Does front running need better regulation?

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Yet again, front running is in the news. Instead of being an aberrant event deserving just a sub-clause in the SEBI Regulations, it has become frequent enough to deserve a detailed discussion and perhaps more elaborate provisions in law.

But what is front running and what are the present provisions in law to punish it? How have they developed and what is further needed to curb it including by giving deterrent punishments?

To be sure, at the outset, front running is repetitive enough. To add just a few more examples of alleged front running, take the HDFC AMC case, or the Reliance Securities case,  the Dipak/Kanaiyalal/Anand Kumar Patel case, etc. The matters have been contentious enough such that litigation even reached the Supreme Court. At one stage, it was even questioned whether SEBI had any powers to punish certain categories of front runners. The Securities Appellate Tribunal had said SEBI did not have such powers. The Supreme Court, though, confirmed that SEBI did have such powers and the SEBI PFUTP Regulations were also amended to further make the issue clear.

But coming back to the core question—what is front running and why is it considered as a harmful practice in securities markets? Front running, simply stated, is illicit profiting from information on significant trades, which information is typically shared by a person with trust and in confidence. Take a simple example. An investor approaches his stock broker with a desire to purchase a significant quantity of shares of a particular company. The experienced stock broker knows that such purchase made in a short span will result in rise in the share price of the company. So he cooks up this idea of making assured, risk-free profits. He first purchases for himself (or through an associate) the shares at the ruling price. Then he executes his client’s orders which, as he anticipated, results in rise in price. He sells the shares at that time at this higher price and pockets the profit. What is also obvious is that this profit is at the cost of his client who ends up paying a higher average price.

Needless to say, this is an evil practice. SEBI, which has a direct concern and mandate to ensure integrity in the market, is expected to curb it.

Such front running may be done not just by stock brokers but by any other person in similar situation. A dealer of an asset management company/mutual fund, for example, may come to know that a large order for the fund is being placed. He carries out a trade for himself first and then for the fund. An employee for a family wealth office may also come across similar orders and trades ahead of such orders.

Front running may be carried out even for large orders of sales, except that it would have a reverse sequence.

Curiously, earlier and even now, front running finds place in law as a small sub-clause of the SEBI PFUTP Regulations which, considering its possibly widespread nature, may sound insufficient. Indeed, earlier, the scope of this sub-clause was also worded narrowly. It applied only to intermediaries such as stock brokers and hence other persons had to be covered under general clauses. This led to litigation which was finally settled by the Supreme Court in favor of SEBI by taking a purposive view. The law, as it stands presently after several amendments, has a wider reach though. It now covers dealings by any person who is in possession of information about an impending transaction of a significant quantity of shares that is not public. It can invite several penal consequences including disgorgement of profits made, penalties, debarment from markets, etc. This is apart from the victim taking direct action against the front runner. Errant employees are almost instantly fired.

The question though is whether the short sub-clause is enough to curb and penalise front running. Front running I think, is akin to insider trading. In case of insider trading too, persons to whom sensitive information is entrusted, break such trust and trade and make a profit for themselves. In case of front running, the loss to the employer/client is directly evident and even quantifiable. Moreover, one wonders whether even the cases being caught are just the tip of the iceberg. Front running, insider trading, etc. are usually carried out by persons sophisticated in the mechanics of securities markets. In a case of pretty slick sleuthing by SEBI, front running was caught by actually checking the CCTV of ATMs from where cash was withdrawn from account of alleged front persons (“mules”). Further, even GPS locations of the mobile were traced to confirm the presence of the persons at that place. In another case of smart spade work, SEBI checked matrimonial sites to dig up links in a case of alleged front running. SEBI’s surveillance of trades often throw up cases of suspicious trading giving the regulator a starting point.

But, still, having a starting point is one thing but linking the dots to draw a legally tenable conclusion is quite another. In comparison to the very detailed regulations for insider trading, the provision for front running appears minimal. For insider trading, elaborate definitions of who is an insider, what is insider trading, what is price sensitive information, etc. are provided. If front running is also rampant and carried out by sophisticated persons, a specialised legal framework for dealing with such cases may be needed. Front running casts a long shadow on mutual funds, stock brokers, etc. which deal in trillions of rupees of investors’ funds. It is high time a focussed look is taken at this evil to retain the investors’ trusts in markets.

Jayant Thakur is a chartered accountant.

Views are personal and do not represent the stand of this publication.