Front-Running by Non-Intermediaries: Supreme Court Clarifies Securities Market Regulations (20 September 2017)

Can individuals who are not intermediaries be held liable for front-running in the securities market? The Supreme Court of India addressed this important question in a series of appeals, clarifying the scope of the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003. This judgment provides crucial insights into market manipulation and the responsibilities of traders.

Citation: Civil Appeal No. 2595 of 2013, with Civil Appeal Nos. 2596 of 2013, 2666 of 2013, 5829 of 2014, and 11195-11196 of 2014.

Judges: N. V. Ramana J. and Ranjan Gogoi J.

The judgment was delivered by a two-judge bench, with both judges providing separate but concurring opinions. Justice N.V. Ramana authored the main judgment, while Justice Ranjan Gogoi provided a supplementary opinion.

Case Background

The Securities and Exchange Board of India (SEBI) initiated investigations into several cases of alleged front-running. Front-running involves trading based on non-public information about impending large transactions. These cases involved both intermediaries and non-intermediaries. The core issue was whether non-intermediaries could be held liable for front-running under the existing regulations.

The appeals were filed by both SEBI and private individuals who were accused of front-running. The Securities Appellate Tribunal (SAT) had taken differing views on the matter in different cases, leading to the appeals before the Supreme Court.

Timeline:

Course of Proceedings

The Securities Appellate Tribunal (SAT) had taken different views in different cases. In some cases, the SAT overturned the orders of the Adjudicating Officer, holding that the actions of non-intermediaries did not amount to fraudulent or unfair trade practices. In other cases, the SAT upheld the orders of the Adjudicating Officer. This inconsistency led to the appeals before the Supreme Court.

Legal Framework

The core of this case revolves around the interpretation of the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003 (FUTP 2003).

Regulation 2(c) of FUTP 2003 defines “fraud” broadly, including any act, expression, omission, or concealment that induces another person to deal in securities, whether or not there is wrongful gain or avoidance of loss.
“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, whether or not there is any wrongful gain or avoidance of any loss, and shall also include-

Regulation 3 of FUTP 2003 prohibits dealing in securities in a fraudulent manner.
No person shall buy, sell or otherwise deal in securities in a fraudulent manner.

Regulation 4(1) of FUTP 2003 prohibits manipulative, fraudulent, and unfair trade practices.
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) specifically addresses front-running by intermediaries, deeming it a fraudulent or unfair trade practice.
An intermediary buying or selling securities in advance of a substantial client order or whereby a futures or option position is taken about an impending transaction in the same or related futures or options contract.

The Supreme Court noted that the definition of “dealing in securities” is broad and inclusive, encompassing buying, selling, or transacting in any way in any security.

Arguments

Submissions on behalf of the Appellant in CIVIL APPEAL NO. 5829 OF 2014:

• The finding of fraud against the appellant under regulations 3 and 4 of FUTP 2003 is not in line with the definition of fraud in Regulation 2(1)(c).
• Sub-clauses (i), (j), (l), (m), (p), (o), and (q) of clause (2) of regulation 4 apply only to intermediaries, not individual buyers or sellers.
• The rest of the sub-clauses in Regulation 4 pertain to activities undertaken by intermediaries, making the entire regulation inapplicable to the appellant.

Submissions on behalf of SEBI:

• The scope of FUTP regulations has significantly expanded from 1995 to 2003.
• The specific prohibition of front-running for intermediaries in Regulation 4(2)(q) should not limit the broader scope of regulation 4.
• The principle of ‘Expressio Unius Est Exclusio Alterius’ should not be used to exclude liability for non-intermediary front-running.

Other counsels either adopted these submissions or provided alternative reasons supporting their respective positions.

The core issue was whether front-running by non-intermediaries is prohibited under regulations 3(a), (b), (c), (d), and 4(1) of FUTP 2003.

Submissions Table

Issues Framed by the Supreme Court

1. Whether ‘front running by non-intermediary’ is a prohibited practice under regulations 3 (a), (b), (c) and (d) and 4(1) of FUTP 2003?

Treatment of the Issue by the Court

Authorities

The Court considered various definitions of “front-running” from legal dictionaries and SEBI circulars. It also analyzed the evolution of the definition of “fraud” under the FUTP regulations.

The Court referred to the following authorities:

Judgment

The Supreme Court held that non-intermediary front-running can be considered a fraudulent or unfair trade practice under regulations 3 and 4(1) of FUTP 2003, provided that the necessary ingredients are satisfied.

How each submission made by the Parties was treated by the Court?

How each authority was viewed by the Court?

The Court relied on the definitions of front-running from various sources to establish the nature of the practice. It also used precedents to interpret the scope of regulations and the meaning of fraud.

• The Court used the definitions from Major Law Lexicon by P. Ramanatha Aiyar and The Black’s Law dictionary to understand the meaning of front-running.
• The Court used SEBI Circular CIR/EFD/1/2012 and Consultative Paper issued by SEBI to understand SEBI’s view on front-running.
• The Court distinguished the principle of strict construction of penal laws as held in Govind Impex Pvt. Ltd. v. Income Tax Department and Krishi Utpadan Mandi Samiti v. Pilibhit Pantnagar Beej Ltd.
• The Court followed the principle of investor protection as held in SEBI v. Kishore R. Ajmera.
• The Court followed the principle of market integrity as held in N. Narayanan v. Adjudicating Officer, SEBI.
• The Court relied on Palmer’s Company Law and Gower & Davies – Principles of Modern Company Law to understand market manipulation.
• The Court distinguished the rule of interpretation ‘expressio unius est exclusio alterius’ as held in Colquhoun v. Brooks and Lowe v. Darling & Sons.
• The Court analyzed Securities and Exchange Commission vs. National Securities, Inc., et al. to understand the scope of securities laws.
• The Court analyzed David Carpenter, Kenneth P. Felis and R. Foster Winans, v. United States to understand the meaning of fraud and fiduciary duty.
• The Court analyzed Vincent F. Chiarella v. United States to understand securities fraud under section 10b of the Securities Exchange Act, 1934.
• The Court used 3 W. Fletcher, Cyclopedia of Law of Private Corporations to understand the confidentiality of corporate information.

