Sunday, November 18, 2012

Front running not a crime, if committed by non-intermediaries - SAT

As highlighted in an earlier post, the Securities Appellate Tribunal (SAT) has held that front running, carried out by a non-intermediary, 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”).
The facts, as narrated in the SAT order, are simple enough. An employee (“D"), designated as a portfolio manager of a certain foreign institutional investor (FII), came to know of certain proposed large trades by such FII. He organized with his cousins 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 reserve transaction he would carry out with such FII. He (with his cousin) allegedly made, and consistently too, such profits amounting to approximately Rs. 1.50 crores.
The Adjudicating Officer held that these transactions were in violation of Regulation 3(a) to 3(d) of the PFUTP Regulations. A penalty aggregating to Rs. 11 crores was 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 with the PFUTP Regulations of 1995 which, according to SAT, covered front running by “any person”.  Since D and his cousins were not intermediaries, 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 also noted that the employer had punished him by, effectively, making him resign. It did not, SAT held, amounted to a manipulative practice or a fraud on the market. Hence, the provisions of Regulations 3(a) to 3(d) could not apply to the present facts.

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 some point to 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 with SEBI 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 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 does start with the phrase “No person shall…”. However, clause (b), which seems to be the relevant clause SAT refers to as specifically referring to front running, 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 clients 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”.

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, considering the nature of the transaction, and the amounts involved and the other cases of a similar nature, that SEBI will appeal this case before the Supreme Court.


Anonymous said...

Front Running or Warehousing?

Thanks for the helpful summary and analysis. In my view, there seems to be a significant ambiguity in the order. As per the investigations by Passport (D's FII employer), D may have actually indulged in the practice of `warehousing' where KB was used to warehouse the shares ahead of Passport's purchase and then sell those to Passport thru synchronized trading. Passport concluded that this was violative of their policies and D was asked to leave. If this is correct, then it definitely is a deceptive act, as by definition, warehousing distorts the price discovery process by helping the beneficiary avoid the impact cost of his large order. So, the gain made by KB to the tune of 1.5 crore was in the nature of `commission’ for acting as the warehousing agent. The real gainer was Passport to the extent of avoided impact cost. KB bought shares, warehoused those and later sold those to Passport at a pre-determined markup. Synchronized trades were executed to ensure all this happens smoothly.

If this view is correct, (in my view) it changes the whole complexion of the case, obviated the need to rely on Reg 4(2)(q) of the FUTP Regulations, 2003. It is clearly covered by the wide language of Reg 3. Also, it’s Passport (thru D) which becomes the primary wrongdoer, and KB only an abettor.

Any thoughts?

-Mangesh Patwardhan

Jayant Thakur, CA said...

@Mangesh Patwardhan..

Interesting point you have made.

All in all, I think it would finally depend on exact facts and whether it would amount to deception in a particular case. Warehousing in certain circumstances may amount to a deception that is violative of the PFUTP Regulations. SAT, however, has said in the present case that a specific provision was needed to make front running a violation. Same principle may apply to warehousing unless it can be, on facts, covered under some clause in the Regulations.

Though, I do feel that even the present ruling on front running needs reconsideration.

Anonymous said...

This order is now more so a reason to expedite appointment of judicial member in SAT, which is missing since almost now a year.

Wondering whether the counsel (with due respect) representing SEBI had/has sufficient operational understaning of such matters, especially in securities market which requires a different level of understanding altogether.

The term "front running" or "customised front running" would anyways fall under the provision of regulation 3(b) dealing with "employing any device, scheme or artifice to defraud". The buyers where "deceptive buyers" which is an admitted position.

SEBI should definitely appeal to supreme court.

Anonymous said...

Further, while the charge is under regulation 3, SAT has not reasoned why regulation 3 has not been breached.

SAT order merely speaks of and compares regulation 4(2)(q) and the corresponding provision thereto in 1995regulations. But, beyond a point this comparison is irrelevant, because charges have not been framed under regulation 4(2)(q).

Jayant Thakur, CA said...


Agree. There is no detailed reasoning why Regulation 3 cannot apply except a statement that it is a private fraud on the employer and no fraud on the market or manipulation of the market.

Appeal to the Supreme Court seems to be very likely, considering the stakes as well as nature of violation, apart from the above reasons.