Supreme Court clarifies fraudulent trading in derivatives: SEBI vs. Rakhi Trading (2018)

Introduction

Date of the Judgment: 8 February 2018

Citation: (2018) INSC 114

Judges: Kurian Joseph, J. and R. Banumathi, J.

Can traders manipulate the stock market by engaging in synchronized and reversed trades in the derivatives segment? The Supreme Court of India recently addressed this critical question in a case involving the Securities and Exchange Board of India (SEBI) and several trading entities. This judgment clarifies what constitutes fraudulent and unfair trade practices in the securities market, particularly concerning derivatives.

The core issue revolved around whether synchronized and reversed trades, where the same parties quickly buy and sell contracts with minimal change in the underlying asset’s value, constitute market manipulation. The Supreme Court examined the actions of traders and brokers, ultimately ruling against the traders for engaging in practices that undermined market integrity.

The judgment was delivered by a bench comprising Justice Kurian Joseph and Justice R. Banumathi, with both judges providing concurring opinions. Justice Kurian Joseph authored the main judgment, while Justice R. Banumathi provided additional reasoning supporting the same conclusion.

Case Background

In 2007, SEBI investigated trading patterns in the derivatives segment of the National Stock Exchange (NSE). They found that some traders were engaging in synchronized trades, where buy and sell orders were placed almost simultaneously, often with the same counterparty. These trades were frequently reversed within minutes or hours, with significant price differences but without substantial changes in the value of the underlying assets.

SEBI issued show cause notices to three traders—Rakhi Trading Private Limited, Tungarli Tradeplace Private Limited, and TLB Securities Limited—and three brokers—Indiabulls Securities Limited, Angel Capital and Debt Market Limited, and Prashant Jayantilal Patel. The notices alleged that these entities had violated regulations prohibiting fraudulent and unfair trade practices.

The traders were accused of executing non-genuine transactions in the Futures and Options (F&O) segment, particularly in NIFTY options and future scrips. These trades were characterized by rapid reversals, where one party booked profits while the other incurred losses, all without any real change in the market value of the underlying assets. The brokers were charged with facilitating these transactions, thereby violating their code of conduct.

The Adjudicating Officer (A.O.) of SEBI found the traders guilty of violating the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 (PFUTP Regulations) and imposed penalties. However, the Securities Appellate Tribunal (SAT) overturned these decisions, leading SEBI to appeal to the Supreme Court.

Timeline:

Legal Framework

The Supreme Court referenced several key legal provisions to establish the framework for its decision:

• The Securities Contracts (Regulation) Act, 1956: This Act regulates the securities market and prevents undesirable transactions.
  • Section 18A: Legalizes contracts in derivatives if traded on a recognized stock exchange.
  • Section 2(ac): Defines “derivative” to include securities derived from debt instruments, shares, and contracts deriving value from underlying securities.
  • Section 2(d): Defines “option in securities” as a contract for the purchase or sale of a right to buy or sell securities in the future.
  • Section 2(h): Defines “securities” to include shares, stocks, bonds, and derivatives.
• The Securities and Exchange Board of India Act, 1992: This Act established SEBI to protect investors and regulate the securities market.
  • Section 15HA: Provides for penalties for fraudulent and unfair trade practices.
  • Section 15I: Deals with adjudication.
  • Section 15T: Provides for appeals to the Securities Appellate Tribunal (SAT).
  • Section 15Z: Provides for appeals to the Supreme Court on questions of law.
  • Section 30: Empowers SEBI to make regulations consistent with the Act.
• The Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 (PFUTP Regulations):
  • Regulation 2(1)(b): Defines “dealing in securities” to include buying, selling, or subscribing to any security.
  • Regulation 3: Prohibits certain dealings in securities, including fraudulent transactions and manipulative devices.
    • Regulation 3(a): Prohibits buying, selling, or dealing in securities in a fraudulent manner.
    • Regulation 3(b): Prohibits using manipulative or deceptive devices in connection with securities.
    • Regulation 3(c): Prohibits employing any device to defraud in connection with dealing in securities.
    • Regulation 3(d): Prohibits any act that operates as a fraud or deceit in connection with dealing in securities.
  • Regulation 4: Prohibits manipulative, fraudulent, and unfair trade practices.
    • Regulation 4(1): Prohibits indulging in fraudulent or unfair trade practices.
    • Regulation 4(2): Defines fraudulent or unfair trade practices to include:
      • Regulation 4(2)(a): Indulging in acts that create a false or misleading appearance of trading.
      • Regulation 4(2)(b): Dealing in securities without intending to transfer beneficial ownership.
      • Regulation 4(2)(e): Any act amounting to manipulation of the price of a security.
      • Regulation 4(2)(g): Entering into a transaction without intending to perform it or change ownership.
  • Regulation 2(1)(c): Defines “fraud” to include misrepresentation, concealment, and deceptive behavior.
    • Regulation 2(1)(c)(2): Suggestion as to a fact which is not true while he does not believe it to be true is fraud.
    • Regulation 2(1)(c)(7): A deceptive behaviour of one depriving another of informed consent or full participation is fraud.
    • Regulation 2(1)(c)(8): A false statement without any reasonable ground for believing it to be true is also fraud.
• Securities and Exchange Board of India (Stockbrokers and Sub-brokers) Regulations, 1992:
  • Schedule II: Code of conduct for stockbrokers, including maintaining integrity, exercising due skill and care, and not indulging in manipulative practices.
  • Regulation 7A: Code of conduct for stockbrokers.

