Aniket Singh Charan and I have a piece in today's Financial Express on the changing nature of 'front running' a type of securities fraud.
“Now, here, you
see, it takes all the running you can do, to keep in the same place. If
you want to get somewhere else, you must run at least twice as fast as that!”
– said the Red Queen to Alice in Through the Looking Glass. There are
many examples in the securities market that perfectly demonstrate the wisdom of
the Red Queen – if you want to make a profit, you need to be faster than the
rest.
While, ordinarily,
asymmetry of information in the securities market is often exploited to achieve
profits, front-running abuses this in a nefarious manner. Front running
involves the use of non-public information pertaining to a “substantial
order”, and trading ahead of it to make profits or avoid losses. Recent
orders by the Securities and Exchange Board of India (“SEBI”), in the matters of Experts appearing on Zee Business and
Ketan Parekh indicate a rise in the number of enforcement actions taken
by the regulator for this particular offence and throws light onto the evolving
forms of front-running. They also provide interesting perspectives on
approaches adopted towards ascertaining what a “substantial order” is
and the “impact” such an order may have on the price and volume traded of
a security.
Although front-running
is a fraudulent practice, in Ketan Parekh (no relation of the first
author), SEBI has done away with the requirement to prove dishonest
intention. What is essential, however, is an inducement to deal in securities,
which is sufficient to demonstrate fraud. A parallel may be drawn to the
Supreme Court ruling in SEBI v. Abhijit Rajan, a case involving
allegations of insider trading. The Supreme Court held that it was immaterial
if actual profit or loss occurred, what is required is a motive to make a
profit from the alleged trade. This motive is a key element in such trades.
In Ketan
Parekh, Quest Investment Advisors Private Limited, a portfolio management company
registered with SEBI, indulged in front-running while in possession of advance
knowledge of impending orders. A key factor in the analysis of front-running
revolved around the interpretation of what constitutes a substantial order and the impact it may have on the price of
the securities. SEBI interpreted the meaning of the substantial order by placing reliance on the “reasonable
person test” while noting that there was very little guidance, precedentially,
available on what constitutes a substantial
order. As per the whole time member (“WTM”), in this matter, a substantial order is one which, in the
estimation of a reasonable person, would impact the price of the concerned securities.
The WTM further stated that “when it is only the estimation of reasonable
person then the assessment of actual impact of such substantial order is not
necessary to determine the substance of the order”. Ideally, determination
of what constitutes a substantial
order should be followed by an assessment of the impact such a substantial order may have on the price of the
securities traded. In the present case, there was no calculation of impact and the reasonable person test was
used to conclude that front-running did in fact, occur.
In another matter,
the front runner had undertaken trades in advance of an impending order. SEBI
held that front-running occurs when an entity makes a trade on the basis of
non-public information regarding a “large
trade” from an investor, which may impact the price of such security. SEBI
matched trades undertaken by the noticee with that of the impending large trade
and found that in almost all instances the trades executed matched that of the
impending order. Interestingly, the WTM observed that for front-running to
occur it was not mandatory that the front-runner’s trades should match with
that of the impending order. The essential element in establishing
front-running is that the trades were made on the basis of non-public
information. Whether the trades executed by the front-runner match the large
order and whether they resulted in profits, are secondary considerations.
In Zee Business,
a far more complicated picture emerges. The alleged violators belonged to three
categories – (i) experts appearing on news channels; (ii) profit makers; and
(iii) enablers. Experts appearing on news channels provided advance information
about the recommendations that were going to be made on the news broadcast
(which was held to be non-public information) to the enablers, who then used
trading terminals provided by profit makers to trade based on such advance
information. SEBI, in its order, analysed the fluctuations in the price and
volume of securities, being traded, pre and post the news broadcast. Notably, a
key ingredient of front-running i.e. the existence of an impending transaction/
substantial order was not
directly present in this case. It was held that the popularity of these shows
had equipped the noticees, with a deep awareness of the impact that expert recommendations wielded over the price and
volume of the securities so recommended. Though there was no substantial order in place, it
was argued that the noticees had a reasonable expectation of an increase in the
price and volume of the securities recommended immediately following the news
broadcast. The favourable movement in the price and trading volumes of the
securities once such recommendations were made, further strengthened this
argument. SEBI utilised a host of strategies to establish links between the
parties – from call data records, WhatsApp/Telegram chats to geographic
location analysis to further prove a nexus. It is rather interesting to note,
that the reasonable person test as
employed in Ketan Parekh, was not relied on in this order. Furthermore,
this order did not discuss who a reasonable
viewer is, and the only metric used to show inducement was the price/volume
fluctuations pre and post the broadcast. Nevertheless, this order has expanded
the contours of front-running (from a plain vanilla pump and dump scheme) to
accommodate situations where there is an intent to defraud investors by abusing
the trust which investors keep with certain individuals- such as the financial
pundits in this case and a substantial
order’s existence can be ascertained on the basis of the
quantifiable response which viewers have for guest recommendations on channels,
like Zee Business, and the change in the volume of trading in such securities. As
has been expressed earlier, the motive is what counts towards making a case of
front running, divorced from any actual profit making.
In all three
cases, SEBI utilised different approaches to ascertain impact and knowledge of
impending orders. On the road to determining substantiality of orders, the
approach adopted by SEBI has seen several variations and the ever changing contours
of front-running pose new challenges in determining liability. SEBI may have to
relook at how it defines front-running in light of these changing dimensions.
After all, a front-runner is not the only one who has to run twice as fast.
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