By Hardeep Singh Chawla, Fourth Year, B.A, LL.B (Hons.), Amity Law School
Editor’s Note: SAT through the case of Dipak Patel v. SEBI, held that the offense of front running cannot be ascribed to anyone except an ‘intermediary’. This order of SAT was in pursuance of the new FUTP Regulations, 2003 which changed the concept of front running altogether. Did the adjudicating authority take a holistic approach while pronouncing this order? Does SEBI have the powers to change the definition of fraud in the first place? What do intermediaries mean?
These are the imminent questions that need to be answered. This case comment seeks to critically analyze SAT’s order, dividing the comment into the merit of SAT’s order, to the argument on legislative intent, to what does an intermediary mean, how the same concept is seen by the US S.E.C and on the whole what it would it mean to the ill-fated investor, for whom antifraud law were enacted in the first place!
Front Running: The definition conundrum post-Dipak Patel world
To understand the context of front running in a holistic manner and the consequences of the judgment in the Securities world, let us examine the definition of front running and intermediary as around these would our vexed questions of law lie.
Traditionally, “Front running means buying or selling of securities ahead of a large order so as to benefit from the subsequent price move. This denotes persons dealing in the market, knowing that a large transaction will take place in the near future and that parties are likely to move in their favor.”
Intermediary means a stock broker, sub-broker, share transfer agent, banker to an issue, trustee of trust deeds, registrar to an issue, merchant banker, underwriter, portfolio manager, investment adviser, depository, participant, custodian or securities, credit rating agency and such other intermediaries as the Securities and Exchange Board of India (“SEBI”) may specify and includes asset management company in relation to the SEBI (Mutual Funds) Regulations, 1996, clearing member of a clearing corporation or clearing house and a trading member of a derivative segment or currency derivatives segment of a stock exchange but does not include foreign institutional investor, foreign venture capital investor, mutual fund, collective investment scheme and venture capital fund.
Recently, Securities Appellate Tribunal (“SAT”) in case of Mr. Dipak Patel vs. Securities and Exchange Board of India, was posed with the question of what was front-running and if anyone except an intermediary can be charged with front running under the current Regulation 3 of Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 (“FUTP Regulations”) has held that a person engaged in front-running, in absence of any specific provision other than an intermediary, cannot be held guilty of the charges leveled against them.
SEBI conducted investigations into the trading activity by Mr. Kanaiyalal Baldevbhai Patel (“KBP”), an individual trader, and a foreign institutional investor (“FII”), registered with SEBI, for the period between January 2007 and March 2009.
It was found that KBP placed and executed orders squared off his position when FII placed its orders, and pursuant to such allegations SEBI showed 799 (557 synchronized trades were executed on National Stock Exchange of India Ltd. (NSE) across 11 scrips between KB and Passport wherein both the buy order by the Passport and sell order by KB with identical price were placed within the gap of a few seconds.
Similarly, there were 192 synchronized trades in 8 scrips between KB and Passport wherein both the sell order by the Passport and buy order by KB with identical price were placed within a time gap of a few seconds. Out of 228 scrips, 214 were common between KB and Passport. Similarly, there were 50 synchronized trades executed between KB and Passport in 6 scrips on the Bombay Stock Exchange Ltd. (BSE) where buy and sell orders with identical price were placed within a few seconds)
Mr. Dipak Patel (“Dipak”) was the portfolio manager of the Passport India Investments, Mauritius based FII and is also related to KBP and Mr. Anandkumar Baldevbhai Patel (“ABP”). SEBI noted that Dipak provided information to KBP and ABP regarding the forthcoming trading activity of the FII. Taking advantage of the same KBP indulged in the alleged ‘front running’. It was noted by SEBI that modus operandi was the telephone number registered in the name of ABP at the common residential address of KBP and ABP. Thus, ABP allegedly aided and abetted KBP and Dipak in these transactions. By adopting this method KBP earned a total profit of INR 1,56,32,364 from the alleged trades.
Contention before SAT:
Whether or not the trading is done in the securities market by another person (not an intermediary) being privy to the impending trades of another broker can be charged with ‘front running’ in violation of Regulation 3 of FUTP Regulations?
