SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003

What this chapter covers

This chapter carries 6 per cent of the III-A examination.

LEARNING OBJECTIVES: After studying this chapter, you should know about the: Different kind of dealings, prohibited in securities · Dealings in securities which are considered as fraudulent and unfair trade practices · Different aspects related to investigation of fraudulent and unfair trade practices

8.1 What fraud means

SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 prohibit fraudulent, unfair and manipulative trade practices in securities. These regulations have been made in exercise of the powers conferred by section 30 of the SEBI Act, 1992.

Regulation 2(1)(c) defines fraud as inclusive of any act, expression, omission or concealment committed whether in a deceitful manner or by a person or by any other person with his connivance or by his agent while dealing in securities in order to induce another person or his agent to deal in securities, whether or not there is any wrongful gain or avoidance of any loss.

Read the last clause carefully — whether or not there is any wrongful gain or avoidance of any loss. The fraud is complete on the inducement; profit is irrelevant.

And note the reach — an act by the person, by any other person with his connivance, or by his agent.

Nine instances:

a) A knowing misrepresentation of the truth or concealment of material fact in order that another person may act, to his detriment.

The first review question quotes this limb — True.

b) A suggestion as to a fact which is not true, by one who does not believe it to be true.

c) An active concealment of a fact by a person having knowledge or belief of the fact.

d) A promise made without any intention of performing it.

e) A representation, whether true or false, made in a reckless and careless manner.

Note limb (e) — a statement may be true and still be fraud, if made recklessly.

f) Any such act or omission as any other law specifically declares to be fraudulent.

g) Deceptive behaviour by a person depriving another of informed consent or full participation.

h) A false statement made without reasonable ground for believing it to be true.

i) The act of an issuer of securities giving out misinformation that affects the market price of the security, resulting in investors being effectively misled even though they did not rely on the statement itself or anything derived from it other than the market price.

Limb (i) is striking — an investor need never have read the false statement. Being misled through the price is enough.

8.2.1 Prohibited dealings

Chapter II of the regulations prohibits certain dealings in securities covering buying, selling or issuance of securities. The regulations prohibit a person to, directly or indirectly:

buy, sell or deal in securities in a fraudulent manner.

The second review question quotes this — all three verbs.

use or employ in connection with issue, purchase or sale of any security listed or proposed to be listed, any manipulative or deceptive device or contrivance in contravention of the provisions of SEBI Act or rules or regulations made thereunder.

employ any device, scheme or artifice to defraud in connection with dealing in or issue of any security listed or proposed to be listed.

engage in any act, practice, course of business which operates or would operate as a fraud or deceit upon any person in connection with any dealing in or issue of securities, which are listed or proposed to be listed.

Four prohibitions, mirroring Section 12A of the SEBI Act, and each covering securities listed or proposed to be listed — the reach extends to an issue before it comes to market.

And note the last one: which operates or would operate as a fraud or deceit. The scheme need not have succeeded.

8.2.2 Deemed manipulative, fraudulent and unfair practices

Dealing in securities shall be deemed to be a manipulative, fraudulent or unfair trade practice if it involves any of the following:

a) knowingly indulging in an act which creates a false or misleading appearance of trading in the securities market.

b) dealing in security not intended to effect transfer of beneficial ownership but intended to operate only as a device to inflate, depress or cause fluctuations in the price of such security for wrongful gain or avoidance of loss.

c) inducing any person to subscribe to an issue of the securities for fraudulently securing the minimum subscription to such issue of securities, by advancing or agreeing to advance any money to any other person or through any other means.

d) inducing any person for dealing in any securities for artificially inflating, depressing, maintaining or causing fluctuation in the price of securities through any means including by paying, offering or agreeing to pay or offer any money or money's worth, directly or indirectly, to any person.

e) any act or omission amounting to manipulation of the price of security including, influencing or manipulating the reference price or benchmark price of any securities.

f) knowingly publishing or causing to publish or reporting or causing to report by a person dealing in securities any information relating to securities, including financial results, financial statements, mergers and acquisitions, regulatory approvals, which is not true or which he does not believe to be true prior to or in the course of dealing in securities.

g) entering into a transaction in securities without the intention of performing it or without the intention of change of ownership of such security.

h) selling, dealing or pledging of stolen, counterfeit or fraudulently issued securities whether in the physical or dematerialized form.