Arguments

SEBI’s Submissions:

• SEBI argued that the stock exchange is a platform for fair trading, and the transactions by the respondents were non-genuine and orchestrated, violating the PFUTP Regulations.
  • SEBI contended that the trades were a misuse of the market mechanism, as there was no commercial basis for the rapid reversals without any significant change in the value of the underlying assets.
  • SEBI emphasized that the synchronized and reversed trades were not genuine dealings in securities, as the parties did not intend to transfer beneficial ownership.
  • SEBI asserted that the traders were playing the market, affecting its integrity by excluding other investors from participating in these trades.
• SEBI submitted that the traders created a false and misleading appearance of trading by repeatedly reversing trades with pre-determined arrangements to book profits and losses.
• SEBI argued that the traders violated Regulations 3(a), 4(1), and 4(2)(a) of the PFUTP Regulations by engaging in fraudulent and unfair trade practices.
• SEBI contended that the brokers did not exercise due diligence and facilitated the fraudulent transactions, thereby violating the code of conduct for stockbrokers.
• SEBI stated that the trades were a misuse of market mechanism as they were not genuine trades. The non-genuineness of these transactions is evident from the fact that there was no commercial basis to suddenly, within a matter of minutes, reverse a transaction when the value of the underlying had not undergone any significant change.

Respondents’ Submissions (Rakhi Trading, Tungarli, TLB):

• The respondents argued that their trades were normal transactions executed on the exchange’s screen-based trading system, maintaining complete anonymity.
  • They contended that the synchronization of trades was a mere coincidence and not a result of any pre-arranged plan.
  • They claimed that the trades were genuine and did not undermine price discovery or influence the market.
• The respondents argued that synchronized trades are not illegal per se, and only those that manipulate the market are prohibited.
  • They distinguished their case from Ketan Parekh (supra) by arguing that the present case deals with the F&O segment, where there is no physical delivery of assets.
  • They contended that there was no change of beneficial ownership, as only contracts were traded, not the underlying assets.
• The respondents argued that their trades did not manipulate the market or induce investors.
• The respondents submitted that the trades were for tax planning purposes and did not violate any regulations.
• The respondents argued that the circular dated 10.03.2005 issued by the NSE was not legally binding.

Respondents’ Submissions (Brokers – Indiabulls, Angel, Prashant):

• The brokers argued that they only acted as intermediaries and carried out the directions of their clients.
  • They contended that they could not have known about the intention of their clients.
  • They asserted that the screen-based trading system does not allow brokers to know the identity of the counterparty.
• The brokers argued that they cannot be held liable merely for facilitating the transactions.
• Indiabulls argued that many of the trades were executed directly by the clients through the internet, over which the broker has little control.
• Angel submitted that they had taken positive steps to curb such trades and had informed the NSE about the trades.

Submissions Table

Issues Framed by the Supreme Court

The Supreme Court framed the following issues for consideration:

1. Whether the factual matrix justified the watchdog’s (SEBI) bite?
2. Whether the synchronized and reversed trades in the derivatives segment constituted fraudulent and unfair trade practices under the PFUTP Regulations?
3. Whether the brokers had violated the code of conduct by facilitating such trades?

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issues

Authorities

The Supreme Court considered the following authorities:

Judgment

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

How each authority was viewed by the Court?