SAT entertained the appeals of the respective appellants and held that SEBI’s order was bad in law holding the appellants guilty of Regulation 3 of the FUTP Regulation. SAT enunciated the following reasons:
KBP activities ‘in principle’ deemed to be front running:
Even though, the term ‘front running’ is absent in the FUTP Regulations, but relying on the definitions quoted by the SEBI’s counsel from Ramanatha Aiyar and Black’s Law Dictionary, SAT held that the arrangement of a person having knowledge of upcoming transaction by a third party which is likely to affect the market price of the security and such deals in the security is front running. In this perspective, SAT held appellants were in process of front running; deducing the manipulation after taking into contemplation in entirety, all the corroborating facts, and positions; predominantly, major variations, and seemingly odd if any, in the market prices at the relevant points in time
Front running without the violation of FUTP Regulations:
SAT is convinced with the position that Regulation 4(2)(q) of the FUTP Regulations, which though not explicitly stating front running, prohibits it, applies to intermediaries to everybody else’s exclusion. To prove this point, SAT examined the changes from FUTP Regulations 1995, to the FUTP Regulations of 2003.
In the Regulations of 1995 front running was prohibited for any person, however, there was a clear departure to include only intermediaries liable for front running. Therefore, it logically followed that SAT through its perusal of Regulation 3 of FUTP Regulations, 2003 – prohibiting a person directly or indirectly to buy, sells or other deal in securities in a fraudulent manner, does not apply.
SAT unequivocally held that since these were regulations prohibiting unfair trade practice, it was imperative upon SEBI to show how the alleged fraud affected the securities market. SAT held that the FII was a major counterparty for trading and placed gigantic orders and hence the individual traders placing small order matching the orders of the FII cannot be ruled out.
The fraud done on part of Mr. Dipak is a fraud against the employer and they are taking necessary action against the same. SAT held since there is no specific provision, it cannot be established in law that the appellants manipulated the marks when the transactions were screen based at the prevalent price.
This order has already started profoundly affecting the anti-fraud regime in the Securities Market (Mr. Sujit Karkera and ors. v. Security Exchange Board of India) took Dipak Patel as a precedent.
SAT’s attempt at gauging legislative intent perusing the regulations of ’95 and ’03 remain a halfhearted endeavor. Fraud has been widely defined by the SEBI Act, 1992 (Section 11(2)(e) read with 12(A)) gives the impression that fraud is to be curbed and the words “employ any device, scheme or artifice to defraud in connection with issue or dealing in securities” have to be borne in mind holistically.
The interesting part here is that dilution of the statutory guidelines by a delegated legislation seems rather unconvincing. Charging SEBI with diluting the anti-fraud rules would be malafide. Perusing FUTP Regulations 2003, fraud is defined in Regulations 2 and 3. Regulation 2(c) defines fraud. Regulation 3 starts with, “No person shall directly or indirectly…”
Counteractively the Regulation borne in mind by the SAT, Regulation 4 starts with “Without prejudice to the provisions of regulation 3, no person shall indulge in a fraudulent or an unfair trade practice in securities,” therefore 4(2)(q) which SAT applied solely to determine front running, forms part of the list and is not an exhaustive list. Regulation 4(2) states, “Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if it involves fraud and may include all or any of the following, namely:-” Pure reliance of on explanation-cum-deeming provision Regulation 4(2)(q), while ignoring the charging regulation and the charging section of the Act, is, therefore, creating this confusion.
Who is an intermediary?
Even if the points discussed are to be ignored and kept at bay, the fundamental question that comes to haunt back SAT, is “Who are the intermediaries?” It hard to comprehend that SAT would uphold the theoretical definition of Intermediaries as in Regulation 2(g) of the Securities and Exchange Board of India (Intermediaries) Regulations, 2008, which would imply that if the distributor is defrauding an individual investor, (s)he would have no recourse. A vast number of intermediaries do not need registration and hence will escape unscathed through this order.
Following this premise, the employees of the intermediaries will also escape the law, since they are mere employees of the intermediaries and not intermediary themselves; and the adequate action against them would be taken by the intermediary. So the employees of the mutual funds are all free to do front running in the guise of “business advice” and SEBI would be bound to look the other way because that is not fraud as per the current ruling.
Views of the US S.E.C:
The U.S. Securities and Exchange Commission recently approved a proposal from the Financial Industry Regulatory Authority (FINRA) to expand the front- running policy. The restrictions imposed by the former front running policy apply till the information about the transaction has been made ‘publicly available’. This rule of ‘publicly available’ information is still retained in the proposal, however, a new standard is proposed of the information becoming ‘stale or obsolete’.