Two defences to (h): where the person selling, dealing in or pledging stolen, counterfeit or fraudulently issued securities was a holder in due course, or where the stolen, counterfeit or fraudulently issued securities were previously traded on the market through a bonafide transaction — in which case such dealing shall not be considered as a manipulative, fraudulent, or unfair trade practice.

i) disseminating information or advice through any media, whether physical or digital, which the disseminator knows to be false or misleading in a reckless or careless manner and which is designed to, or likely to influence the decision of investors dealing in securities.

j) a market participant entering into transactions on behalf of client without the knowledge of or instructions from client or mis utilizing or diverting the funds or securities of the client held in a fiduciary capacity.

k) circular transactions in respect of security entered into between persons including intermediaries to artificially provide a false appearance of trading in such security or to inflate, depress or cause fluctuations in the price of such security.

l) fraudulent inducement of any person by a market participant to deal in securities with the objective of enhancing his brokerage or commission or income.

m) an intermediary predating or otherwise falsifying records including contract notes, client instructions, the balance of securities statement, client account statements.

n) any order in securities placed by a person, while directly or indirectly in possession of information that is not publicly available, regarding a substantial impending transaction in those securities, its underlying securities or its derivative.

Limb (n) is front running.

o) knowingly planting false or misleading news which may induce sale or purchase of securities.

p) mis-selling of securities or services relating to the securities market. Mis-selling means sale of securities or services relating to securities market by any person, directly or indirectly, by (i) knowingly making a false or misleading statement, or (ii) knowingly concealing or omitting material facts, or (iii) knowingly concealing the associated risk, or (iv) not taking reasonable care to ensure the suitability of the securities or service to the buyer.

Note the fourth limb of mis-selling — it needs no knowledge at all, only a failure to take reasonable care to ensure the suitability.

And illegal mobilization of funds by sponsoring or causing to be sponsored or carrying on or causing to be carried on any collective investment scheme by any person.

The list is not closed. It is clarified that the acts or omissions listed in this sub-regulation are not exhaustive and that any act or omission is prohibited if it falls within the purview of regulation 3, notwithstanding that it is not included in this sub-regulation or is described as being committed only by a certain category of persons in this sub-regulation.

Two important consequences. A practice not on the list is still caught if it falls within regulation 3. And a practice described as being committed by, say, an intermediary is not confined to intermediaries.

Which is why the third review question is True. An intermediary who gives a client information about a security as cannot be verified by the clients before their dealing in such security falls squarely within the definition of fraud — limb (b), a suggestion as to a fact which is not true, by one who does not believe it to be true; limb (e), a representation, whether true or false, made in a reckless and careless manner; and limb (h), a false statement made without reasonable ground for believing it to be true — quite apart from the express clarification that the deemed list are not exhaustive.

"Market Participant shall include any person or entity registered under Section 12 of the Act and its employees and agents."

8.3 Investigation

Under regulation 8(1), it shall be the duty of every person who is under investigation:

a) To produce books, accounts and other documents that may be required by the Investigating Authority and also to furnish statements and information that is sought.

b) To appear before the Investigating Authority personally when required to do so and to answer questions posed by the authority.

Produce, and appear personally.

SEBI's directions. Without prejudice to sections 11 and 11B of the SEBI Act, SEBI may by an order, for reasons to be recorded in writing, in the interests of the investors and the securities market, issue or take any of the following actions or directions, either pending investigation or enquiry or on completion of the investigation or enquiry:

(a) Suspend the trading of the security found to be or prima facie found to be involved in fraudulent and unfair trade practice on recognised stock exchange.

