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

What this chapter covers

This chapter carries about 6 per cent of the III-C 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 Introduction

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.

Made under section 30 — the same rule-making power that produced the SCRR.

What is fraud?

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 twice — whether or not there is any wrongful gain or avoidance of any loss. Fraud under these Regulations does not require that anyone actually profited.

Note also the breadth of the opening — any act, expression, omission or concealment, committed by the person, by any other person with his connivance or by his agent.

Nine instances are cited:

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

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.

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.

Instance (a) is the first review question — True.

Instance (e) is worth pausing on. A representation, whether true or false, made in a reckless and careless manner is fraud. So is (h) a false statement made without reasonable ground for believing it to be true. Recklessness suffices; deliberate lying is not required.

And instance (i) is the fraud-on-the-market principle — investors are misled even though they did not rely on the statement itself or anything derived from it other than the market price. A person who never read the false announcement but bought at the price it created is still a victim.

The third review question asks whether fraud includes an intermediary providing his clients with such information relating to security as cannot be verified by the clients before their dealing in such security. The paper marks this True. The idea sits comfortably with instances (g) — deceptive behaviour by a person depriving another of informed consent or full participation — and (h). Answer as the paper frames it.

8.2.1 Prohibited dealings — Chapter II

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;

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 limbs, and the first covers all three verbs — buy, sell or deal in securities in a fraudulent manner. That is the second review question, answered All of the above.

These four mirror section 12A(a), (b) and (c) of the SEBI Act, which is why enforcement orders in this area routinely cite both.

Note "directly or indirectly", and note listed or proposed to be listed — the prohibitions reach the issue stage.

8.2.2 The seventeen deemed 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.

But (h) has two exceptions. If the person selling, dealing in or pledging stolen, counterfeit or fraudulently issued securities was a holder in due course, or if the stolen, counterfeit or fraudulently issued securities were previously traded on the market through a bonafide transaction, then such selling, dealing or pledging... 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;

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.

q) 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.

Limb (n) is the front-running provision. An order placed while directly or indirectly in possession of information that is not publicly available, regarding a substantial impending transaction — which is exactly what the Supreme Court dealt with in Kanaiyalal Baldevbhai Patel.

Limb (p)(iv) is notable — not taking reasonable care to ensure the suitability of the securities or service to the buyer is mis-selling even without any false statement. Negligence suffices.

And the list is open. For the removal of doubts, 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.

So describing a practice as one committed by an intermediary does not confine it to intermediaries.

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.

Documents and personal attendance — both.

SEBI's directions

SEBI may without prejudice to the provisions contained in sub-section (1), (2), (2A) and (3) of section 11 and section 11B of the SEBI Act, 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, namely –

(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 either pending investigation or enquiry or on completion — SEBI need not wait.

Note also the words "prima facie" in (a) and (d). A preliminary view suffices for these interim measures.

And limb (h) is the restorative one — a direction to sell, for restoring the status quo ante.

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.

That is the fourth review question — both suspend and cancel.

Case 8.1: SEBI vs First Financial Services Limited

A preferential allotment used as a façade.

The scrip of FFSL was suspended from trading on the Bombay Stock Exchange (BSE) from June, 2000 to July 08, 2011. After the revocation of suspension and before May 15, 2012, the scrip was traded on only two days July 8, 2011 and November 16, 2011 and the closing price of the scrip on these days was Rs.7.12 and Rs.5.10 respectively.

Then two preferential allotments. The company made two preferential allotments of shares - 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. These shares were under lock-in for one year from the date of respective allotment and after the expiry of the lock-in most of these shares were sold in the market.

Rs. 20 a share, when the scrip had last closed at Rs. 5.10.

Then the price rise. After the preferential allotment and during the lock-in period, the price of the scrip witnessed a steep rise with very low traded volume. The price of the scrip rose by 4824.3% during the period from May 15, 2012 to February 8, 2013. After the price rise period, the scrip was traded in high volume and most of the shares issued to preferential allottees were off-loaded in the market. This period was mainly between February 11, 2013 and December 12, 2013.

A rise of 4824.3 per cent on very low volume, followed by heavy selling.

Then a split and a fall. On December 13, 2013 the shares of FFSL were sub-divided into ten equity shares of Re.1 each from one equity share of Rs.10 each. Subsequently, the scrip witnessed a fall in price.

The fundamentals did not support any of it. There was a marginal increase in profit of FFSL during 2012-13. The company had registered a net profit of Rs. 0.32 crore, Rs. 0.48 crore and Rs. 0.07 crore for the financial year ended March 2012, March 2013 and March 2014 respectively.

