Front Running: Exploring the Scope for Criminal Charges

Introduction

Indian mutual fund industry witnessed a highly shaking front-running scandal¹ at Axis Mutual Fund in the month of May 2022. Two employees including the Chief Fund Manager were allegedly involved in making illegal gains through the practice of front running. It basically means that these fund managers have in advance, either directly or indirectly, invested money in those securities where Axis Mutual Fund was about to infuse large chunk of money; and thereby made huge gains through the “impact cost” that the infusion of fund has created.

The idea or the incident of front-running cases is not new to Indian financial market. These major fund scams have happened several times in the past as well, such as — HDFC Mutual Fund Scam², Reliance Securities Scam³, Fidelity Group Fund Scam, etc. However, the interesting and noteworthy aspect in this case is exploring the possibility of imposing criminal charges on the defaulter. The initial inquiry by Securities and Exchange Board of India (SEBI) suggested that they are willing to charge the defaulters with criminal punishment, which is unlike the general approach taken by it in the form of civil penalties and disgorgement of funds in front-running cases. Therefore, it would be worthwhile to investigate the idea of imposing criminal charges in cases of front running, from a legal standpoint.

Legal framework

The term “front running” does not find any direct mention either under the SEBI Act⁴ or under the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating of Securities Market) Regulations, 2003 (the PFUTP Regulations)⁵. This term is only used in the 2020 Master Circular for Mutual Funds⁶, which strictly restricts any such transactions. Now, even though there is no direct mention, these kinds of transactions and the power of SEBI to issue directions and penalties in such transaction, can be traced back to the SEBI Act and the PFUTP Regulations.

Regulation 4 of the PFUTP Regulations prohibits any “manipulative, fraudulent or unfair trade practices”⁷; and Regulation 4(2)(q) specifically covers the front-running transactions by laying out that — “Any order in securities placed by a person directly or indirectly, in possession of information that is not publicly available, regarding impending transaction in those securities” would be deemed fraudulent and unfair. On one hand, the specific penalty for engaging in fraudulent and unfair trade practices is laid down under Section 15-HA⁸ of the SEBI Act. It provides for a penalty of not less than five lakhs, and which may extend to twenty-five crores. Now, on other hand Section 24⁹ of the SEBI Act provides power for imposing the punishment of imprisonment in case anyone contravenes the provision of the SEBI Act or Regulations made under it. It would thereby also extend to the contraventions under the PFUTP Regulations.

Section 24 of the SEBI Act enables it to initiate criminal proceedings in cases of contravention, attempt to contravention or abetting the contravention of any provision of the Act or any rule made under the scope of the Act. Unlike specific offences and their penalties mentioned under Chapter VI-A, Section 24 can be invoked by SEBI as it deems fit. It is essential to note that these criminal proceedings can be initiated in a court of law, even when a penalty has been imposed by SEBI, as those penalties are only civil in nature. Hence, there can be parallel civil and criminal proceedings in the same matter and the courts have time and again confirmed the same¹⁰. However, there has been a general caution on invocation of the said provision as limited and dependent on the gravity of the facts of the cases as is demonstrated and properly analysed in the next segment of this post.

Analysis

As has been discussed, SEBI has a wide range of power to initiate a variety of proceedings and thereafter pass directions as required. It can initiate board proceedings under Sections 11¹¹, 11-B¹², 11-D¹³; enquiry proceedings under Chapter V; adjudication proceedings under Chapter VI-A; and criminal proceedings under Section 24 of the SEBI Act. It can also, if required, go ahead with settlement proceedings under the Securities and Exchange Board of India (Settlement Proceedings) Regulations, 2018¹⁴ and recovery proceedings under Section 28-A¹⁵.