(b) Restrain persons from accessing the securities market and prohibit any person associated with securities market to buy, sell or deal in securities.

(c) Suspend any office-bearer of any stock exchange or self-regulatory organisation from holding such position.

(d) Impound and retain the proceeds or securities in respect of any transaction which is in violation or prima facie in violation of these regulations.

(e) Direct an intermediary or any person associated with the securities market in any manner not to dispose of or alienate an asset forming part of a fraudulent and unfair transaction.

(f) Require the person concerned to call upon any of its officers, other employees or representatives to refrain from dealing in securities in any particular manner.

(g) Prohibit the person concerned from disposing of any of the securities acquired in contravention of these regulations.

(h) Direct the person concerned to dispose of any such securities acquired in contravention of these regulations, in such manner as the Board may deem fit, for restoring the status quo ante.

Eight directions, and note that (h) is restorative — for restoring the status quo ante.

And note "prima facie" in (a) and (d) — the powers may be used before anything is proved.

Against an intermediary, SEBI may also:

i. Issue a warning or censure; ii. Suspend the registration of the intermediary; iii. Cancel the registration of the intermediary.

The fourth review question asks about the last two — SEBI may both cancel and suspend.

The cases

Case 8.1 — First Financial Services

A preferential allotment used as a device. The scrip was suspended from trading on the Bombay Stock Exchange (BSE) from June, 2000 to July 08, 2011, and after revocation traded on only two days, closing at Rs.7.12 and Rs.5.10.

Then two preferential allotments — first on December 08, 2011 (for 54,50,000 equity shares) and another on April 28, 2012 (for 22,50,000 equity shares) at a price of Rs. 20 each to 83 persons, locked in for one year.

During the lock-in, the price rose by 4824.3% during the period from May 15, 2012 to February 8, 2013, on very low volume. After the price rise period, the scrip was traded in high volume and most of the shares issued to preferential allottees were off-loaded.

Where the money went: out of the allotment proceeds of Rs 15 crores, a sum of Rs.6.57 crore was transferred back to the allottees indirectly through multiple layers of transactions and around Rs. 7.94 crore was transferred to entities connected to FFSL.

SEBI's conclusion: FFSL had no intention to utilise the funds raised through the preferential allotments as per the disclosed objectives at the time of allotment and the preferential allotment was used as a device to route a significant portion of allotment money to certain allottees/ entities, connected to the company — the exercise being merely a façade to benefit some of its connected allottees through the sale of their shares post the lock-in period.

Violations: Section 12A(a), (b) and (c) of the SEBI Act, 1992 read with Regulations 3(a), (b), (c), (d) and Regulations 4(1), 4(2), (a) and (e).

Order: after interim orders restraining 154 entities and confirmatory orders against 149, the final order restrained 29 entities (including FFSL)... for a period of three years.

Case 8.2 — Kanaiyalal Baldevbhai Patel (Supreme Court)

Front running by non-intermediaries. A trader placed orders ahead of orders placed by Passport India Investment (Mauritius) Ltd., tipped by a cousin who was its portfolio manager, earning Rs. 1,56,32,364.01. Similar patterns arose with a trader of CITIGROUP Global Markets Mauritius Pvt. Ltd., with a bank equity dealer's wife, and with a client tipped by someone privy to certain confidential information of Religare.

The question: whether 'front running by non-intermediary' is a prohibited practice under regulations 3 (a), (b), (c) and (d) and 4(1) of FUTP 2003.

Three forms of front running:

(1) trading by third parties who are tipped on an impending block trade ("tippee" trading).

(2) transactions in which the owner or purchaser of the block trade himself engages in the offsetting futures or options transaction as a means of "hedging" against price fluctuations caused by the block transaction ("self-front-running").

