This article is written by Varchaswa Dubey from the School of Law, JECRC University, Jaipur. This article distinguishes insider trading from front running. Furthermore, the article also reflects the effects of insider trading and front-running.
Insider trading refers to the mala fide practice where the trade of a company’s securities is misused by the individuals who already have access to the company, and such access is not usually available to those who are not a part of the company.
Front-running on the other hand, which is sometimes also called tailgating, refers to the trade of stock or any other asset of the company by an individual who already has inside knowledge of the transactions of the company, which shall affect the price of the asset, and this knowledge being brought or sold to clients will affect the price of an asset.
Understanding insider trading
There is no established definition of insider trading however it is referred to as “any buying or selling of a security in breach of a fiduciary duty or other relationship of trust and confidence, based on material, nonpublic information about the security.”
The offence of insider trading is also not reserved in the Indian Penal Code, 1860, but Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015 defines an insider as any person who is connected, or possesses or have access to any unpublished price sensitive information, while trading refers to the subscribing, buying, selling, dealing, or agreeing to subscribe, to buy, sell, or deal in any securities of a company.
The Securities and Exchange Board of India in its regulations states that no person who is an insider shall communicate, provide, or allow, or access to any unpublished price, or any sensitive information, concerning the company or securities listed to any person including the other insider of the company except when such communication is made in furtherance of legitimate purposes, the performance of duties or discharge of the legal obligation.
Origins of insider trading
The concept of insider trading is not new for the corporate sector however, in India, the practice of insider trading is relatively new compared to other nations. After recognizing insider trading as an unlawful act, the first attempt to eliminate insider trading was undertaken by the Company Law Committee, 1952. The recommendations of the 1952 committee can be reflected by Section 307 and Section 308 in the Companies Act, 1956. Later, the Sachar Committee, 1978, a high powered expert committee on Companies Act, and the Monopolies and restrictive Trade practices Act, 1969, which not only considered Section 307 and Section 308 of Companies Act, 1956 but also recommended that there shall be full disclosure of the transactions by persons who have made any price sensitive information and prohibition of transactions by any such individuals. The Patel Committee, 1984 highlighted the absence of legislation concerning insider trading in India and also recommended penalties for insider trading.
Effects of insider trading
- Effects on the market: insider trading discourages the interest of the investors and the faith of individuals in the investment business as the investors face loss in the business due to the advantage being taken by inside traders, leading to market inefficiency.
- Effects on the company: the company where insider trading has been caught not only loses its reputation in the market based on which most of the investors invest their money in the company, but also insider trading leads to huge losses to the company.
Meaning of front running
Front-running is the trade of stocks or any other financial asset by an employee who has the particular knowledge of any transaction which will take place in the future and such transaction affects the price. E.g. a broken being an insider of the company gets to know that an investor is about to buy 5000 shares of the company which will increase the price of the stocks of the company, and the broker himself buys 1000 shares in the company, then such events shall be referred to as front running.
Front-running has been explicitly reflected in Regulation 4 (2)(q) of SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003, which states that “an intermediary buying or selling securities in advance of a substantial client order or whereby a future or option position is taken about an impending transaction in the same or related futures or options contract.”
The concept of front-running is very similar to insider trading as in both of them, an insider is involved, however, in front-running, the insider takes advantage of the information he/she has regarding any future transaction and such person uses such information for personal gains.
The existence of front-running has always been suspected in the Indian markets, with rumours of front-running in the stock markets, by inside traders and brokers before the actual trade happens. However, there are no conclusive proofs of the origin of front running in India.
Types of front-running
The Supreme Court of India, in the case of Shri Anandkumar Baldevbhai Patel v. Sebi (2019), highlighted three types of front-running present.
- Trading by third parties who gets a tip about any future transaction which is about to take place.
- Owner or purchaser of trade himself engaged in the future trade in the offsetting of future transactions.
- Transactions where an intermediary knows some trades ahead of that order for the intermediary’s gain.
Effects of front running
The practice of front running not only gives an extra profit to the insiders of the company but also affects the market price of the shares.
- Front running increases the chances of inter-dealer order.
- Dealers of stocks who practice front-running have chances of making a high profit.
- Front-running eventually slows down the process of the company, which later affects the decisions of investors and dealers of the company.
- Front-running also reduces the costs of the liquidity of the company.