On civil side, SEBI can initiate board proceedings and pass relevant directions under Section 11-B. These directions involve restraining the defaulter from accessing security market, securing the management of defaulting entity, disgorgement of profits made, etc. Disgorgement of fund means to take back the gains which were wrongfully/illegally procured by the defaulter. Moreover, the Board may find the directions under Section 11-B to be insufficient and therefore, can also initiate adjudication proceedings under Chapter VI-A of the SEBI Act and pass appropriate penalties provided under Section 15-HA. Chapter VI-A of the SEBI Act contains penalty provisions for specific scenarios, amongst which, Section 15-HA provides penalty for the violation of the PFUTP Regulations and thereby covers the cases of front running within its ambit.

However, when it comes to criminal proceedings there are no specific provisions; and instead, there is only one general and widely worded provision in “miscellaneous” chapter of the SEBI Act. Section 24(1) provides that, the Board can initiate the criminal proceedings on “any person” who contravenes the provisions of the SEBI Act or Rules and Regulation made under it. This definition is broad enough to cover every offence committed in violation of the SEBI Act or any regulation associated with it; however, under this provision, the burden of proof is very high as compared to what is required in proceedings under Sections 11 and 15¹⁶. Like any other criminal offence, “mens rea” will have to be established here which puts a high burden of proof to establish the charges.

Further, the definition of Section 24(1) is in line with the latest amended PFUTP Regulations, in the sense that it uses the term “any person”. It not only covers the intermediaries, but anyone, including an individual or an entity, who engages in the practice of front running. The Supreme Court in Prakash Gupta v. SEBI¹⁷, interpreted the legislative scheme of the SEBI Act and thereafter made it sufficiently clear that Section 24(1) is an omnibus provision, and it has to be treated as the sentencing provision for “most banal of offences, to the most egregious of market disruptions and frauds”. This means that the provision can be invoked in any offence under the Act, irrespective of the nature and intensity of the offence. Therefore, it can safely be assumed that there is no inherent bar on invoking Section 24 i.e. criminal proceedings, in the front-running cases.

However, in practice, the applicability of such provision in practice narrates a different story. SEBI does not tend to invoke criminal proceedings in every other case. An analysis on Section 24 jurisprudence would say that the criminal proceedings are mostly invoked in the cases, where investors’ money is directly involved and defrauded¹⁸. Majority of these cases belong to the defrauding which happens in collective investment schemes (CIS)¹⁹. Here, large pool of money is collected under some specific schemes and thereafter investors’ money is defrauded, and they suffer direct tangible losses, which is attributed to direct dealing with investors’ money.

Coming back to the front-running cases, there have been a considerable number of such cases in the past, which includes some famous ones such as Fidelity Group, Nilesh Kapadia in HDFC Asset Management Companies (AMC), Deutsche Mutual Fund, among others. There has not been a single case of front running, where Section 24 has been invoked till now. Generally, there are three directions²⁰ which are issued in almost all of these front-running cases. First, is direction to disgorge the amount which is equivalent to the wrongly/illegal gains made; second is the direction to refrain the defaulters from accessing the securities market for an appropriate specified period; and third is to pass penalties under Section 15-HA.

Although SEBI has the power to invoke criminal proceedings in the front-running cases, it would be unprecedented if it goes with such an option in the present Axis Mutual Fund Scam. The matter is still in the investigation stage. SEBI is conducting its investigation, as provided under Section 11-C²¹ of the SEBI Act. The invocation of criminal proceedings depends a lot on how the situation unfolds in the future. SEBI might go ahead with Section 24, if it thinks that the matter is grave enough and a criminal proceeding is required to protect the investors’ interest.

Conclusion

Section 11 along with the Preamble of the SEBI Act provides very wide powers to SEBI when it comes to protecting investors’ interest. It has the power to initiate different kinds of proceedings. However, caution must be exercised when invoking criminal proceedings, because under civil proceedings, other than disgorging the fund, hefty penalties have been already charged. It must also be kept in mind that in cases of front running, while there are specific provisions for imposing civil penalties under Section 15-HA, there is no such provision in criminal proceedings under Section 24 of the SEBI Act. Moreover, being a common law jurisprudence, it is difficult to rationalise the first instance for invocation, especially when similar instances have happened in the past.