FRONT-RUNNING

[Mr. M. GOVINDARAJAN]

The term ‘front-running’ is defined by www.wikipedia.org as the illegal practice of a stock broker executing  orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers.  When orders previously submitted by its customers will predictably affect the price of the security, purchasing first for its own account gives the broker an unfair advantage, since it can expect to close out its position at a profit based on the new price level. The front running broker either buys for his own account (before filling customer buy orders that drive up the price), or sells (where the broker sells for its own account, before filling customer sell orders that drive down the price).  For example, suppose a broker receives an order from a customer to buy a large block of 400,000 shares of some stock, but before placing the order for the customer the broker buys 20,000 shares of the same stock for his own account at Rs.100 per share, then afterward places the customer's order for 400,000 shares, driving the price up to Rs.102 per share and allowing the broker to immediately sell his shares for, say, Rs.101.75, generating a significant profit of Rs.35,000 in just a short time. This Rs.35,000 is likely to be just a part of the additional cost to the customer's purchase caused by the broker's self-dealing.

Whether ‘front-running’ is an offence?  It is offence if it is caused by intermediaries and not by traders as decided by Securities Appellate Tribunal in its order dated 17.12.2012 in ‘Sujit Karkera and others V. Adjudicating Officer, SEBI, Mumbai’ in Appeal No. 167/2012 (www.sat.gov.in). In this case the appellants are traders in securities.  The present appeal is directed against an order passed by the adjudicating officer of the Securities and Exchange Board of India (for short the Board) by which a penalty of Rs.60,73,316/-, Rs. 54,19,212/- and Rs.4,66,108/- respectively has been imposed on the appellants. The above penalties were imposed under section 15HA of the Securities and Exchange Board of India Act, 1992 (the Act) in relation to the violation of regulations 3 and 4 of the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 (FUTP Regulations).

The Board investigated the trading activity of the appellants and found that the group, while trading through B P Equities Pvt. Ltd., was trading ahead of the trades of Citigroup Global Markets Mauritius Pvt. Ltd. (CGMMPL) for the period October 01, 2008 to December 31, 2008 and the trades were put in with prior knowledge of the trades of CGMMPL. The impugned trades related to the orders of CGMMPL in the scrip of Aurobindo Pharma Ltd., ICICI Bank Ltd. and State Bank of India. The prior knowledge in the trading of the above scrips was obtained from Mr. Suresh Menon, a trader of CGMMPL. Call records of the Mr. Sujit Karkera, the first appellant and Mr. Suresh Menon were examined and it was noticed that during the material period the transactions in the scrips were discussed in clear terms between the two. The transcripts of the telephonic conversation revealed flow of information of the scrip, order quantity, order timing and price of the scrip which were passed on to the appellants by Mr. Suresh Menon while in possession of the orders of CGMMPL. It was therefore alleged that the appellants had prior information of the order details of CGMMPL and had sold shares prior to the selling of the shares of CGMMPL. It was also noticed that after purchasing the shares at a low price when CGMMPL was selling the shares they sold the shares subsequently earning profits. A charge of violation of regulations 3 and 4 of the FUTP Regulations was leveled against the appellants.

The appellants contended the following:

• The transactions impugned in the order of Adjudicating Officer took place in the ordinary course of business through stock exchange mechanism and there was no connivance with CGMMPL;
• The transactions were at the market rate and they were not dictated  by any prior information from Mr. Suresh Menon as alleged;
• There was no ‘front-running’ in the alleged transaction;

The Board submitted the following before the Tribunal:

• The transcripts of the telephonic conversation in the present case clearly establish prior information regarding the order, time and quantity of the scrips transacted;
• The said transactions have to regarded as a wrong doing in the market;
• Regulation 3 of the FUTP Regulations is wide enough to cover the wrong doing indulged in by the appellants and a reference to regulation 4(2)(q) of the FUTP Regulations is uncalled for.

The Tribunal did not accept the contentions of the petitioners that the transactions were in the nature of ordinary market operations. The facts on record establish that there was constant flow of information to the appellants from Mr. Suresh Menon and the telephonic conversation related specifically to the order, place, time and quantity of the scrips transacted. On a consideration of the facts on record and the material relied on by the adjudicating officer we have no hesitation in holding that the alleged transactions of the appellant are in the nature of “front running”. The additional supporting evidence available in this case is the telephonic conversation of the appellant with Mr. Suresh Menon. taxmanagementindia.com

However the Tribunal agreed with the appellants that the 1995 Regulations prohibited front running by any person dealing in the securities market and a departure has been made in the Regulations of 2003 whereby front running has been prohibited only by intermediaries. In the absence of any specific provision in the Act, rules or regulations prohibiting front running by a person other than an intermediary, the tribunal is of the view that the appellants cannot be held guilty of the charges leveled against them. There is no denying the fact that when the appellants placed their order, these were screen based and at the prevalent market price. 

The Tribunal observed that in the present case the appellants are traders and not intermediaries. The Tribunal held that the appellants cannot be held guilty violating the provisions of FUTP Regulations. There is no specific provision in the Act, rules or regulations prohibiting front running by a person other than an intermediary. Since the appellants are not intermediaries they cannot be held to have violated the provisions of regulations 3 and 4 by indulging in front running.  In view of the discussion above, the Tribunal set aside the impugned order of the Adjudicating authority and allowed the appeal. 

One of the handicaps suffered by the Board while regulating front-running is it is not empowered to tap phones. The Board had sought a notification to get this power under the Telegraphs Act but the Government did not accede to its request. However the Finance Minister said that the Government could provide the Board with call records data on case to case basis. The Board is also to amend the regulations to bring the traders also under the purview of FUTP regulations for front-running.