- Front-running also affects the welfare of the company, its dealers, and investors. The investors earn fewer profits because their profits are affected by front-running, and this eventually affects the company as its investors are reduced.
- Front-running reduces the risks dealers face when trading ahead of customers.
Difference between insider trading and front running
There lies a thin line of difference between insider trading and front running, however, the abuse of market factor is common among both, which is usually done by a person who possesses the inside knowledge which is usually not available to a person who is not a member of the organization.
In India, there are no such laws that differentiate insider trading from front running or vice versa, instead, the laws treat both types of offences as almost the same. The SEBI on the other hand has provided a little difference between insider trading and front running, however, SEBI also most of the time deals with the cases of front running according to the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003.
The only major difference between insider trading and front running is that insider trading is construed to have taken place when a person trades in the securities of a listed company while in possession of unpublished price-sensitive information.
In front running, the information possessed by an individual is misused for personal purposes and there exists a breach of duty on the part of the person who was responsible for keeping honest trade, however, in case of insider trading, the unpublished price sensitive information (UPSI) is exploited for personal gains.
Meaning of unpublished price sensitive information
According to SEBI, unpublished price sensitive information means any information which is related to the following matters or is of concern, directly or indirectly, to a company, and is not generally known or published by such company” for general information, but which if published or known, is likely to materially affect the price of securities of that company in the market:
- Financial results (both half-yearly and annual) of the company.
- Intended declaration of dividend (both interim/final).
- Issue of shares by way of public rights, bonuses, etc.
- Any major expansion plans or execution of new projects.
- Amalgamations, mergers, and takeovers.
- Disposal of the whole or substantially the whole of the undertaking.
- Such other information which may affect the earnings of the company.
The HDFC AMC front running case
The case was concerned with Sections 11(1), Section 11(4)(d), and Section 11B of the Securities and Exchange Board of India Act, 1992 in the matter of front-running of trades of HDFC Asset Management Company Limited by ‘Sanghvi group’ and ‘Kalpana group’.
In the year 2007, the SEBI unearthed numerous circumstances of front-running by a dealer of HDFC Asset Management Company (AMC). According to SEBI, in its order dated November 2019 and July 2020, the total unlawful gain achieved through front running was rupees 1.52 crore and rupees 2.86 crores respectively.
Later, the SEBI imposed a penalty on the concerned entities associated with front-running and also enacted strict rules regarding the traders of mutual funds and other such institutes, to curb the flow of insider information regarding the upcoming trade of the company. The SEBI also made a settlement with the HDFC AMC and imposed a fine of Rs 2 crore on 4 entities in the HDFC AMC front-running case.
Role of SEBI regarding insider trading and front running
The SEBI in its Securities and Exchange Board of India Act, 1992 provides rules and regulations concerning the protection of interests of investors in securities and to promote the development, regulation, securities market, bestowed the 1992 Act which also established SEBI. The 1992 Act, under Section 12A, reserves the prohibition of insider trading and prohibits any sale or purchase regarding the sale or purchase of any securities, or defrauds any securities, or undertakes any practice, business which operates as fraud, or engages in insider trading, etc.
The SEBI is a statutory body that is also the primary authority concerned with insider trading as most of the events are related to insider trading.
The powers of SEBI are reflected in the SEBI Act, 1992 in its Section 11, which includes the prohibition of insider trading in Section 11(2)(g) of the said Act. Section 15G of the SEBI Act also reserves the punishment for insider trading which shall not be less than ten lakh rupees but which may extend to twenty-five crore rupees or three times the amount of profits made out of insider trading, whichever is higher.
SEBI can also initiate any criminal proceedings concerning front-running in any company under Section 11 of the SEBI Act.
Insider trading and front-running, both have serious effects on the company, its investors, and the overall value of the company. Such malpractices shall be eliminated, protecting the interest of all the concerned persons in a company. With the increase in the use of technology, not only new laws concerning insider trading and front-running should be introduced, but also modern technology should be used.
The use of technology will not only lead to a permanent record of shares and stock traders but also will prevent any trading which may otherwise affect the value of the company, however, to establish a system completely based on technology, it is also necessary to supervise those who are assigned with the task of recording the transactions. Therefore, SEBI must not only regularly cross-check the transactions of an institution but also the laws shall be enforced more stringently so that the interest of investors and faith of people in trading remains protected.
LawSikho has created a telegram group for exchanging legal knowledge, referrals, and various opportunities. You can click on this link and join: