[By Renuka Nevgi]
The author is a student at Maharashtra National Law University, Mumbai.
Introduction: Meaning and Nature
Front running is an illegal act of buying or selling securities based on non-public information regarding a substantial future transaction likely to influence the price. It includes entering into options or futures contracts before an imminent transaction while anticipating the fluctuation in the price after the information will become public. This term has been defined in the SEBI Circular dated 25th May 2012. Regulation 4(2)(q) of SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 classifies front running as a manipulative, fraudulent and unfair trade practice. Furthermore, Sec. 12A(e) of the SEBI Act also lays down that a person shall not deal in securities directly or indirectly while possessing non-public information. Front running may take place in several ways through intermediaries as well as non-intermediaries. Orders can be placed in tranches and all such tranches placed before the last tranche of the Big Client will classify as front running transactions. This practice involves illegal usage of confidential information given to an intermediary resultantly amounting to unfair leverage. This article critically analyses the extant legal provisions as well as judicial decisions dealing with front running by non-intermediaries and juxtaposes it with those in the other jurisdictions. The author also attempts to provide constructive suggestions in order to impose effective strictures on this manipulative practice.
Kinds of Front running
According to the decision in case of SEBI v. Shri Kanaiyalal Baldevbhai Patel and Ors, front running consists of three forms of conduct: (1) ‘tippee trading’ which means trading by third parties who are given information or tipped on an impending block trade, (2) ‘self- front running’ implying the transactions wherein the purchasers or owners of block themselves involve in offsetting options or futures transaction by indulging in ‘hedging’, and (3) ‘trading ahead’ refers to a transaction in which an intermediary trades for own profit ahead of an impending customer block order. When confidential information is passed on to a third party, it results in the breach of duty prescribed by law. Specifically, if the tippee is cognizant of the breach and thereby induces the person to share such information, it is considered to be a ‘fraud’ by the recipient tippee.
Front running behaviour can be classified into two categories as confirmed by a SEBI Order in the matter of Reliance Securities Ltd.: (i) ‘BBS’ or Buy-Buy-Sell: This is when the front-runner places own buy order preceding the last tranche of Big Client’s buy order. Subsequently, the front runner keeps selling the securities bought earlier at an escalated price. And (ii) ‘SSB’ or Sell-Sell-Buy: This happens when the front-runner places own sell orders preceding the last tranche of Big Client’s sell order. Consequently, the front-runner buys securities at a reduced price as and when the Big Client’s sell order gets executed.
Indian judicial pronouncements w.r.t. non-intermediaries
If only intermediaries are held responsible for front running, then the manipulators will get the leeway to engage in iniquitous activities through name lending or by masking their identity. However, as decided in the matter of Manish Chaturvedi & Ors., name lending is a serious offence and one cannot be absolved of the liability simply by claiming obliviousness. If these activities remain uncontrolled, then those who aid and abet such unfair practices will also detrimentally affect the interest of investors. When the accounts are rented out to third parties, they become the custodians of those securities or funds. Although the account holder still remains as the technical owner, the non-intermediary or third party employs its own resources which may be utilised for illegal purposes. The account holder may also receive direct or indirect gratification in return for the same. This deceitful practise helps the third parties to carry out fraudulent activities while concealing their identity.
Under Indian law, the standard of proof required to establish front-running by third parties is a preponderance of probability, whereas any clinching evidence is not needed. The modus operandi is determined by collective analysis which leads to inference in relation to the conduct of the manipulators in the securities market. Circumstantial evidence including the pattern of trading could suffice to prove a fact. Different participants in the front running are broadly categorised as (1) ‘information carriers’ which have access to the content of non-public information (2) ‘front runner holder accounts’ that are registered owners of the trading accounts. (3) ‘mule account holders’ are the entities employed by the information carrier which operates the account set comprising of the trading account, Demat account and bank account.
In case of defiance of PFUTP regulations, SEBI had also imposed penalties that that act as a deterrent to all those who indulged in serious violations. A maximum penalty of INR 25 crores or three times of profits generated from such practice can be imposed under the SEBI Act. Along with this, SEBI is also vested with the power to institute other civil suits under the SEBI (Intermediaries) Regulations, 2008 and criminal proceedings under Sec. 24 of the SEBI Act.