What weighed in the mind of the Court?

The Court emphasized the need to protect market integrity and investor confidence. It noted that the definition of fraud under FUTP 2003 is broad and includes acts that induce others to deal in securities, even without deceit. The Court also highlighted that the regulations aim to curb market manipulation and ensure a level playing field.

Fact:Law Ratio

The court emphasized that the law should be interpreted to prevent unjust claims, fraud, and expediency over principle. The court also noted that the definition of “dealing in securities” is broad and inclusive.

Logical Reasoning

The Court also considered the element of causation, requiring SEBI to establish that harm was induced by the materialization of a risk not disclosed due to the tippee’s fraudulent practice.

The Court observed that the provisions of regulations 3(a), (b), (c), (d) and 4(1) are couched in general terms to cover diverse situations and possibilities.

The Court also analyzed American jurisprudence, particularly the cases of David Carpenter, Kenneth P. Felis and R. Foster Winans, v. United States and Vincent F. Chiarella v. United States, to understand the concept of fraud in securities markets.

The Court emphasized that confidentiality has a bearing on the case. It stated that a person conveying confidential information to another person (tippee) breaches his duty prescribed by law, and if the recipient of such information knows of the breach and trades, and there is an inducement to bring about an inequitable result, then the recipient tippee may be said to have committed the fraud.

The Court concluded that the concerned parties in the cases before it were involved in fraudulent practices that violated market integrity.

Justice Ranjan Gogoi, in his concurring opinion, emphasized that the definition of fraud in Regulation 2(c) focuses on whether an act induces another person to deal in securities, not necessarily whether the act was deceitful. He also highlighted that the word “induce” means to entice or persuade someone to take a certain course of action.

Justice Gogoi stated that a person can be said to have induced another person to act in a particular way if, based on the facts and statements made by the first person, the second person commits or omits to perform an act. The test is whether the second person would have acted in the manner he did but for the representation of the facts made by the first person.

Justice Gogoi also clarified that while Regulation 3(a) prohibits dealing in securities in a fraudulent manner, Regulation 4 operates independently and prohibits fraudulent or unfair trade practices. He noted that Regulation 4 is without prejudice to Regulation 3.

Justice Gogoi concluded that if a person parts with information regarding acquisition of shares and the recipient trades based on that information, it can be inferred that the recipient was induced to deal in securities.

Justice Gogoi also noted that mens rea is not an indispensable requirement to attract the rigor of Regulations 3 and 4 of the 2003 Regulations. The correct test is one of preponderance of probabilities.

The Court allowed Civil Appeal Nos. 2595, 2596, and 2666 of 2013, and dismissed Civil Appeal Nos. 5829 of 2014 and 11195-11196 of 2014.

Key Takeaways

• Non-intermediaries can be held liable for front-running if they trade based on confidential information and induce others to deal in securities.
• The definition of “fraud” under FUTP 2003 is broad and includes acts that induce others to deal in securities, even without deceit.
• The regulations aim to protect market integrity and investor confidence by curbing market manipulation.
• The element of causation is important, and SEBI must establish that harm was induced by the materialization of a risk not disclosed due to the tippee’s fraudulent practice.
• Mens rea is not an indispensable requirement to attract the rigor of Regulations 3 and 4 of the 2003 Regulations. The correct test is one of preponderance of probabilities.

Directions

The Supreme Court set aside the orders of the Appellate Tribunal in Civil Appeal Nos. 2595, 2596, and 2666 of 2013 and restored the findings and penalties imposed by the Adjudicating Officer.

Development of Law

This judgment clarifies that non-intermediary front-running is a prohibited practice under the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003. The ratio decidendi is that the definition of fraud is broad and includes acts that induce others to deal in securities, even without deceit. This expands the scope of the regulations beyond just intermediaries.

Conclusion

The Supreme Court’s judgment in this case clarifies the scope of regulations governing front-running in the securities market. It establishes that non-intermediaries can be held liable for such activities if they trade on confidential information and induce others to deal in securities. This ruling reinforces the importance of market integrity and investor protection.

Category

Parent category: Securities Law

Child categories:

• Front-Running
• Market Manipulation
• Fraudulent Trade Practices
• Unfair Trade Practices
• Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003
• Regulation 2(c), Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003
• Regulation 3, Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003
• Regulation 4, Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003

FAQ

Q: What is front-running in the securities market?

A: Front-running is the practice of trading based on non-public information about impending large transactions, typically to profit from the subsequent price movement.

Q: Can non-intermediaries be held liable for front-running?

A: Yes, according to this Supreme Court judgment, non-intermediaries can be held liable for front-running if they trade based on confidential information and induce others to deal in securities.

Q: What is the definition of “fraud” under the FUTP 2003 regulations?

A: The definition of fraud under FUTP 2003 is broad and includes any act, expression, omission, or concealment that induces another person to deal in securities, whether or not there is wrongful gain or avoidance of loss.

Q: What is the significance of this judgment?

A: This judgment clarifies that the regulations governing front-running apply not only to intermediaries but also to non-intermediaries, reinforcing the importance of market integrity and investor protection.

Q: What is the role of SEBI in these cases?

A: SEBI is the regulatory body that investigates and takes action against fraudulent and unfair trade practices in the securities market. It plays a crucial role in ensuring market integrity and investor confidence.