• Ketan Parekh v. Securities and Exchange Board of India: The Court distinguished this case, stating that it pertained to the cash segment and not the F&O segment.
• Nirmal Bang Securities Pvt. Ltd. vs. Securities and Exchange Board of India: The Court noted that the Board also understands that the law is that only such synchronized trades violate the Regulations which manipulate the market.
• Viram Investment Pvt. Ltd. vs. Securities and Exchange Board of India: The Court did not delve into the issue of tax planning as it was not mentioned in the show cause notices, leaving the correctness of the findings open.
• Securities and Exchange Board of India and Ors. v. Shri Kanaiyalal Baldevbhai Patel and Ors.: The Court relied on this case to define unfair trade practices.
• Securities And Exchange Board of India v. Kishore R. Ajmera: The Court relied on this case to establish the standard of proof and factors to be considered in synchronized transactions.
• Securities and Exchange Board of India v. Accord Capital Markets Ltd.: The Court relied on this case to highlight the fact that synchronized trades cannot take place in the absence of any specific understanding/arrangement between the clients.
• N. Narayanan v. Adjudicating Officer, Securities and Exchange Board of India: The Court relied on this case to emphasize the need to protect investors and maintain market integrity.

The Supreme Court held that the traders engaged in a fraudulent and unfair trade practice by executing synchronized and reversed trades, violating Regulations 3(a), 4(1), and 4(2)(a) of the PFUTP Regulations. The Court emphasized that the trades were not genuine, as the parties did not intend to transfer beneficial ownership and created a misleading appearance of trading. The Court also stated that the platform of the stock exchange has been used for a non-genuine trade.

The Court rejected the argument that only trades that manipulate the market are prohibited, stating that the traders’ actions had an adverse impact on the fairness, integrity, and transparency of the stock market. The Court stated that by synchronization and rapid reverse trade, the price discovery system itself is affected.

The Court also clarified that even in the derivatives segment, there is a change of rights in a contract, and the reverse trades did not involve a genuine change of rights.

However, the Court found that there was no evidence of negligence or connivance on the part of the brokers, and therefore, the orders against them were set aside.

What weighed in the mind of the Court?

The Supreme Court’s decision was heavily influenced by the following factors:

• Non-Genuine Transactions: The Court found that the trades were not genuine as they were executed with a pre-arranged understanding to book profits and losses, rather than for genuine trading purposes.
• Lack of Beneficial Ownership Transfer: The Court emphasized that the traders did not intend to transfer beneficial ownership of the contracts, indicating the trades were merely a device to manipulate the market.
• Misuse of Market Mechanism: The Court noted that the traders misused the stock exchange platform by engaging in orchestrated trades that excluded other investors.
• Impact on Market Integrity: The Court highlighted that the synchronized and reversed trades undermined the fairness, integrity, and transparency of the stock market.
• Creation of False Appearance: The Court found that the trades created a false and misleading appearance of trading, violating the PFUTP Regulations.
• Rapid Reversals and Price Variations: The Court observed that the rapid reversals and significant price differences without any change in the underlying asset’s value indicated a manipulative intent.
• Pre-Arranged Understanding: The Court inferred that the traders had a pre-arranged understanding to book profits and losses, which is not in consonance with the market trend and human conduct.
• Violation of Regulations: The Court held that the traders violated Regulations 3(a), 4(1), and 4(2)(a) of the PFUTP Regulations by engaging in fraudulent and unfair trade practices.

The Court’s reasoning was based on a strong emphasis on maintaining the integrity of the securities market and protecting investors from manipulative practices.

Sentiment Analysis Table:

Fact:Law Ratio Table:

Flowchart

Conclusion

The Supreme Court’s judgment in SEBI vs. Rakhi Trading Private Ltd. is a landmark decision that clarifies the scope of fraudulent and unfair trade practices in the derivatives market. The Court emphasized that synchronized and reversed trades, when executed with the intention to manipulate the market, are not genuine dealings in securities and violate the PFUTP Regulations. This ruling reinforces the importance of maintaining market integrity and protecting investors from manipulative schemes.

The judgment establishes that even in the derivatives segment, where there is no physical transfer of assets, the trading of contracts must be genuine and not merely a device to book profits and losses. The Court’s emphasis on the intention of the parties and the impact of the trades on market integrity provides a clear guideline for future cases involving similar issues.

While the Court upheld SEBI’s decision against the traders, it also clarified that brokers cannot be held liable for merely facilitating such trades unless there is evidence of negligence or connivance. This aspect of the judgment provides a degree of protection for brokers who act as intermediaries in the market.

Overall, the judgment serves as a strong deterrent against fraudulent and manipulative trading practices in the derivatives market, emphasizing the need for fair and transparent trading mechanisms to protect the interests of all investors.