“Front-Running” in India Challenges Regulators

In an interesting turn of events, the Securities and Exchange Board of India (SEBI) has announced that it needs to review its regulations that deal with front-running.

The Securities Appellate Tribunal (SAT) recently set aside an SEBI order barring a portfolio manager of a foreign institutional investor from trading in the market for abusive trading strategies that violated SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Markets) Regulations, 2003, or FUTP.

Dipak Patel was the portfolio manager of Passport India Investment (Mauritius) Limited, a sub-account of Passport Capital, LLC, a foreign institutional investor registered with SEBI. Passport Capital LLC is a San Francisco-based, federally registered investment adviser with the U.S. Securities and Exchange Commission.

SEBI’s investigation revealed that Dipak Patel had passed on advance information about trading activities of Passport India in the securities market to his cousins from 2007 to 2009. Dipak Patel’s cousins had executed several synchronized trades to match Passport India’s dealings and benefitted from the price fluctuations caused by the large buy-sell orders of Passport India. Based on detailed analysis of the trading activities and the banking transactions between Dipak Patel and his cousins, SEBI barred  Dipak Patel and his cousins from trading, and also ordered the cousins to deposit the profits amounting to Rs 1,12,68,659 (approximately US$205,000) to the National Stock Exchange.

On appeal, SAT overruled the SEBI order and observed that the orders were placed at market price; there was no clear evidence of manipulation of the market, and FUTP regulations on front-running apply only to intermediaries. Hence the alleged fraud on the part of Dipak Patel may be just one involving his employer, SAT stated, noting that the employer had terminated Patel’s services after an internal investigation.

At CFA Institute, our members strictly follow the CFA Institute Code of Ethics and Standards of Professional Conduct, and we believe that front-running transactions by anyone based on knowledge of upcoming trading, as occurred in the Patel case, is unethical and prohibited by the Code and Standards. High ethical standards are critical to maintaining the public’s trust in financial markets and in the investment profession.

Globally, the International Organization of Securities Commissions (IOSCO) core objectives of securities regulation is to ensure markets are fair, efficient, and transparent which is closely linked to protecting investors from misleading, manipulative, or fraudulent practices, including insider trading, front-running or trading ahead of customers, and misuse of client assets.

How Is Front-Running Defined by Regulators across Different Jurisdictions?

Interestingly, we found that different jurisdictions interpret front-running differently. For example, the Hong Kong Securities and Futures Commission defines front running as the “unethical practice of a broker trading an equity based on information from a research analyst before passing the information to his or her clients.” Singapore Exchange (SGX), on the other hand, states that “a Member, Approved Trader or Registered Representative shall not trade in contracts for its own accounts or for an account associated with or connected to that Member, Approved Trader or Registered Representative, if that Member, Approved Trader or Registered Representative also has in hand Customers’ orders (including discretion orders) to do the same at the prevailing market price or at the same price.”

The U.S. Securities and Exchange Commission recently approved a proposal from the Financial Industry Regulatory Authority (FINRA) to expand the front- running policy “to apply to all securities and other financial instruments and contracts (in addition to the existing options and security futures) that overlay the security that is the subject of an imminent block transaction and that have a value that is materially related to, or otherwise acts as a substitute for, the underlying security.” Specifically, FINRA proposed to expand the front-running policy to cover trading in an option, derivative, security-based swap, or other financial instrument overlying a security that is the subject of an imminent block transaction.

According to FINRA, firms are permitted to trade ahead of a customer’s block order “when the purpose of such trading is to fulfill the customer order without potential for abusive trading practices, and when the customer has authorized such trading, including that the firm has disclosed to the customer that it may trade ahead of, or alongside of, the customer’s order.” This is technically known as “warehousing.”

The purpose of such detailed definitions by regulators in each of the above jurisdictions is to ensure that regulations are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to remove impediments to, and perfect the mechanisms of, a free and open market, and to protect investors and the public interest.

As stated in the CFA Institute Asset Manager Code of Professional Conduct, managers are responsible to maximize client portfolio value by seeking best execution for all client transactions and give priority to investments made on behalf of the client over those that benefit the managers’ own interests.

Unfortunately, the FUTP regulations of SEBI need more clarity in how it defines front-running instead of relying on broad terms such as “unfair trade practice or market manipulation,” as in the case of Dipak Patel and Passport India. SEBI has to determine whether this is a clear case of front-running.

The basic question is whether Dipak Patel and his cousins behaved ethically. Was this a case of collusion given the volume of bank account transactions among the group? If front-running is restricted to merely intermediaries, per the FUTP definition (as interpreted by SAT),  is the sharing of confidential trading information ahead of the employer and making gains consistently for two years legal and ethical in the context of just and equitable principles of securities market trade practices?

The test of true market integrity goes beyond regulatory enforcement. The solution is more deep-rooted in the culture of adhering to ethical principles and conduct by market players. Against this backdrop, it is not surprising that in the CFA Institute Global Market Sentiment Survey 2013, a staggering 71 percent of participants from India responded that the lack of ethical culture in firms is the primary contributing factor driving the lack of investor trust. Perhaps it is the understanding of how to behave ethically, and the consequences of unethical behavior, that must serve as the starting point.

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