Supreme Court Clarifies “Non-Intermediary Front-Running” under SEBI Regulations: SEBI vs. Kanaiyalal Baldevbhai Patel (2017)

Date of the Judgment: September 20, 2017
Citation: (2017) INSC 763
Judges: N. V. Ramana, J., Ranjan Gogoi, J.
Can individuals who are not intermediaries be held liable for front-running in the securities market? The Supreme Court of India addressed this crucial question in a batch of appeals, clarifying the scope of the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 (FUTP Regulations). The court examined whether “non-intermediary front-running” constitutes a prohibited practice under these regulations. The bench was composed of Justice N.V. Ramana, who authored the main opinion, and Justice Ranjan Gogoi, who provided a concurring opinion.

Case Background

The Securities and Exchange Board of India (SEBI) initiated investigations into several cases of alleged front-running. In one case, SEBI found that Shri Kanaiyalal Baldevbhai Patel (KB) was trading ahead of orders placed by Passport India Investment (Mauritius) Ltd. (PII). Dipak Patel, the portfolio manager of PII and cousin of KB, allegedly provided KB with information about PII’s forthcoming trading activity. KB then used this information to trade before PII, profiting from the price movements caused by PII’s large orders. Similarly, in another case, Sujit Karkera and his group were accused of trading ahead of Citigroup Global Markets Mauritius Pvt. Ltd. (CGMMPL) based on information from Suresh Menon, a trader at CGMMPL. In another instance, Vibha Sharma, wife of an equity dealer at Central Bank of India, was accused of front-running the bank’s orders based on information from her husband. Lastly, Pooja Menghani was accused of front-running based on information from Deepak Khurana of Religare Securities Ltd.

Timeline:

Course of Proceedings

The Securities Appellate Tribunal (SAT) had taken different views in different cases. In some cases, SAT overturned the orders of the Adjudicating Officer, holding that the actions did not amount to fraudulent or unfair trade practices. In other cases, SAT upheld the Adjudicating Officer’s orders. This divergence of opinion led to SEBI and the individuals involved filing appeals before the Supreme Court.

Legal Framework

The core of this case revolves around the interpretation of the FUTP Regulations, 2003. These regulations were enacted by SEBI to prevent fraudulent and unfair trade practices in the securities market. Key provisions include:

• Regulation 2(c) defines “fraud” broadly to include any act, expression, omission, or concealment, whether deceitful or not, that induces another person to deal in securities. It also includes specific instances such as misrepresentation, concealment of facts, and deceptive behavior.
  “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…
• Regulation 3 prohibits dealing in securities in a fraudulent manner.
  No person shall directly or indirectly- (a)buy, sell or otherwise deal in securities in a fraudulent manner;
• Regulation 4(1) prohibits indulging in fraudulent or unfair trade practices in securities.
  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) deems front-running by intermediaries as 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 court noted that the definition of “dealing in securities” is broad and inclusive, encompassing buying, selling, subscribing, or otherwise transacting in any security. The regulations aim to protect the investing public and maintain the integrity of the securities market.

Arguments

Arguments on behalf of the Appellants (Individuals):

• It was argued that the finding of fraud under Regulations 3 and 4 of FUTP 2003 is contrary to the definition of fraud in Regulation 2(1)(c).
• It was contended that sub-clauses of Regulation 4(2) apply only to intermediaries and not to individual buyers or sellers.
• It was argued that Regulation 4 is inapplicable to the case of the applicant as it seeks to regulate the conduct of intermediaries.

Arguments on behalf of the Respondent (SEBI):

• SEBI argued that the ambit of FUTP regulations has significantly expanded from 1995 to 2003.
• SEBI contended that the inclusion of a specific prohibition of front-running for intermediaries under Regulation 4(2)(q) should not limit the scope of Regulation 4.
• SEBI argued that the principle of ‘Expressio Unius Est Exclusio Alterius’ should not be used to exclude non-intermediary front-running from liability.