And the money went back where it came from. The company did not utilise the money received by it on allotment of preference shares to the tune of Rs 15 crores for the purposes for which it was raised and most of the money were transferred back to the allottees or were transferred to certain buyers in the post-lock-in period through multiple layers of transactions. The company had funded some allottees to subscribe to its shares in the preferential allotments.

**Of the Rs 15 crore, 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.

The 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) of SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003.

SEBI's findings. 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. Taken with the price manipulation, this established that the preferential allotment exercise of FFSL was merely a façade to benefit some of its connected allottees through the sale of their shares post the lock-in period. In sum, FFSL, its directors along with the Comfort group and certain other entities orchestrated a fraudulent scheme involving preferential allotment route, which ultimately benefitted a few allottees and was never retained for utilization as per the stated objects of the issue.

The procedure and outcome. Two interim orders of December 19, 2014 and August 11, 2015 restrained 154 entities; four confirmatory orders confirm[ed] the directions against 149 entities and revok[ed] the directions against 5 entities. FFSL appealed, and SAT vide order dated May 03, 2017 directed SEBI to pass appropriate order in the matter by March 31, 2018. SEBI passed the final order on April 2, 2018, due to the intervening holidays from 29th of March to 1st of April, 2018.

As per the final order, 29 entities (including FFSL) were restrained from accessing the securities market and were prohibited from buying, selling or otherwise dealing in securities, directly or indirectly, or being associated with the securities market in any manner, for a period of three years, from the date of the order. The order also revoked all the earlier interim and confirmatory orders issued between December 2014 and August 2016.

Case 8.2: Supreme Court — SEBI vs Kanaiyalal Baldevbhai Patel

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.

Five appeals were heard together.

Kanaiyalal Baldevbhai Patel was putting orders ahead of orders placed by Passport India Investment (Mauritius) Ltd. whose portfolio manager Dipak Patel was a cousin of KB and of AB. It was alleged that Dipak Patel provided information to KB and AB regarding the forthcoming trading activity of the PII, and trades were executed using the telephone number registered in the name of AB at the common residential address of KB and AB. It was estimated that the KB earned a total profit of Rs. 1,56,32,364.01.

Sujit Karkera and Group traded ahead of the trades of CITIGROUP Global Markets Mauritius Pvt. Ltd. (CGMMPL) on the basis of information provided by Suresh Menon (trader of CGMMPL), with several calls made between Suresh Menon and his family friend Sujit Karkera exchanging scrip name, order quantity, order timing, and order price.

Jitendra Kumar Sharma was an equity dealer employed by the Central Bank of India, and his wife Vibha Sharma allegedly engaged herself in front running Central Bank of India's large-scale orders allegedly with the knowledge obtained from her husband, her trades substantially matched with the trades of the bank.

Pooja Menghan traded four scrips by utilizing the information provided by Deepak Khurana who was privy to certain confidential information of Religare, and it was found that the appellant's sell orders (quantity and price) substantially matched with the buy orders (quantity and price) of other traders and that her sell order limit price was always above the sell LTP but was the same or very close to the buy limit price of other traders.

The three forms of front-running

Front-running comprises of at least three forms of conduct. They are:

(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"); and

(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").

In this batch of appeals, the first and the last types of trade i.e., tippee trading and trading ahead are dealt with. 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 has three elements. In order to establish charges against tippee, under regulations 3(a), (b), (c) and (d) and 4(1) of FUTP 2003, one needs to 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.

A duty of confidence · knowledge of the breach · trading anyway.

And both sides are liable. 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.

The order: having regard to 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, the conduct was in breach of the code of business integrity in the securities market, and the consequences for such breach including penal consequences under the provisions of Section 15HA of the SEBI Act must visit the concerned defaulters. SAT's orders in three appeals were set aside and the findings recorded and the penalty imposed by the Adjudicating Officer is restored; the other two appeals were dismissed.

Case 8.3: Sunita Gupta vs SEBI

Synchronised, circular and reversal trading, and a failed sub-broker defence.

SEBI's order of March 27, 2018... imposed a penalty of Rs. 25 lakh upon the appellant for violation of Sections 12(A)(a), 12(A)(b), 12(A)(c) of SEBI Act, 1992 and regulations 3(a), 3(b), 3(c), 3(d), 4(1), 4(2)(a) & 4(2)(e) of the PFUTP Regulations, relating to trading in M/s. Gangotri Textiles Ltd. between April 7, 2005 to May 31, 2006.

The history. A show cause notice of December 12, 2013 was followed by an order of July 22, 2014 whereby a penalty of Rs. 60 lakhs were imposed. SAT remanded on April 29, 2016, holding that since the question as to whether the appellant traded on the Stock Exchange at Mumbai as a sub-broker or in individual capacity goes to the root of the matter, we deem it proper to quash and set aside the impugned order and restore the matter for fresh decision on merits. A fresh adjudicating officer then reduced the penalty to Rs. 25 lakh.

