SAT's New Twist To Front-Running!

Can an investor engage in front running and yet escape punishment by SEBI? Well, the Securities Appellate Tribunal or SAT says yes; as long as the investor is not a market intermediary. Payaswini Upadhyay has more on the Tribunal's curious interpretation of the applicability of SEBI's FUTP or fraudulent and unfair trade practices regulations.

The Players
Passport India Investment - a Mauritius based FII.
Dipak Patel - Portfolio Manager at Passport India
Kanaiyalal Patel or KB - An individual trader; and cousin to Dipak Patel. The Allegation
Over 2 years, KB indulged in 799 synchronized trades as well as front running that earned him a profit of over Rs 1.5 crore. The Charge
Violation of SEBI's Fraudulent and Unfair Trade Practices Regulations The Modus Operandi
SEBI's investigation showed that between 2007 and 2009, Dipak Patel passed on information to KB regarding Passport India's forthcoming trades. KB used this information to indulge in front running -- meaning, he placed and executed orders before Passport India, and squared off his position after Passport India placed its orders. KB and Passport India have also been accused of synchronized trades. The Penalty
In February 2011, SEBI imposed a fine of Rs 5 crore each on Dipak Patel and KB. The Appeal
Dipak  Patel moved the Securities Appellate Tribunal against SEBI's order The Verdict
Not Guilty. The Argument
In response to the allegation of synchronized trades, Dipak Patel argued that all the trades executed by his cousin were in the normal course, screen-based, and carried out at the prevalent market price. So there was no market manipulation. SAT bought that argument
In response to SEBI's allegation of front running and on information regarding trades to KB, Patel denied doing so. He argued that any communication of information between him and his cousin pertained to business advise. SAT believed him. JN Gupta
Former ED, SEBI
"SAT has said that it was a screen-based order, it matched the stock exchange order, only 'X' percentage matched, 'Y' did not match. So with this logic, are we saying that on a screen-based system, there cannot be a fraud? There is a fraud because people have acted on communication. Now you cannot set aside dozens of communication between Mr Patel and his relative and they come up and say that it was related to business advisory for metal trade. That means it's a very simple message that is going to the market that today if I am giving you some inside information, all that you have to do is to send me an email or SMS talking on a different subject."
Dipak Patel went on to argue that while the 1995 FUTP Regulations prohibited front running by any person, the 2003 FUTP Regulations prohibit front running only by intermediaries. And he argues that he is not an intermediary.
SAT agreed there is no specific provision in the Act prohibiting front running by traders. This interpretation has the legal community divided. Anand Desai
Partner, DSK Legal
"So 4(1) basically prohibits a fraud or on an unfair trade practice. 4(2) i.e. sub regulation (2) lists out provision which are deemed to be fraudulent - those are not exhaustive; they are indicative. 4(2)q being one of those which has been considered by SAT clearly talks about 'intermediaries' and thereby SAT has interpreted that correctly. Since 4(2) is not exhaustive and 4(1) can thereby go beyond that, possible an argument can be raised under 4(1) to say there are two parts- one is fraud and one is unfair trade practice. And unfair trade practice is not exhaustively defined anywhere and should therefore cover situation where someone has an undue advantage in the market as compared to others as has happened in this case." FUTP Regulations, 2003
Reg 4(1): "….no person shall indulge in a fraudulent or an unfair trade practice in securities." FUTP Regulations, 2003
Reg 4(2)(q): Prohibits front running by intermediaries FUTP Regulations, 2003
Reg 4(1): Prohibits any ‘person’ from indulging in fraudulent or unfair trade practice in securities Hitesh Jain
Partner, ALMT Legal
"If you apply the strict interpretation of statute and particularly in a statute which has penal consequences, you have to read it as it is. And the very fact that 'any other person trading in securities' has been deleted- this factor has weighed in the mind of SAT and that is the reason they've come to the conclusion that at the end of the day, he is not an intermediary; he is only a person - they have recognized this distinction." JN Gupta
Former ED, SEBI
"What SAT has missed that it is Passport Capital which was an intermediary and anybody who gets associated with that intermediary, in whatever capacity, is responsible. I would say that an accomplice is as much responsible as the person who has framed the scheme. So in this case Dipak Patel framed the scheme and put it to practice by using his relative. So his relative becomes an accomplice and since Dipak Patel is part of Passport Capital, he becomes an intermediary. If you go by what SAT has said, then in order for SEBI or anyone to have a front running case, the intermediary should record on a stamp paper that look this is the process by which we're going to do front running, these are the parties that'll be involved etc- which is not going to be the case. So front running pre-supposes an order and an order cannot be with an individual."
SAT also disagreed with SEBI's allegations that Patel had committed fraud against the market. SAT held that if at all there is fraud by Dipak Patel, it is against his employer i.e. Passport India Investment and not against the market. Anand Desai
Partner, DSK Legal
"There could have been an argument and I don't see that in the order as to how much it was raised- an argument of unfair trade practice which is the second part. So there is fraud and unfair trade practice. And then there is a deeming provision - the deeming provision is the sub regulation that has been picked up and interpreted. Possibly the unfair argument could've been raised more because somewhere I think the purpose of SEBI and SAT is to regulating the market such that it operates transparently and on an equal basis."
If SEBI decides to rest its case here, then SAT’s order in the Dipak Patel case could severely impact SEBI’s future cases against what constitutes front running and who the FUTP regulations can apply to. In Mumbai, Payaswini Upadhyay