothing distinctive or new in the order.
The law relating to front running has seen ups and downs in the past, with even
contradictory decisions of SAT, but the Supreme Court (SEBI vs. Kanaiyalal
B. Patel [2017] 144 SCL 5 (SC)) largely settled the matter. Yet, this order
raises and reminds of concerns that the law has not been thought through well
and the orders cause injustice and even inequity to parties.
What
is front running?
Front running has been
discussed several times earlier herein in this column. Simply stated, it is
about a person having knowledge of impending large trade orders, who then
trades ahead (hence ‘front running’) to profit from such orders.
Large orders usually influence the price. The front-runner buys first and then
sells the shares to the original buyer and profits. The original buyer ends up
paying a higher price and thus suffers. Similarly, in case of large sell
orders, the front runner sells first and then, when the original seller comes
to the market to sell, the front runner squares off his trades by selling. In
the first case, the buyer ends up paying a higher price for his buys and in the
second case, he gets a lesser price for his sale.
The legal dispute as to which types of front running
violate the law
Front running, as the
Supreme Court analysed, can be put in three categories. In the first category
are cases where a person comes to know of such proposed large trades and trades
ahead. In the second category are cases where the person, who proposes to carry
out large trades, himself carries out hedging or similar
offsetting trades to protect himself of the effect on price his large trades
would cause. Third case is of an intermediary who comes to know
of a client’s proposed large trades and trades ahead of him.
The third category is
specifically prohibited under the SEBI PFUTP Regulations (Regulation 4(2)(q)).
The second category is not considered to be front running or the like. The
prolonged dispute was largely about the first category where a person who comes
to know of such proposed large trades and owes a fiduciary duty not to use it.
The Supreme Court held that merely because there was a specific provision for
front running by intermediaries did not mean that non-intermediary front
running cannot be covered under generic provisions. In other words, such front
running was covered under the general and broad definition of fraud. Hence, the
first category was also deemed to be wrongful.
Facts
in the present case
In the present case, the
facts, briefly and simplified, were as follows: A private company, apparently
engaged in jewellery business, had entered into large trades in shares. The
trades were looked after by an employee who coordinated these trades with the
stock broker. However, he traded ahead and made significant profits of Rs. 38
lakh. By an earlier order, he was debarred for a period of three years. By the
present order, he was required to disgorge this profit plus interest
aggregating to Rs. 61.73 lakh.
Controversial
issues in the Order
Three issues arise.
First,
whether, in such cases, the interests of investors or markets are adversely
affected and thus whether SEBI can and should have any role. To elaborate, the
losses in such cases can be of two types. One are losses specific to a person
who has been directly affected by such front running. In the present case, it
is the employer private company who ended up paying a higher price. However,
certain wrongs could also affect investors generally and also end up harming
the reputation and integrity of capital markets such that investors may
hesitate dealing therein on fear that the markets could be rigged.
In the present case, SEBI
asserted, and rightly so, that the question of whether there was violation of
the PFUTP Regulations had attained finality. This is because in the previous
order in the same party’s case, violation of the Regulations was upheld and
affirmed by the decision of the Supreme Court. The earlier order of SEBI where
it debarred the front runner had given detailed reasons and the appeal against it
was dismissed. However, in the current order, SEBI repeatedly stated that
interests of investors and markets generally were harmed. This is curious and
goes to the fundamentals of the question whether such cases should at all be
held to be fraudulent as to be violation of the Regulations.
Take a simplified example
of what happens in such cases. A person desires to buy, say, 10 lakh shares of
company A when the price is Rs.100. His purchase would result in increase in
price to Rs. 103. The employee, who is authorised to execute this order, trades
ahead and buys 10 lakh shares for himself resulting in price rising to Rs. 103.
He then asks the broker to execute his employer’s order at the ruling price of
Rs. 103 while he himself sells on the other side. Effectively, he makes a
profit that could be Rs. 3 or more per share. Clearly, this profit is made at
the cost of his employer in breach of trust his employer bestowed on him.
However, can such private breach of trust be treated as such a fraud in dealing
in securities as in violation of the Regulations? That would be stretching the
scope of the Regulations wider than its intention/ spirit and perhaps even the
letter. It is submitted that merely because a fraud involves securities, this
should not result in SEBI taking action unless markets or other investors
generally are harmed.
It is also submitted that
there are no losses to investors generally in such cases. As the example given
above shows, it is only the employer who loses. Even without such front running,
the public investors would have got the same price on sale. They would have
sold the shares at the same price to the employer as they did to the employee.
The credibility of the markets too also arguably did not suffer since the fraud
was committed by the employee on the employer and not by the system. Of course,
because of such front running, the volume in shares doubled but that by itself,
it is submitted, is not sufficient reason to extend scope of the Regulations to
private breach of trusts/frauds. Private breaches of trust can be of such wide
and varied nature that SEBI may end up meddling in private disputes.
Secondly,
treating such front running as in violation of the Regulations would result in
double punishment of the front runner. Firstly, he would be punished by the
employer. It is very likely that he would lose his job. Secondly, he would be
required to make good the loss to the employer. Thirdly, the employee may lose
his reputation and may not find job easily. It is also possible that the employer
may initiate prosecution against him. However, it is seen that SEBI too is
punishing such a person. In the present case, it is seen that he has been
debarred from the markets for three years and he has already undergone this
term. Secondly, he has been asked to disgorge the profits with 12% interest.
Thirdly, it is possible that he may be asked to pay penalty, which can be upto
3 times the profits made or Rs. 25 crore whichever is higher. There is also a
possibility of him being prosecuted. Such dual punishment does not stand to
reason.
Thirdly,
there is inequity and injustice involved here. The loss has been caused to the
employer in this case. However, it is SEBI that has disgorged the profits, none
of which goes to the person who has lost the money. This profit and even
interest fairly belongs to the employer. Interestingly, it is seen in this case
that the employee had very low annual income and these profits from front
running thus were very significant. These earnings enabled even him to buy a flat.
This flat has now been encumbered by SEBI and quite possibly be made to be sold
to pay to SEBI the disgorged profits plus interest. In this case, there may not
be much left for the employer. Even if there was something left, the employee
would be paying the profits plus interest twice. The disgorged amount is
credited by SEBI to Investor Protection and Education Fund. In principle, the
party who has suffered the losses could approach SEBI and request that the
amount disgorged be paid to him. In practice, it is very likely that this
process could be prolonged and cumbersome. Curiously, in this Order, SEBI had
stated, incorrectly I submit, that public investors have also suffered part of
the losses. This is despite the fact that there was a fairly specific finding
that the front runner had traded ahead only for his employer’s trades. Thus, it
is possible that the party may get only part of the money and that too after
considerable effort.
When the Order itself is so
clear in its finding, it stands to reason that the Order itself should provide
that the disgorged amount be paid to the employer. This is of course subject to
necessary safeguards for refund in case an appellate authority overturns the
order wholly or partially.
This principle should apply
even to cases where intermediaries were involved. It is the client of the stock
broker who suffers and this illegitimate profit disgorged needs to be handed
over to him. Similarly, as it had happened in the case of a reputed mutual
fund, where a senior employee front ran his employer fund’s trades, the SEBI
order should provide for handing over such disgorged profits directly to the
credit of the fund for benefit of the unit holders.
Conclusion
To conclude and summarise,
the law relating to front running involving private breach of trust needs to be
revisited. SEBI should concern itself only to cases where the interests of
investors/markets are affected. Even where it takes action, it should ensure
that the persons who have lost monies because of such front running are
compensated. The SEBI order should itself provide for handing over of the
amounts disgorged to the party who has lost on account of such front running.
