By Sandeep Parekh
In Through the Looking Glass, the Red Queen told Alice, “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” There are many examples in the securities market that perfectly demonstrate the wisdom of the Red Queen—if you want to make a profit, you need to be faster than the rest.While ordinarily, asymmetry of information in the securities market is often exploited to achieve profits, frontrunning abuses this nefariously. It involves the use of non-public information pertaining to a substantial order (SO), and trading ahead of it to make profits or avoid losses.
Recent orders by the Securities and Exchange Board of India (Sebi) in the matters of Experts appearing on Zee Business and Ketan Parekh indicate a rise in the number of enforcement actions taken by the regulator for this particular offence and throws light onto the evolving forms of frontrunning. They also provide interesting perspectives on approaches adopted towards ascertaining what a SO is and the impact such an order may have on the price and volume traded of a security.In Ketan Parekh (no relation of the first author), Sebi has done away with the requirement to prove dishonest intention. What is essential, however, is an inducement to deal in securities, which is sufficient to demonstrate fraud. A parallel may be drawn to the Supreme Court ruling in Sebi v. Abhijit Rajan, a case involving allegations of insider trading.
The Supreme Court held that it was immaterial if actual profit or loss occurred, what is required is a motive to make a profit from the alleged trade. This motive is a key element in such trades. In Ketan Parekh, Quest Investment Advisors Private Limited, a portfolio management company registered with Sebi, indulged in frontrunning while in possession of advance knowledge of impending orders. Sebi interpreted the meaning of the SO by placing reliance on the “reasonable person test” (RPT) while noting that there was very little guidance on what constitutes a SO. The whole-time member (WTM) in this matter opined that a SO would, per a reasonable person, would impact the price of the concerned securities. The WTM further stated that “when it is only the estimation of reasonable person then the assessment of actual impact of such substantial order is not necessary to determine the substance of the order.”
Ideally, determination of what constitutes a SO should be followed by an assessment of the impact such an order may have on the price of the securities traded. In the present case, there was no calculation of impact and the RPT was used to conclude that frontrunning did, in fact, occur.In another matter, the frontrunner had undertaken trades in advance of an impending order. Sebi held that frontrunning occurs when an entity makes a trade on the basis of non-public information regarding a “large trade” from an investor, which may impact the price of such security. Sebi matched trades undertaken by the noticee with that of the impending large trade and found that in almost all instances the trades executed matched that of the impending order. Interestingly, the WTM observed that for frontrunning to occur, it was not mandatory that the frontrunner’s trades should match with that of the impending order. The essential element in establishing frontrunning is that the trades were made on the basis of non-public information.
In Zee Business, a far more complicated picture emerges. The alleged violators belonged to three categories—(i) experts appearing on news channels; (ii) profit makers; and (iii) enablers. Experts appearing on news channels provided advance information about the recommendations that were going to be made on the news broadcast (which was held to be non-public information) to the enablers, who then used trading terminals provided by profit makers to trade based on such advance information. Sebi, in its order, analysed the fluctuations in the price and volume of securities, being traded, pre and post the news broadcast. Notably, a key ingredient of front-running i.e. the existence of an impending transaction/ SO was not directly present in this case. It was held that the popularity of these shows had equipped the noticees, with a deep awareness of the impact that expert recommendations wielded over the price and volume of the securities so recommended. Though there was no SO in place, it was argued that the noticees had a reasonable expectation of an increase in the price and volume of the securities recommended immediately following the news broadcast.
The favourable movement in the price and trading volumes of the securities once such recommendations were made further strengthened this argument. Sebi utilised a host of strategies to establish links between the parties—from call data records, WhatsApp/Telegram chats, to geographic location analysis to further prove a nexus. It is rather interesting to note that the reasonable person test as employed in Ketan Parekh was not relied on in this order. Furthermore, this order did not discuss who a reasonable viewer is, and the only metric used to show inducement was the price/volume fluctuations pre and post the broadcast. Nevertheless, this order has expanded the contours of frontrunning to accommodate situations where there is an intent to defraud investors by abusing the trust which they keep with certain individuals, such as the financial pundits in this case.
A SO’s existence can be ascertained on the basis of the quantifiable response which viewers have for guest recommendations on channels, like Zee Business, and the change in the volume of trading in such securities. The motive is what counts towards making a case of frontrunning, divorced from any actual profit making. In all three cases, Sebi utilised different approaches to ascertain impact and knowledge of impending orders. On the road to determining the substantiality of orders, the approach adopted by Sebi has seen several variations and the ever-changing contours of frontrunning pose new challenges in determining liability. Sebi may have to relook at how it defines frontrunning in light of these changing dimensions. After all, a frontrunner is not the only one who has to run twice as fast.
Coauthored with Aniket Singh Charan, associate, Finsec Law Advisors
Sandeep Parekh, managing partner, Finsec Law Advisors