A few days ago, the Securities Appellate Tribunal (SAT) passed its order on an appeal by Emkay Global Financial Services Limited against the National Stock Exchange (NSE) and several investors in a case involving a “flash crash”. This case raises interesting legal and contractual issues, although they were substantially resolved through an interpretation of the bye laws and various circulars issued by the NSE.
The case arose due to a “fat finger” trade, which involves an error in inputing information into a computer while executing a trade. In October 2012, a dealer of Emkay Global placed an order to sell 17 lakh NIFTY 50 units ‘based on quantity’ instead of Rs. 17 lakh in value. Due to this error, the sell order was executed for a value of Rs. 980 crores, which was vastly in excess of the contemplated transaction. While the dealer immediately realised the situation and tried to cancel the order, he was unable to do so as it had already entered the exchange server. The enormity of the situation can be attributed to a confluence of factors that led to a “perfect storm”. The risk management measures at Emkay Global’s end did not function to backstop the human error. Moreover, NSE’s circuit breaker system did not arrest the market fall when the NIFTY index fell by 10%. Following this incident, the Disciplinary Action Committee (DAC) of the NSE investigated the matter and imposed a penalty of Rs. 25 lakhs on Emkay Global and certain other trading parties. NSE also rejected a request by Emkay Global for annulment of the trade on account of the error.
It is against these actions that Emkay Global appealed before the SAT. From a legal standpoint, SAT was concerned with three broad questions, on two of which it returned a finding. First, it considered whether the erroneous trades are liable to be treated as a “material mistake” and hence to be annulled by virtue of NSE’s bye law 5(a). SAT decided to provide a narrow interpretation to the expression “material mistake” and that since the trades occurred due to a failure in the risk management system of Emkay Global, it amounted to breach of duty/ negligence which cannot be a circumstance for invocation of bye law 5(a). SAT’s interpretation suggests that bye law 5(a) contemplates inviolability of dealings on the stock exchange and that “it is evident that the expression ‘material mistake’ in Bye law 5(a) would be attributable to such trades which affect sanctity of the trade in spite of it being executed after exercising due care, caution and diligence”. Moreover, SAT was categorical in that the magnitude of the loss caused it not determinative of “material mistake”.
Second, it was found that various investors had placed unrealistic orders to buy NIFTY 50 at prices distant from the prevailing market price, and that these trades were effected without the stipulated margin money. Hence, apart from the lack of diligence on the part of Emkay Global, there were also violations on the part of the investors who purchased the securities so as to derive unanticipated profits. SAT seemed to display some concern on this count given that NSE does not seem to have considered these matters in detail while rejecting annulment of the trades. Hence, SAT set aside NSE’s orders against the annulment of trades relating to two counterparties and remanded the matter for fresh consideration. Hence, in these instances, the question of annulment of the trades has been left open and for further consideration.
Third, SAT refused to annul the trades on the ground of the failure of NSE’s systems to halt trading when the NIFTY index fell below 10%.
A majority of SAT consisting of two members rejected Emkay Global’s appeal on the first and third issues discussed above, and remanded the second for fresh consideration. In a separate order, the third member refused annulment and rule against Emkay Global.
While the legalities and technicalities of the circumstances have been discussed in detail in SAT’s order, the essential question revolving around this dispute is whether sanctity of trades ought to be preserved despite the erroneous nature of the trades. SAT’s outcome has largely pointed towards upholding these trades, and therefore preserving the sanctity. This has economic implications as such an approach would preserve market integrity. Where SAT has left the matter for further consideration, the issue does not pertain to the erroneous nature of the trade but rather to the non-compliance of the counteparties with relevant NSE requirements regarding princing and margin. Overall, this approach may be considered somewhat harsh as it leaves no room for error on the parties of trading entities and their dealers, who are cast with the onerous obligations of establishing and maintaining the necessary risk management systems, procedures and practices. The obligations are further enforced by powers conferred upon the stock exchange to penalise the offenders so as to have a deterrent effect against the lack of care and diligence. Given the strict nature of this approach, there is no risk of moral hazard.
On the other hand, unyielding insistence on sanctity of trades could confer windfall gains upon counterparties who are fortunate (and perhaps even canny) to have taken the benefit of the erroneous trades. One method of preventing undue advantage to such counterparties would be to disgorge the profits they may have obtained so as to balance the equities between the parties. The fact that SAT has left the door open for some form of reconsideration (including annulment) suggests it is cognisant of these inequities that need to be rectified.
In all, flash crashes that are caused by errors such as fat finger trades bring about significant complexities in the markets, especially given their magnitudes. While systems and processes can help guard against the occurrence of such events, they may be faced with a “perfect storm” situation wherein the regulatory and dispute resolution mechanisms would have to be invoked to dispense justice to the parties affected by the error.
For a further analysis of the SAT order and its implications, please see “SAT order on NSE's actions after the Emkay crash”.