The findings. A number of entities collectively called Vishvas group, including the appellant herein, have manipulated trading in the scrip of Gangotri during the investigation period. During the investigation period these entities had executed a large number of synchronized trade, circular trades and reversal trades and traded in significant variation to the Last Traded Price (LTP). The group's totals were 5198404 and 4711903 shares bought and sold on BSE and 3876420 and 3592980 on NSE; the appellant had bought and sold 342246 shares of Gangotri in BSE; and the price of the scrip varied from 43 rupees to 71 rupees indicating substantial volatility.

The sub-broker defence failed on the documents. The appellant has not given any documents / evidence to demonstrate that she was dealing on behalf of her clients in terms of bank account transactions, demat account transactions, ledgers, contract notes etc. She was registered as a client of Parasram, her broker, since June 2002, 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, Parasram itself confirmed that the impugned trades were carried out by the appellant in her capacity as client. There was no document/ agreement entered into between the stockbroker, the appellant and her so-called client. And pursuant to an amendment to broker regulations in the year 2003 sub-brokers were prohibited from handling funds and securities of clients and issuing contract notes to clients.

On coincidence, SAT was blunt: the appellant could not explain why and how so many of her trades were in the nature of synchronized and reversed trades and that too most of the time within a few seconds with trades of other entities in the Vishvas group. Such synchronization and reversal of trade are not possible without a prior meeting of minds.

On quantum: the penalty imposable under Section 15HA of the SEBI Act is three times the amount of profit or Rs. 25 crore whichever is higher. Therefore, while imposing an amount of Rs. 25 lakhs only as a penalty the AO has factored in all the mitigating circumstances including that the appellant might have made a loss.

The order: no reason to interfere with the amount of penalty imposed. Appeal is dismissed.

Case 8.4: SEBI vs Hemant Ghai and others — the "Stock 20-20" matter

On analysis of the trading pattern of 2 entities viz., Jaya Hemant Ghai and Ms Shyam M Ghai for the period January 2019 to May 2020, high co-relation of the trades of aforesaid entities was observed with recommendations furnished in the show stock 20-20 aired on channel CNBC-Aawaz.

The findings. Hemant Ghai was hosting/co-hosting various shows; stock 20-20. This show featured recommendations on certain stocks to be brought/sold during the day. Jaya Ghai and Shyam Ghai had undertaken a large number of Buy-today-sell-tomorrow (BTST) trades during the relevant period in synchronisation with recommendations made in the show. Shares were brought the previous day before the recommendation and sold immediately on recommendation day.

And the relationships: Jaya Ghai was the wife of Hemant Ghai and Shyam Ghai was the mother of Hemant Ghai.

The proceeds: Trades were executed in the trading account of Jaya Ghai and Shyam Ghai in violation of provisions of the SEBI Act and SEBI (PFUTP) Regulations and earned proceeds amounting to Rs 2.95 crore through limited trades examined during the period.

The mechanism: Hemant Ghai had advance information on the buy recommendation of shares to be made on the next day and the trades in the trading account of Jaya Ghai and Shyam Ghai 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 KYC: 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. Since the conduct of the aforementioned entities appears to be unfair and not in the interest of investors and the securities market, necessary action has to be taken against them immediately. It is a fit case, pending detailed examination, effective and expeditious preventive action is required by way of ad-interim order to preserve the safety and integrity of the market.

The directions: the entities were restrained from buying, selling or dealing in the securities, either directly or indirectly in any manner whatsoever till further directions, with liberty to close out open derivative positions till 3 months from date of order; Hemant Ghai shall cease and desist from undertaking directly or indirectly any activity related to investment advice, sell/buy recommendations, publishing research reports etc related to the securities market till further directions; bank accounts of entities to the extent of amount in the order to be impounded, the money moved to an escrow account not [to] be released without permission of SEBI; bank account of aforesaid entities are frozen for any further debits; the entities to furnish full inventory of assets held by them jointly or severally including bank accounts, Demat accounts mutual fund investment, immovable properties, and not to dispose off or create a charge on the assets; and depositories and Registrar Transfer agents to ensure no credits in the accounts held by them jointly or severally till further direction.

Every one of those directions maps onto the eight powers listed in the chapter — restraint from the market, impounding proceeds, and a bar on alienating assets.

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 fraudulently — All of the above; that fraud includes an intermediary giving clients information as cannot be verified by the clients before their dealing in such security — True; and that SEBI may both cancel and suspend an intermediary's registration — Both a & b.