Transparency and disclosure are the basic tenets of any efficient securities market. However, one cannot deny that various market participants are placed differently regarding access to information; this in turn, materially influences their trading strategy. Trading strategies based on superior information obtained by fair means are not prohibited under the regulatory framework.

The Indian securities market regulator, the Securities and Exchange Board of India (“SEBI”), has in the recent past increased its scrutiny of market participants who have tried to distort the level playing field in the securities market by taking advantage of unequal information acquired through unfair means.

A slew of recent SEBI actions involve instances where an investor has placed an order in a stock while in possession of “non-public information” of “a substantial impending transaction” in that stock.

Such trade orders are considered “front running” under SEBI regulations.

EVOLUTION OF THE REGULATIONS

The SEBI first attempted to bring front running under the regulatory ambit as a ‘fraudulent and unfair trade practice’ under the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Markets) Regulations, 1995 (“1995 regulations”).

Regulation 6(b) of the 1995 regulations prohibited “any person” from dealing in securities pending execution of “any order” of such person’s client relating to the same securities. However, there was a shift when the SEBI repealed the 1995 regulations and introduced the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Markets) Regulations, 2003 (“2003 Regulations”).

Under regulation 4(2)(q) of the 2003 Regulations, executing a front running order was deemed fraudulent or an unfair trade practice if it involved an “intermediary” and the front running order was placed in advance of a “substantial” client order.

The definition of front running under the 2003 regulations was legally tested when SEBI took action against the portfolio manager of a sub-account of a foreign institutional investor for front running the orders of the sub-account in collusion with certain others. The SEBI found such persons liable for violating the 2003 regulations (SEBI Order dated September 30, 2011).

An appeal against the SEBI order was allowed by the Hon’ble Securities Appellate Tribunal (“SAT”) on the basis that there was no specific provision in the 2003 regulations that prohibited front running by a person other than an intermediary (SAT Order dated November 9, 2012).

On an appeal by the SEBI against the SAT order, the Supreme Court found the conduct of the persons charged with front running to be fraudulent and an unfair trade practice (Supreme Court Order dated September 20, 2017 in the matter of SEBI vs. Shri Kanaiyalal Baldevbhai Patel and Other Connected Appeals) (“Kanaiyalal Patel”). In effect, the Supreme Court widened the scope of the definition of front running by including within its ambit front running by a non-intermediary. The Court emphasized the fiduciary relationship between an employer and employee which obligates the employee to protect the non-public information of the employer. The Court held that if there is a breach of such obligation and the recipient (tippee) 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 fraud.

The SEBI, by an amendment dated February 1, 2019, sought to bring further clarity to the ingredients of front running by amending Regulation 4(2)(q) of the 2003 Regulations. To bring a charge of front running under such regulation, the following ingredients need to satisfied:

1. The alleged front runner is in possession of non-public information;
2. The information relates to a substantial transaction; and
3. The order is placed in advance of the substantial transaction.

NON-PUBLIC INFORMATION

As held by the Supreme Court in the Kanaiyalal Patel, any information generated by a company in its ordinary course of business, is confidential information of the company concerned. Such information will be non-public in nature until it has been disclosed by the company to individuals other than those who need to know such information in the ordinary course of business.

SUBSTANTIAL TRANSACTION

Regulation 4(2)(q) requires that the information should be related to a “substantial” transaction. The term “substantial” has not been defined or explained in the regulations.

In the matter of Front Running Trading Activity of Dealers of Reliance Securities Ltd. and Other Connected Entities, decided on January 30, 2023, the SEBI observed that there cannot be a straitjacket definition of what is “substantial” which can apply to all cases. The SEBI observed that whether an impending order is “substantial” or not is a subjective assessment of an individual trader by taking into account a host of factors such as liquidity in the stock, corporate announcements, if any, trading in peer group stocks, general trends in the securities market and prevalent economic situation.

The authors submit that if the question of whether an impending order is “substantial” is indeed the subjective assessment of an individual trader, the answer will always be in the affirmative. The purpose of executing a front running trade is to benefit from information asymmetry and therefore, unless the individual trader foresees benefit from the trade, the order will not be placed.

