In 1942, at a meeting of the commissioners of the US securities regulator, the SEC, one of them asked rhetorically, “Well, we are against fraud, aren’t we?” And thus was drafted the famous rule against fraud in US securities regulations. For a humble rule, which must live under the tutelage of a section of an act, it is quite a prima donna. Mention Rule 10b-5 or just 10b-5 and lawyers and laymen the world over often recognise the massive jurisprudence that came out of this brief conversation. The SEC unanimously adopted Rule 10b-5, prohibiting any person from employing any device, scheme, or artifice to defraud investors including making any untrue statement of a material fact or omitting to state a material fact in connection with the purchase or sale of any security.
This story is interesting given the recent ruling of our Securities Appellate Tribunal (SAT), which held that front-running (a form of fraud) is illegal only if committed by an intermediary. In other words, front-running is legal if committed by a non-intermediary. The facts in brief were as follows: The portfolio manager of a foreign institutional investor (FII), who made investment decisions for the FII, before buying stocks for the FII bought those stocks in his personal account. Thereafter, the manager sold those shares through the exchange mechanism to the FII and made huge gains in the process. When one buys large quantities of shares over a period of time resulting in a large acquisition of shares, clearly the price would gradually move up. If, at the end of that period, one were to sell those shares, one would make a tidy profit at the cost of one’s duty not to defraud. That sounds quite fraudulent: your own manager skimming the cream off the milk and adding sewage water and selling to you.
Interestingly, an internal investigation by a law firm found this to be fraudulent and fired the manager. Sebi also sought to penalise the manger for this fraud on its client. The manager went on to appeal and won. SAT in its ruling observed, “Examined in the above perspective, [it] is clear that the appellants were doing front-running in relation to the trades of the passport [FII].” However, it set aside Sebi’s order penalising the manager and two others for front-running on the grounds that (a) since the alleged persons were not intermediaries, the regulations wouldn’t apply to them and (b) there is no fraud played on the market by the alleged persons.
This order will profoundly disturb the anti-fraud laws currently protecting investors in India for the following reasons:
First, fraud has been widely defined by the Sebi Act, 1992 (see S. 11(2)(e) read with S 12A of Sebi Act), and it is not clear that even Sebi has the power to dilute the anti-fraud rule enacted by the Parliament of India. Fraud is also well understood in common law and the definition approximately follows the common law definition.
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 (India’s version of Rule 10b-5), also defines it expansively in Regulations 2 and 3. Regulation 2(c) defines fraud inclusively as, “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”. Regulation 3 starts with, “No person shall directly or indirectly...”. In contrast, Regulation 4, which was exclusively relied upon by SAT 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.” Regulation 4(2)(q), on which the SAT relied upon, is not an exhaustive clause. It forms a part of the list, which is an inclusive one, and which states in the beginning, “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 :-”. Relying on an explanation-cum-deeming-provision while ignoring the charging regulation and the charging section of the Act and the common law understanding of the meaning of fraud created this rather unfair conclusion.
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? It is hard to believe that one must be registered with Sebi to be called an intermediary. 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. In other words, if your distributor defrauds you, as per this ruling, you will have no recourse. It should be remembered that distributor misselling and churning are the biggest banes of India’s equity markets. People have been so often and so completely cheated by many that Sebi is now planning to introduce a new regulation to cover them. But even after the new regulations, a vast number of intermediaries will not require any registration with Sebi. Extending this further, even employees of registered intermediaries will be exempt as they are not intermediaries, only employees of intermediaries. So, front-running by employees of your mutual fund asset manager will be allowed to freely rip off the mutual fund clients. As per the SAT ruling, they now will be able to commit fraud on investors without fear.
Fourth, SAT didn’t even ask the question of 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? The relevant question to ask is whether fraud occurred and if it did, what remedies and penalties need to be administered. The Sebi Act, which incidentally also created SAT, has a preamble which starts with, “An Act to provide for the establishment of a Board to protect the interests of investors in securities.” The point is to protect investors, not exempt wrongdoers if they wear a particular hat.
One could argue that the SAT came to such a decision on the facts of the case. Unfortunately, that is not the case and Sebi would be left with virtually no powers in relation to front-running even by intermediaries. Clearly, the remit of the law is to prohibit fraud by any person against any person. Any other interpretation begs the question: “Well, we are against fraud, aren’t we?”
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