Regulations in foreign countries
In the jurisdiction of U.S., front running has been classified as a separate offence by the Financial Industry Regulatory Authority. The brokers or firms are not allowed to place their interests after gaining knowledge of an imminent trade. However, if such a trade is necessary to facilitate the execution of the client’s order, they can do it with the client’s free consent. Rule 5270 includes mule account holders because it has a wide scope since it includes members as well as the persons associated with members. Thus, the third-party traders are also impliedly included within the purview of frontrunning under the FINRA Rules. Likewise, under the EU Market Abuse Regulations, Rules 23 and 24 categorically include third parties whose account is used by the trader to obtain unfair gains indirectly. It also contains a presumption of the traders themselves placing the orders if such confidential information is used to acquire or dispose off any relevant financial instrument. Upon receiving a mandate from the European Commission soliciting technical advice from the European Securities and Markets Authority (ESMA), a consultation paper was published which included also recommended for better clarity in regard with pre-hedging and front running.
South Africa has enacted a securities regulation Financial Markets Act, 2012 to control the manipulative practices including front running. Clause 5 of Sec. 78 encompasses the non-intermediaries dealing in securities after getting information from the insider. The intelligible language of this Act enables to bring clarity as to the prevailing law. With respect to Canada, the Investment Industry Regulatory Organisation supervises and regulates all the activities. Rule 4.1 of the Universal Market Integrity Rules (UMIR) comprehensively defines front running. It is divided into three types: (1) the intermediary itself placing an order (2) soliciting an order from a third party (3) leaking such confidential information to a third party. It also sets forth certain defences or exceptions. For example, the person was an employee of the same firm, but did not have the knowledge of client order or transaction was entered for arbitrage account. The existence of specific knowledge concerning the order is a pre-condition under the provision. Hence, Rule 4.1 sufficiently conjectures most of the probabilities thereby addressing the problem of making the non-intermediaries accountable.
Analysis and Conclusion
In 2013, the Securities Appellate Tribunal had ruled that front running by non-intermediaries is not banned because Regulation 4(2)(q) of PFUTP does not encompass third parties. This was eventually overruled by the Hon’ble Supreme Court of India in 2017. It was observed that the definition of front running cannot be put in a straight jacket formula and liberal interpretation should be given to the concept. The regulations under PFUTP will also be applicable to other connected persons fulfilling the following criteria: (1) person had a duty to keep the non-public information confidential (2) tippee was aware of the breach of duty (3) tippee trades thereby defrauding the person. Such conflicting judgments necessitate the passing of regulation or amendment by the policymakers to clarify whether non-intermediaries having synchronised transactions can be held liable for front running. What cannot be done directly, should also not be done indirectly. This calls for a need to enact a specific provision barring third parties from using privileged information obtained through a broker. Another important question is whether mere inter-linkages between the broker and the third party are sufficient to prove leakage of non-public information or mens rea is mandatory to be proven. The standard of proof will be higher if mens rea is also required to be established. The inter-link between broker and third party and usage of such information should translate into a presumption against the non-intermediary. A more comprehensive definition of front running similar to that in Rule 4.1 of UMIR is needed for crystallising all the provisions relating to front running by non-intermediaries. Along with the general definition, a few exceptions also need to be carved out expressly.
Commonly, such third parties attempt to pass off the trades which have been pre-positioned as genuine trades. This implies they venture to pass off their front-run trades as those executed in the normal course of trading. In such transactions, the layering between the source of confidential information and the entities who execute the trades is done at multiple levels so as to maintain the obscurity of the participants. As rightly decided by the Supreme Court, a connotation that shields the stakeholders against unjust claims and frauds must be considered. Apart from the specific Big Client, other investors in the market may also suffer due to such transactions. Front running is not only a fraud against individuals, but it also threatens the market’s integrity. These illegal and unethical practices by non-intermediaries must be curbed with strong hands so as to proscribe them from camouflaging and evading detection by the regulatory authorities. Promulgation of detailed stringent regulations will enable to control of these trading activities by inter-linked third parties thereby maintaining an equilibrium in the market.