Securities and Exchange Board of India (Sebi) has done well to admit that it needs to review regulations that deal with front running. The main reason Securities Appellate Tribunal (SAT) recently set aside a Sebi order penalizing three people for front running was that existing laws don’t prohibit non-brokers from engaging in such trades. But the markets regulator should now be careful that in its zeal to penalize offenders, it doesn’t come up with draconian laws on front running.
Prof. Jayanth Varma of IIM-Ahmedabad points out in his blog, “Front running by brokers and other intermediaries is a breach of fiduciary obligation that they owe to their clients, but it is not self evident that every Tom, Dick and Harry on the planet has any fiduciary obligation not to front run orders that they expect other people to place. In fact, such form of front running is legal and common through out the world.” He points to the front-running trades by Goldman Sachs when Long Term Capital Management (LTCM) was near its death in 1998. When Goldman was brought in to help raise new money to recapitalize LTCM, it was still allowed to do due diligence even though it flatly refused to sign a non-disclosure agreement. A Goldman trader was cited later justifying the front-running trades, “If you think a gorilla has to sell, then you sure want to sell first. We are very clear on where the line is; that’s not illegal.” Varma lists a number of other occasions where it will be difficult for regulator to pin down front-running trades. “There is a whole industry devoted to front running, index mutual funds trading ahead of an index reconstitution, or a commodity exchange-traded fund rolling over its futures positions to the next month,” he writes.
Having said that, the case Sebi investigated was vastly different. Dipak Patel was a portfolio manager at an foreign institutional investor named Passport Capital Llc, and Sebi found that he passed on advance information about Passport’s trades in the Indian market to his cousins in India. Sebi has produced adequate information of the trades of the cousins, which happened a few hours before Passport’s orders hit the market, and in some cases the brothers sold their newly acquired shares back to Passport, making about Rs.1.5 crore in the process.
There is little doubt in Sebi’s mind that such trades are fraudulent. In the past, it has penalized HDFC Mutual Fund and a few of its executives in two similar cases. But it must be noted that in those cases, the fund and its executives were penalized for not performing their fiduciary responsibility of protecting the fund’s investors. This was in contravention of Sebi’s mutual fund rules. In the Passport case, as well, Dipak Gupta and Passport had a fiduciary obligation of working in the best interests of the fund’s investors. The catch, however, is this does not come under Sebi’s jurisdiction, but under the regulator where Passport is domiciled.
In this scenario, it was right for SAT to look at Sebi rules on front running. Current rules on front running cover only transactions entered into by brokers ahead of client trades. They don’t cover transactions by portfolio managers and their relatives. It’s evident that Sebi was well aware of this. In its adjudication order, the regulator charged the three brothers under section 3 (a) (b) (c) and (d) of the Sebi Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets Regulations, 2003, which talk of general fraud and manipulation in the securities market, and not under the section on front running.
Some have argued that the above case is a clear case of fraud and should be penalized even if it doesn’t attract the current provisions of the front-running rule. The counter argument is that the fraud was a private one against the investors of the fund, and not against the market in general. Chartered accountant Jayant Thakur says, “it is sometimes argued that this form of front running by a non-intermediary does not cause any loss to the market at large, and constitute only a private fraud against the employer. But similar arguments can be made against strictures on insider trading. Both insider trading and front running go against principles of a fair and equitable market and Sebi must formulate effective laws to prevent the same.” Thakur also has an insightful blog on this at indiacorplaw.blogspot.in.
He adds that there are a lot of things to be unhappy about in this case. Sebi’s adjudication order doesn’t have sufficient reasoning explaining how and which provisions of Sebi’s laws have been violated; Sebi’s weak defence at SAT; as well as the inadequate and narrow drafting of Sebi’s laws in this regard. “Corrective action is needed in each of these areas,” he says. Some have criticized SAT’s order, but the tribunal has done well under the circumstances.
Sebi should now take corrective action to avoid a repeat. It’s clear that it sees Dipak Patel and associates activities as illegal. Its laws on front running should be appropriately drafted to penalize such behaviour. But as pointed earlier, given the myriad forms of front-running trades, Sebi should ensure that it doesn’t come up with draconian laws that stifle the market.
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