Innovativeness of the argument: The appellants argued that the specific mention of intermediaries in Regulation 4(2)(q) implied that non-intermediaries were excluded, which was a novel interpretation of the provision.

Issues Framed by the Supreme Court

The primary issue before the Supreme Court was:

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

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

Authorities

The Supreme Court considered the following authorities:

Judgment

The Supreme Court held that non-intermediary front-running can be prohibited under Regulations 3 and 4(1) of the FUTP Regulations, provided that the elements of fraud are satisfied. The court clarified that the definition of “fraud” is broad and includes any act that induces another person to deal in securities, regardless of whether it is deceitful.

The court emphasized that the term “induce” means persuading someone to take a certain course of action. The court 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 an act or omits to perform any particular act. The court also clarified that the element of dishonesty need not be present or proved to establish the charge of fraud under the FUTP Regulations.

The court also stated that the regulations aim to maintain a level playing field in the market, and possession of information is fraudulent only when acquired in bad faith and induces an inequitable result. The court held that confidential information of a company is its property and any breach of duty by conveying such information to a tippee amounts to fraud.

The court also held that the principle of ‘expressio unius est exclusio alterius’ is not applicable in this case as the intention of the legislation was to provide a catch-all provision.

The court emphasized that the provisions of Regulations 3(a), (b), (c), (d), and 4(1) are broad enough to cover diverse situations and that a pigeon-hole approach is not applicable.

The court allowed the appeals filed by SEBI against Kanaiyalal Baldevbhai Patel, Dipak Patel and Sujit Karkera, holding them liable for front-running. The court dismissed the appeals filed by Pooja Menghani and Vibha Sharma, upholding the decisions against them.

How each authority was viewed by the Court?

• The court relied on the definitions of front-running from Major Law Lexicon by P. Ramanatha Aiyar, The Black’s Law Dictionary, and Nancy Folbre* to understand the concept of front-running.
• The court referred to SEBI’s Circular CIR/EFD/1/2012* and a Consultative Paper issued by SEBI* to understand SEBI’s view of front-running as a manipulative practice.
• The court distinguished the principle of strict construction of penal laws as argued in Govind Impex Pvt. Ltd. v. Income Tax Department and Krishi Utpadan Mandi Samiti v. Pilibhit Pantnagar Beej Ltd.*, by referring to the purpose of the SEBI Act as held in SEBI v. Kishore R. Ajmera*.
• The court relied on N. Narayanan v. Adjudicating Officer, SEBI* for the need to preserve market integrity and prevent market abuse.
• The court used Palmer’s Company Law and Gower & Davies – Principles of Modern Company Law* for the definition of market manipulation.
• The court held that the principle of ‘expressio unius est exclusio alterius’ is not a rule of law by referring to Colquhoun v. Brooks and Lowe v. Darling & Sons*.
• The court referred to Securities and Exchange Commission vs. National Securities, Inc.* for the history of litigation under section 10(b) of the Securities Exchange Act.
• The court used David Carpenter, Kenneth P. Felis and R. Foster Winans, v. United States* for the definition of fraud in the context of securities trading.
• The court referred to Vincent F. Chiarella v. United States* for the requirement of a duty to disclose for securities fraud.
• The court used 3 W. Fletcher, Cyclopedia of Law of Private Corporations* for the definition of confidential information.

What weighed in the mind of the Court?

The Supreme Court’s decision was heavily influenced by the need to maintain market integrity and protect investors from fraudulent practices. The court emphasized that the FUTP Regulations are designed to prevent market manipulation and ensure a level playing field for all participants. The court’s reasoning focused on the broad definition of fraud, the concept of inducement, and the importance of confidentiality in the securities market.

The court considered both the factual aspects of the case, such as the timing and volume of trades, and the legal aspects, such as the interpretation of the FUTP Regulations. The analysis shows that the legal considerations weighed more heavily in the court’s decision.