Both the standards are proposed as ‘either-or’ meaning thereby if either of them is satisfied the trade restriction is lifted. The test of ‘stale or obsolete’ is rested on facts and circumstances that surround the transaction. This includes various factors such as time elapsed from the transaction, various members getting to know about such a transaction or significant change in the market conditions.
The proposed expansion of the definition is that it is to apply to “all securities and financial instruments and contracts (in addition to the existing options and security futures) that overlay the security that is the subject of an imminent block transaction and that has a value that is materially related to or otherwise acts as a substitute for, the underlying security.”
The need for this extensive definition stems from the fact that fraud needs to be prevented but at the same time free and open market conditions should be accessible to all. The US S.E.C doesn’t classify categories of people who would be exempted if wearing a certain hat, which is precisely what SAT’s order do- exempts if wearing a certain hat.
What happens to the ill-fated investor?
What is surprising is that the SAT didn’t consider the ill-fated investor, the final end consumer who pool their savings into a mutual fund. Isn’t the moot point of anti-fraud law to protect investors? The SEBI Act, which incidentally also created SAT, has a preamble which proclaims, “An Act to provide for the establishment of a Board to protect the interests of investors in securities.” The point is to protect the investors and to not exempt accused if they under the guise of a certain role.
Options with SEBI?
SEBI could appeal to the Supreme Court for an expansive interpretation of the provision while pointing to the SAT’s ignorance of the charging section whilst giving its order, however weighing the strict interpretation of penal laws they could be on shaky grounds. The SEBI Act of 1992 which created the SAT has the objective of protecting investors in the market, the view taken by SAT seems very restrictive and narrow to achieve the objectives of the said Act! It would best be for the Supreme Court to end this matter once and for all. Or, the SEBI could amend the FUTP regulations and let the person acquitted by SAT go without any penal consequences.
In fact, Mr. U. K. Sinha, Chairman of SEBI, very recently stated that “On this particular aspect of front running, we will have to look at our regulations to see if it needs more improvement and strengthening.”
In 1942, at a conference of the commissioners of the US securities regulator, the SEC, one of them asked rhetorically, “Well, we are against fraud, aren’t we?” Today we need to ask the SAT the same question!
Formatted on February 21st, 2019.
 Law Lexicon by P Ramanatha Aiyar (4th Edition 2010)
 Regulation 2(g) of the Securities and Exchange Board of India (Intermediaries) Regulations, 2008
 Appeal No. 216 of 2011; Date of Decision – November 9, 2012. Appeal nos. 74 and 78 of 2012 also combined.
 an intermediary buying or selling securities in advance of a substantial client order or whereby a futures or option position is taken about an impending transaction in the same or related futures or options contract.
 2(c) of FUTP Regulation; “fraud” includes any act, expression, omission or concealment committed whether in a deceitful manner or not by a person or by any other person with his connivance or by his agent while dealing in securities in order to induce another person or his agent to deal in securities, whether or not there is any wrongful gain or avoidance of any loss, and shall also include-
(1) a knowing misrepresentation of the truth or concealment of material fact in order that another person may act to his detriment; (2) a suggestion as to a fact which is not true by one who does not believe it to be true; (3) an active concealment of a fact by a person having knowledge or belief of the fact; (4) a promise made without any intention of performing it; (5) a representation made in a reckless and careless manner whether it be true or false; (6) any such act or omission as any other law specifically declares to be fraudulent; (7) deceptive behavior by a person depriving another of informed consent or full participation; (8) a false statement made without reasonable ground for believing it to be true; (9) the act of an issuer of securities giving out misinformation that affects the market price of the security, resulting in investors being effectively misled even though they did not rely on the statement itself or anything derived from it other than the market price; and “fraudulent” shall be construed accordingly.
 Appeal No.167 of 2012
 S. 11 Functions of Board
(e) prohibiting fraudulent and unfair trade practices relating to securities markets;
 Supra note 6
 http://www.sec.gov/rules/sro/finra/2012/34-67774.pdf (last accessed July 25, 2013)
 New Definition of Front Running, http://www.sec.gov/rules/sro/finra/2012/34-67774.pdf (last accessed July 25, 2013)
Business Standard http://www.business-standard.com/article/markets/sebi-to-take-re-look-at-front-running-norms-112112600056_1.html (last accessed July 25, 2013)