A Rule of Reason for Self-Trades?

[The following guest post is
contributed by Nikunj Agarwal, a 4th
year student at RML National Law University, Lucknow and Arjun Agarwal, a 3rd year student at WB National
University of Juridical Sciences, Kolkata. The authors can be contacted at [email protected]]
Prefatory
It
is one of the well-known principles of securities regulation that the primary
objective of such regulation is to ensure that the market information is
accurate and dissemination of such information is not prejudicial or beneficial
only to a particular group over others. Then, zealous pursuit by a capital
market regulator to ensure that the quality of information in the market is
accurate can only be commended. However, sometimes zealousness translates into
rigidity and a conscious choice to overlook the obvious alternatives. It seems
that is the case with ‘self trade restriction’ in securities markets in India. ‘Wrongful’
self trades are essentially concerned with manipulation of information about
market liquidity and price of the scrip. Therefore, execution of such trades is
considered unfair and fraudulent and therefore a breach of the basic norms of
securities laws. It also seems obvious that the person entering into any
commercial transaction has to ensure that his conduct is not violative of any
law of the land.
However,
the conundrum of Indian securities law is that the regulator has assumed that
every self trade is wrongful and ipso
jure
violative of securities laws. Further, the problem snowballs when a
self trade, on quantitative basis, cannot manipulate price or liquidity
information in the market but is still held wrongful and in violation of
securities laws. The worst case scenario in Indian law is where self trade
occurs due to technical inadvertent matching with no intention to effect or has
no actual effect on relevant information in the market and yet it is
categorized as wrongful and violative of securities laws.
In
this post, we submit that although the law states that self trades are ‘per se’ illegal, there are specific
instances where Securities and Exchange Board of India (“SEBI”) and Securities
Appellate Tribunal (“SAT”) have departed from a mechanical application of the
stated ‘per se rule’. In these cases,
a more pragmatic approach, similar to the ‘rule of reason’ approach in
competition law, has been adopted. It is here where the subject matter of
crucial analysis lies: does the regulator understand every self trade to be
‘wrongful’? In the course of our analysis we will establish that law is still
in a state of confusion as regards unintentional technical violations. In such
instances, there might be absence of ‘material market harm’ such as where
matched trades constitute very low fraction of the total trading volume in the
scrip whereby the materiality of market effect is negligible. If the ‘per se rule’ is the applicable law, then
even such instances shall be violative of the
SEBI (Prohibition Of Fraudulent And Unfair Trade Practices Relating To
Securities Market) Regulations, 2003 (
PFUTP Regulations”). However, if the aim and objective of
the regulations is to address fraudulent and unfair trading in the securities
markets, then penalizing such accidental self trades would be beyond the scope
of the regulations.
The Necessity of ‘Intent’
The element of fraud appears
to be a pre-requisite in all the parts of Regulations 3 and 4 of the PFUTP
Regulations
. Further, since the term ‘fraud’
has been principally defined under Regulation 2(c), though inclusively, to mean
such trades which are entered into in order to ‘induce others’, it would be
difficult to call such trades fraudulent within the meaning of the PFUTP Regulations.
Furthermore,
since these trades are accidental in nature, no meaningful deterrence could be
achieved where the defaulters could do nothing to prevent such matches from
occurring in the future. This clearly means that a distinction must be made
between ‘wrongful self trades’ and ‘non-wrongful self trades’. The latter do
not mean legitimate or ‘lawful self trades’.
The
aim of securities laws must rightfully be to eliminate all avoidable market
aberrations. But, pursuing this goal by means of punishing every market
aberration might not always serve the purpose. Self trades, if material and
substantial, affect market information regarding particular securities.
Therefore, as long as a fictitious rule of ‘theoretical market harm’ whereby
even single self trade of even one share is deemed to adversely affect the
market, any adverse consequence on market information cannot be identified in
such instances.
The
Varying Standards
The
authorities appear to have taken an equivocating stand by applying opposite legal
standards in different cases. In Balwinder
Singh v. SEBI
, the SAT observed that “self trades/wash trades are per
se not allowed
under SEBI Act/Rules, since these do not result in
actual/beneficial ownership of shares and only result in increase in volumes in
particular scrip, which create illusion of increased trading in these scrip and
may mislead investors in trading in these scrips and disturb/distort securities
market
”.