(3) transactions where an intermediary with knowledge of an impending customer block order trades ahead of that order for the intermediary's own profit ("trading ahead").

Trading ahead has been explicitly recognized under regulation 4(2)(q) of FUTP 2003.

The holding: non-intermediary front running may be brought under the prohibition prescribed under regulations 3 and 4 (1), for being fraudulent or unfair trade practice, provided that the ingredients under those heads are satisfied.

And the test for a tippee: one must prove that a person who had provided the tip was under a duty to keep the non-public information under confidence, further such breach of duty was known to the tippee and he still trades thereby defrauding the person, whose orders were front-runned, by inducing him to deal at the price he did.

Three elements — a duty of confidence, the tippee's knowledge of its breach, and trading despite it.

And joint liability: the parting of information with regard to an imminent bulk purchase and the subsequent transaction thereto are so intrinsically connected that no other conclusion but one of joint liability of both the initiator of the fraudulent practice and the other party who had knowingly aided in the same is possible.

What proved the case: the volume of shares sold and purchased; the proximity of time between the transactions of sale and purchase and the repeated nature of transactions on different dates.

Case 8.3 — Sunita Gupta (SAT)

Synchronised, circular and reversal trading in the scrip of Gangotri Textiles, where a group executed a large number of synchronized trade, circular trades and reversal trades and traded in significant variation to the Last Traded Price (LTP), the price moving from 43 rupees to 71 rupees.

The appellant's defence — that she traded as a sub-broker for a client — failed for want of evidence: all the trades were carried out in the Unique Client Code (UCC) of the appellant and that Unique Client Code is not that of any sub-broker, and the broker itself confirmed that the impugned trades were carried out by the appellant in her capacity as client.

The chance defence failed too: such synchronization and reversal of trade are not possible without a prior meeting of minds.

On penalty: SAT noted that the penalty imposable under Section 15HA of the SEBI Act is three times the amount of profit or Rs. 25 crore whichever is higher, and that the adjudicating officer had already reduced it from Rs. 60 lakhs to Rs. 25 lakhs, factoring in all the mitigating circumstances including that the appellant might have made a loss. Appeal dismissed.

Case 8.4 — Hemant Ghai

A television anchor's recommendations traded in advance. Analysis showed high co-relation of the trades of aforesaid entities with recommendations furnished in the show stock 20-20 aired on channel CNBC-Aawaz.

The pattern: the anchor's wife and mother had undertaken a large number of Buy-today-sell-tomorrow (BTST) trades... in synchronisation with recommendations made in the show. Shares were brought the previous day before the recommendation and sold immediately on recommendation day, earning Rs 2.95 crore.

The reasoning: he had advance information on the buy recommendation of shares to be made on the next day and the trades... were designed to take advantage of advance information of buy recommendation given on the show, knowing fully well that buy recommendation would have a positive impact on price and volume of shares.

And control was inferred from the paperwork: from the KYC details of Jaya Ghai and Shyam Ghai, it was observed that the email id provided therein belonged to Hemant Ghai. Prima facie, observed that Hemant Ghai was controlling and operating these two trading accounts.

The ad-interim order: restraint from dealing in securities, three months to close out/square up open derivative positions, a direction that he cease and desist from undertaking directly or indirectly any activity related to investment advice, sell/buy recommendations, publishing research reports, impounding of bank balances to be moved to escrow account, freezing of accounts for debits, an inventory of assets, and directions to depositories and Registrar Transfer agents to ensure no credits in the accounts.

The chapter's review questions confirm that fraud includes a wilful misrepresentation of truth OR concealment of material fact, in order that another person may act, to his detriment — True; that the regulations prohibit a person from buying, selling or dealing in securities in a fraudulent manner; that an intermediary providing clients with information that cannot be verified before dealing is caught — True; and that SEBI may both cancel and suspend the registration of an intermediary.