Logical Reasoning

The court considered alternative interpretations of the regulations, particularly the argument that Regulation 4(2)(q) specifically mentions intermediaries, implying that non-intermediaries are excluded. However, the court rejected this interpretation, stating that Regulation 4(1) operates independently and has a broader scope. The court also rejected the argument that the principle of ‘expressio unius est exclusio alterius’ should apply, emphasizing that the intention of the regulations was to provide a catch-all provision.

The court’s decision was based on the broad language of the regulations, the need to protect market integrity, and the principle that confidential information should not be exploited for personal gain. The court concluded that the actions of the individuals involved in front-running were fraudulent and violated the FUTP Regulations.

The Supreme Court’s decision was based on the following reasons:

• The definition of fraud under Regulation 2(c) is broad and inclusive.
• The term “induce” means persuading someone to take a certain course of action.
• The regulations aim to maintain a level playing field in the market.
• Confidential information should not be exploited for personal gain.
• The principle of ‘expressio unius est exclusio alterius’ is not applicable in this case.
• The provisions of Regulations 3 and 4(1) are broad enough to cover diverse situations.

The court quoted the following from the judgment:

“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…

Without prejudice to the provisions of regulation 3, no person shall indulge in a fraudulent or an unfair trade practice in securities.

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.

Both Justice N.V. Ramana and Justice Ranjan Gogoi delivered concurring opinions. Justice Ramana authored the main opinion, while Justice Gogoi provided a separate concurring opinion, emphasizing that the case could be resolved within a narrow spectrum of law and focusing on the meaning of “induce” in Regulation 2(c). Both judges agreed on the outcome of the appeals.

The court’s reasoning, legal interpretation, and application to the facts were thorough. The court analyzed the regulations, considered the arguments of both sides, and applied the law to the specific facts of each case. The court’s decision clarifies the scope of the FUTP Regulations and provides guidance for future cases involving front-running.

The judgment has significant implications for future cases. It clarifies that non-intermediaries can be held liable for front-running, provided that the elements of fraud are satisfied. This decision will likely lead to increased scrutiny of trading activities and may result in more enforcement actions by SEBI.

The court did not introduce any new doctrines or legal principles, but it clarified the interpretation of existing regulations. The court’s analysis of the meaning of “induce” and the scope of Regulation 4(1) provides a clearer understanding of the law.

Key Takeaways

• Non-intermediaries can be held liable for front-running under the FUTP Regulations.
• The definition of “fraud” is broad and includes acts that induce trading in securities.
• The element of dishonesty need not be present to establish fraud under the FUTP Regulations.
• Confidential information should not be exploited for personal gain.
• The FUTP Regulations aim to maintain a level playing field in the securities market.

The decision will likely lead to increased vigilance by SEBI and may result in more enforcement actions against individuals involved in front-running. The judgment will also serve as a deterrent to those who may be tempted to engage in such practices.

Directions

The Supreme Court set aside the orders passed by the Securities Appellate Tribunal in Civil Appeal Nos. 2595, 2596 and 2666 of 2013 and restored the findings recorded and the penalty imposed by the Adjudicating Officer. The Court dismissed Civil Appeal Nos. 5829 of 2014 and 11195-11196 of 2014.

Development of Law

The ratio decidendi of this case is that non-intermediary front-running is a prohibited practice under regulations 3 and 4(1) of FUTP 2003 if the elements of fraud are satisfied. This clarifies the previous position where it was argued that only intermediaries could be held liable for front-running under the regulations.

Conclusion

The Supreme Court’s judgment in this case clarifies the scope of the FUTP Regulations, 2003, and establishes that non-intermediaries can be held liable for front-running. The court’s interpretation of “fraud” and “inducement” provides a clear framework for future cases. This decision reinforces the importance of maintaining market integrity and protecting investors from fraudulent practices.