In
Anita
Dalal v. SEBI
, the SAT observed:
Self trades admittedly are
illegal
. This Tribunal has held
in several cases that self trades call
for punitive action since they are illegal in nature
. In M/s. Jayantilal
Khandwala & Sons Pvt. Ltd. vs. Securities and Exchange Board of India, this
Tribunal has held that “one cannot buy and sell shares from himself. Such
transactions are obviously fictitious and meant only to create false volumes on
the trading screen of the exchange
”.
Further,
in HJ
Securities Pvt Ltd v. SEBI
, the SAT noted that “Simply because the number of such self trades is not large by itself
cannot justify execution of self trades
”.
The
above ruling must be contrasted with observations of the SAT in Smt.
Krupa Sanjay Soni v. SEBI
where it had taken a view that “a few instances of self trades in themselves
would not, ipso facto, amount to an objectionable trades
”.  But, in Systematix
Shares & Stocks (India) Limited v. SEBI
, the SAT observed that “it has been held in several cases by this
Tribunal that self trades are fictitious and reprehensible. Trades, where
beneficial ownership is not transferred, are admittedly manipulative in nature.”
It is pertinent to note
here that the SAT seems to have read the law to mean that ‘self trades ipso
jure amount to manipulative conduct and therefore punishable under securities
laws’.
Analysis
It
is submitted that while framing the test whether to penalize a self trade, the
correct approach is to adopt a two-pronged analysis. In the first stage, it
must be analyzed whether intention to manipulate or commit fraud is present.
Such analysis must inevitably be subjective and intention must not be presumed
only by the fact that self trade has happened. If intention is established, for
the purpose of establishing liability, a further enquiry into ‘materiality of
market harm’ should not be conducted. This is the direct mandate of the PFUTP Regulations
since even where no market harm arises, a demonstrated manipulative and
fraudulent activity must be punished under the regulations.
In
the second approach, where intention to commit fraud or manipulate the market
is found lacking and where the entire transaction was not a product of
manipulative activity, the true crux of the problem lies. In such cases, the SAT
seems to have taken an approach that if the volume of shares traded is large
and material impact on market information can be established, such transaction
must be punished. In a very recent decision of Re: Bharatiya Global Infomedia Limited and Ors, SEBI adopted the
abovementioned approach to find liability for self trades.
It
is submitted that the requirements of Regulation 4(2) are very specific in
nature. The test laid down in the regulation demand a manipulative intent to
affect market information. Even if we read clause (a) as a strict liability
clause, the test would be to prove ‘misleading appearance of trading’. However,
in cases where the shares traded are highly liquid and self trades happen due
to mere technical reasons, the requirements of Regulation 4 are not met. It
seems absurd to read a strict liability offence in a regulation meant to punish
unfair and manipulative activities. As long as self trade is defined in the
regulations is read and understood as a strict liability offence, the approach
of the tribunal appears to be ultra vires
the regulations.
The
requirements of intention and materiality must not be so confused so that one
is presumed to lead to the other. As already stated, though securities laws
must aim at restricting self trades, it is not the same thing as punishing
every instance of self trade as manipulative and unfair trade practice. The
reasoning adopted by the SEBI and the SAT for penalizing technical self trades
is available in the HJ Securities
judgment where the tribunal held that “The
appellant is free to adopt any business model but he has to ensure that
whatever business model he adopts, it is in conformity with the regulatory
framework
” Even if the regulations are read to incorporate ‘a duty to
prevent market harm’, such duty must be located in the text of specific
provision under the regulations.
In
instances where all reasonable precautions were taken and yet self trades
happen due to technical reasons or inadvertently it seems difficult to invoke
the ‘duty to prevent’ to find a violation of the regulations.  Invocation of ‘materiality of adverse market
effect’ as a new and innovative standard to find a violation of the regulations
would be clearly outside the scope and objective of the regulations. Therefore,
it is plausible to say that substantiality or materiality of the adverse market
effect caused by the self trade should not be invoked as an independent element
in finding a liability for violation of the regulations. The standard of
substantiality or materiality must be invoked as a supplementary but not
independent standard for violation of the regulations.
Conclusion
Therefore,
it is submitted that to suggest that ‘self trades are per se illegal’ is both
factually and legally incorrect and a rule of reason must be adopted to
identify ‘wrongful self trades’ punishable under the PFUTP Regulations.
Certainly, the self trades which do not qualify as ‘wrongful’ do not become
‘valid’ and are still subject to restrictions and reprehensions under the
securities laws but, as long as a deeming fiction is incorporated into the law,
they cannot be branded as manipulative and fraudulent.
– Nikunj Agarwal & Arjun Agarwal

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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