In the matter of Front Running of Orders of Quest Investment Advisors Private Limited by Ketan Bhupendra Parekh and Bhupendra Jasvantrai Parekh, decided on February 10, 2023, the SEBI again noted that there cannot be a single test to determine whether an order is “substantial”. In this case, the SEBI employed a “reasonable person” test; the question framed was whether in the assessment of a reasonable person the transaction will likely impact the price of the stock.

Apart from these subjective tests, SEBI in its Interim Order-cum-Show Cause Notice in the matter of Interim Order-cum-Show Cause Notice in the matter of Front Running by Banhem Securities Pvt. Ltd. and Ninja Securities Pvt. Ltd. dated March 28, 2023 has attempted to numerically quantify a criteria to determine whether the impeding transaction (which was front run) was substantial or not. In this matter, SEBI considered the impending order to be substantial if it was at least 3% of the total traded quantity in the stock on that day and if the order size was greater than or equal to 4,000 shares. Ostensibly such numerical metrics (in terms of volume) were employed to bring clarity to the interpretation of the term “substantial”, however, the Interim Order-cum-Show Cause Notice is silent on the rationale for using such figures.

The authors submit that since front running activity is mainly an intra-day activity where the alleged front runner is trying to make a quick profit, both volume and price criteria should be applied to determine whether the impending order which was front run was substantial or not.

Regarding volume, it would be relevant to analyze the order book in the stock prior to the placement of the order by the alleged front runner to determine whether or not the impending order was substantial.

Further, regarding price, the relevant metric to determine whether an impending order is substantial would be the impact or the likely impact of the impending order on the price of the stock. The SEBI in the matter of CNBC Awaaz decided on June 11, 2024 has examined the impact of a recommendation given by a television anchor on the price movement (intra-day) in the recommended stock. The same method, which considers price movement in the stock 15 minutes prior to and after the recommendation, can be applied to stocks involved in front running activity.

PATTERNS OF FRONT RUNNING TRADES

Typical patterns of a front running trade are either a BBS pattern (buy by the alleged front runner, buy by the client and subsequent sell by the alleged front runner) or an SSB pattern (sell by the alleged front runner, sell by the client and subsequent buy by the alleged front runner).

The first leg in these patterns is the front running leg.

The SEBI in its recent order in the matter of Front Running by Kajal Savla decided on May 31, 2024 has observed that there can be other patterns of a front running trade. In this matter it was held that a BSB pattern (buy by the alleged front runner, sell by the alleged front runner and then the buy by the client) was also a front running trade as the orders by the alleged front runner were placed prior to the buy order of the client. Based on Regulation 4(2)(q), the finding of SEBI appears to be correct. The SEBI noted the second leg of the alleged front runner’s orders which takes advantage of the first leg, need not necessarily be placed after the client order since the exchanges permit “limit orders”, i.e., contingent orders such as “sell if the price is more than INR X” or “buy if the price is lower than INR Y”. It can also be contended that the alleged front runner who was in possession of non-public information while placing the front running order, saw a better opportunity even prior to the placement of the order of the client and exited the stock or it can be argued that the front runner in order to camouflage front running trades with other trades, may execute a trade which does not conform to a typical front running trading pattern. There may also arise a situation where the alleged front runner has placed the order after the placement of the initial tranche of the order of the client but prior to the last tranche of client’s order. The SEBI observed in its order that clients often place their orders in smaller tranches so that securities can be bought or sold at prices beneficial to them. Therefore, the alleged front runner can gain from placing an order at any time before the last or substantial tranche of the client’s order.

The authors submit however that caution needs to be exercised before arriving at a finding of a front running trade if a BSB pattern or a situation in which the order is placed by the alleged front runner after the initial tranche of the client’s order but prior to the last tranche, forms a significant portion of the trades in question. In such a scenario, establishing a flow of information to the alleged front runner becomes imperative to demonstrate that the order was placed by the front runner while in possession of the non-public information.

Similar to BSB, there may yet be another pattern - SBB (sell by the alleged front runner, buy by the alleged front runner and then the buy by the client) which could be considered front running in a particular case based on the above analysis, subject to the authors’ cautionary note regarding establishing a flow of information.

CONCLUSION

The SEBI’s proactive stance to initiate prosecutions in several front running cases in the recent past must be welcomed from the perspective of preserving market integrity. However, evidentiary issues and interpretational challenges remain. Further development in the jurisprudence on front running trades should resolve or mitigate some of these issues and challenges.