20 November 2012

Front running - SAT ruling exempts fraudsters

Jayant Thakur has a piece in indiacorplaw.blogspot.in on a recent case where SAT has held that front running is illegal only if committed by an intermediary. I agree with his criticism. This will profoundly disturb the anti-fraud laws currently protecting investors. Please see his post summarising the facts. Here are my views:

First, fraud has been widely defined by SEBI Act, 1992. See S. 11(2)(e) read with S. 12A. I am not even sure SEBI has the power to dilute the anti-fraud rule

Second, SEBI has in fact not diluted the anti-fraud rules. The SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 also defines it expansively in Reg. 3. By contrast Reg. 4 which has been exclusively relied upon by SAT to give the persons a free ticket is clearly couched in the following words: "Without prejudice to the provisions of regulation 3, no person shall indulge in a fraudulent or an unfair trade practice in securities."

Third, even if one were to ignore both the above points, qualifying the front running prohibition only to intermediaries would beg the question who are intermediaries? I would find it very hard to believe that one must be registered with SEBI to be called an intermediary. If a portfolio manager to an FII is not an intermediary then who is? Merely relying on the definition of an intermediary who is required to be registered with SEBI will narrow the definition to exclude even investment advisors.

Fourth, SAT didn't even ask the question what happens to the hapless investors i.e. the final investors who comprise  the FII vehicle. They might be 'widows and orphans' or pensioners who have been cheated. Isn't the point of the anti-fraud law to protect the investors.

Fifth, it makes no logical sense to restrict securities anti-fraud rule (even if one) to apply only to intermediaries and that too registered intermediaries. The point is to protect investors,  not punish wrongdoers if they wear a particular hat.

Clearly, this is not the end of this story and SEBI will likely appeal against this.

1 comment:

Anonymous said...

First, there is a basic confusion over the exact nature of practice here. As per SAT Order, it’s front running, as per Passport’s internal investigations, it’s warehousing. These two are conceptually distinct, and the wrongdoer / victim analysis would change accordingly.

Second, leaving that aside and assuming it to be a case of front running, I’ll try to argue the issue from both sides.

In support of SAT’s Order – One, Section 11(1)(e) and 12A do not define fraud per se, only ourlaw any fraudulent activity and empower SEBI to take appropriate measures. The whole issue here was whether front running by a non-intermediary is fraud or not, so invoking these provisions simply begs the question. Two, if front running (in general) amounts to fraud and therefore is covered under Regulation 3 of the FUTP 2003 Regulations, there was no need to specifically mention front running by an intermediary in Regulation 4., it becomes superfluous. Three, the inclusion of intermediary front running and omission of non-intermediary front running from Reg. 4 implies that SEBI intended to bring the former (but not the later) conduct with the definition of fraud.

Against – One, The Supreme Court has recently rejected a substantially similar argument in the Sahara case, so there is recent precedence to rely on. There, the argument was that since the Companies Act definition of `securities’ explicitly includes hybrids and the SCRA definition does not, hybrids are not securities for the purpose of SCRA. The SC rejected this rationale. Two, in a few cases, SAT likened front running to insider trading. Borrowing from insider trading jurisprudence regarding tipper – tipee liability, SAT could have probably fastened derivative tipee liability on KB (with D as the tipper). Three – An intermediary is prohibited from front running on the basis of information legitimately acquired by him during the course of his business. It is illogical that a third party who acquires the information illegally is allowed to do that!

-Mangesh Patwardhan