SEBI has passed an order on 8th May 2018 in a case of front running. On the face of it, there is nothing distinctive. The law relating to front running has seen ups and downs in the past, with even contradictory decisions of SAT, but the Supreme Court ([2017] 144 SCL 5 (SC)) largely settled the matter. Yet, this order raises and reminds of concerns that the law has not been thought through well and the orders cause injustice and even inequity to parties.
Front running has been discussed several times earlier herein (see, for example, here, here and here). Simply stated, it is about a person having knowledge of impending large trade orders, who then trades ahead (hence ‘front running’) to profit from such orders. Large orders usually influence the price. The front runner buys first and then sells the shares to the original buyer and profits. The original buyer ends up paying a higher price and thus suffers.
Front running, as the Supreme Court analysed, can be put in 3 categories. One is where a person comes to know of such proposed large trades and trades ahead. Second is where the person, who proposes to carry out large trades, himself carries out hedging or similar off setting trades to protect himself of the effect on price his large trades would cause. Third case is of an intermediary who comes to know of a client’s proposed large trades and trades ahead of him.
The third category is specifically prohibited under the SEBI PFUTP Regulations (Regulation 4(2)(q)). The second category is not considered to be front running or the like. The prolonged dispute was largely about the first category where a person who comes to know of such proposed large trades and owes a fiduciary duty not to use it. The Supreme Court held that merely because there was a specific provision for front running by intermediaries did not mean that non-intermediary front running cannot be covered under generic provisions. Hence, the first category was also deemed to be wrongful.
In the present case, the facts, briefly and simplified, were as follows. A private company, apparently engaged in jewellery business, had entered into large trades in shares. The trades were looked after an employee who coordinated these trades with the stock broker. However, he traded ahead and made significant profits of Rs. 38 lakhs. By an earlier order, he was debarred for a period of three years. By the present order, he was required to disgorge this profit plus interest aggregating to Rs. 61.73 lakhs.
Three issues arise.
One is whether, in such cases, the interests of investors or markets are adversely affected and thus whether SEBI can and should have any role. SEBI asserted, and rightly so, that the issue of violation of the PFUTP Regulations had attained finality owing to the previous order in the same party’s case, and also the decision of the Supreme Court. However, SEBI repeatedly stated that interests of investors and markets generally were harmed. This is curious and goes to the fundamentals of the question whether such cases should at all be held to be fraudulent as to be violation of the Regulations. Take a simplified example of what happens in such cases. A person desires to buy, say, 10 lakh shares of company A when the price is Rs.100. His purchase would result in increase in price to Rs. 103. The employee, who is authorised to execute this order, trades ahead and buys 10 lakhs shares for himself resulting in price rising to Rs. 103. He then asks the broker to execute his employer’s order at the ruling price of Rs. 103 while he himself sells on the other side. Effectively, he makes a profit of Rs. 3 or more per share. Clearly, this profit is made at the cost of his employer in breach of trust his employer bestowed on him. However, can such private breach of trust be treated as such a fraud in dealing in securities as in violation of the Regulations? That would be stretching the scope of the Regulations wider than what is the intention and spirit and perhaps even the letter. It is submitted that merely because a fraud involves securities should not result in SEBI taking action unless markets or other investors generally are harmed.
It is also submitted that there are no losses to investors generally in such cases. As the example given above shows, it is only the employer who loses. Even without such front running, the public investors would have got the same price on sale. They would have sold the shares at the same price to the employer as they did to the employee. The credibility of the markets too is not lost since the fraud was committed by the employee on the employer and not by the system. Of course, because of such front running, the volume in shares doubled but that by itself, it is submitted, is not sufficient reason to extend scope of the Regulations to private breach of trusts/frauds. Private breaches of trust can be of such wide and varied nature that SEBI may end up meddling in private disputes.
Secondly, treating such front running as in violation of the Regulations would result in double punishment of the front runner. Firstly, he would be punished by the employer. It is very likely that he would lose his job. Secondly, he would be required to make good the loss to the employer. Thirdly, the employee may lose his reputation and may not find job easily. It is also possible that the employer may initiate prosecution against him. However, it is seen that SEBI too is punishing such a person. In the present case, it is seen that he has been debarred from the markets for three years. Secondly, he has been asked to disgorge the profits and that too with 12% interest. Thirdly, it is possible that he may be asked to pay penalty, which can be upto 3 times the profits made or Rs. 25 crores whichever is higher. There is also a possibility of him being prosecuted. Such dual punishment does not stand to reason.
Thirdly, there is inequity and injustice involved here. The loss has been caused to the employer in this case. However, it is SEBI that has disgorged the profits, none of which goes to the person who has lost the money. This profit and even interest fairly belongs to the employer. Interestingly, it is seen in this case that the employee had very low annual income and these profits from front running thus were very significant. These earnings enabled even him to buy a flat. This flat has now been encumbered by SEBI and quite possibly be made to be sold to pay to SEBI the disgorged profits plus interest. In this case, there may not be much left for the employer. Even if there was, the employee would be paying the profits plus interest twice.
This principle should apply even to cases where intermediaries were involved. It is the client of the stock broker who suffers and this illegitimate profit disgorged needs to be handed over to him.
To conclude and summarise, the law relating to front running involving private breach of trust needs to be revisited. SEBI should concern itself only to cases where the interests of investors/markets are affected. Secondly, even where it takes action, it should ensure that the persons who have lost monies because of such front running are compensated and the disgorged profits should not be retained by it even for Investor Protection and Education. The order itself should provide for restitution to the persons who have lost money, particularly in case like this where the loss cause to identified investors is more or less self evident.
In my opinion, the front runner in acquiring shares at a lower price point, deprives sellers who sell to him from taking advantage of a higher price caused due to the impending significant trade. Thus, SEBI steps in.
@Arka Saha.
If the front runner was absent, it would have been the original buyer who would have purchased at the same price. The front runner replaces the buyer’s orders with his own. Hence, I gave the example of purchases at Rs. 100. In ordinary course, the original buyer would have started buying at Rs. 100. Instead, the front runner buys first – against at Rs. 100. The seller does not lose. But the original buyer has to buy at the increased price, with the front runner selling now.