Front-Running: SEBI's Measures To Safeguard Market Integrity

Front running involves individual(s) or entity(ies) executing buy or sell orders, on the floor of the stock exchange, based on prior knowledge of an upcoming large trade, where that upcoming trade (usually by institutions including mutual funds) is likely to influence the security's price. The intention of a front runner, in both cases unscrupulously and unethically, is to buy the security at a lower price and sell it to the institution at a higher price or sell the security at a higher price with the knowledge that the institution will subsequently sell and drive the price of the security below the front runner's sale price. The prior knowledge of a large trade gives an advantageous position to a front runner, and a front runner unduly benefits at the expense of other investors who are unaware of the upcoming trade. This has been a regulatory consideration for The Securities and Exchange Board of India (SEBI) for several years now.

On August 1, 2024¹, SEBI notified the Second Amendment (Amendment) to the SEBI (Mutual Funds) Regulations, 1996, which defined the expression "market abuse" and stipulated the introduction of institutional mechanisms in Asset Management Companies (AMCs) to prevent market abuse.

On August 5, 2024, SEBI issued a follow-on circular² outlining principles basis which the institutional mechanism is required to be set up. The Association of Mutual Funds in India (AMFI) was directed to formulate a standard operating procedure (SOP), which SOP was published by AMFI on or about August 28, 2024.

This article analyses SEBI's efforts to curb market abuse, including front running, and focuses on judicial and regulatory precedents, consultation papers and regulatory amendments.

1. Judicial Precedents: Background to the Amendment

A few notable orders which furthered the need to evaluate and implement institutional mechanisms are briefly discussed below:

2. Notable steps taken by SEBI to curb front running and other forms of misconduct

1. Report of Committee on Fair Market Conduct under the Chairmanship of Dr. T.K. Viswanathan, August 8, 2018⁹ - The SEBI Committee on Fair Market Conduct established in 2017 sought to address amendments to curb market abuses, including front running. The committee recommended that front running by non-intermediaries should be covered under the scope of Regulation 3 and 4(1) of the PFUTP Regulations. It advocated for SEBI to have the power to intercept telephone calls and electronic communications to curb front running. It also recommended that intermediaries adopt preventive mechanisms similar to those of listed companies including periodic process reviews of internal controls and disclosure requirements to prevent such instances of misconduct. The Committee relied on the judgement of the Supreme Court of India in the case of SEBI v. Kanaiyalal¹⁰ , wherein it was held that the definition of "fraud" should be extended to include actions or omissions that induce others to trade in securities, even without deceit, expanding the scope of front running from an intermediary to any person who may be connected in the trade.

2. SEBI (Mutual Funds) (Second Amendment) Regulations, 2020 – This amendment was a substantial step taken by SEBI to curb market abuse practices via implementation of a framework for fund managers and dealers. Via this amendment, SEBI inserted Regulation 6B(b), Regulation 6(C) and Part B, for fund managers and dealers under the Fifth Schedule which subjected them to a general code of conduct, specified communication channels, nature and quantum of disclosures and specific execution standards.

3. SEBI (Prohibition of Insider Trading) (Amendment) Regulations, 2022 – The second amendment to SEBI PIT regulations included mutual funds within its scope. SEBI not only amended the definition of securities (to include mutual funds) but inserted Chapter – II A – Restrictions on Communication in relation to and trading by insiders in the units of mutual funds. This ensured stricter rules against insider trading for individuals and entities involved in management or operations of mutual funds.

4. Consultation Paper issued by SEBI on May 20, 2023¹¹ – The consultation paper issued by SEBI sought to address gaps in the existing regulatory framework and noted that existing provisions did not cast responsibility on AMCs or their senior management to put in place systems for deterrence, detection or reporting of market abuse or fraudulent transactions. The paper sought public comments on several in-principle monitoring mechanisms including strengthening of surveillance systems for detecting suspicious trading patterns, enhancing disclosure requirements and periodic review of such disclosures for trading entities and increasing accountability (including stricter penalties) for confirmed cases of front running.

5. The Board Meetings of SEBI dated April 30, 2024 and June 27, 2024 – The April Board meeting, with the intent of taking forward the in principle matters discussed in the consultation paper of May 2023, of SEBI focused on relaxing the recording requirements compliances for face to face and out of office communication and the setting up of a structural mechanism for the purposes of identification identifying and deterrence deterring of market abuse.

6. The August 2024 Amendment and August 5 circular– Taking into consideration the opinion of the industry specialists and other experts, the following amendments were introduced to SEBI's Mutual Funds Regulations, 1996:

   Regulation 2(nb) The definition of market abuse	"market abuse" includes manipulative, fraudulent and unfair trade practices which may contravene Section 12A of the Act or any of the provisions of the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 or the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015
   Sub-regulations 27, 28 and 29 Setting up of an Institutional mechanism and whistle blower policy	27 - The asset management company shall put in place an institutional mechanism, as may be specified by the Board, for the identification and deterrence of potential market abuse including front-running and fraudulent transactions in securities.
   	28 - The Chief Executive Officer or Managing Director or such other person of equivalent or analogous rank and Chief Compliance Officer of the asset management company shall be responsible and accountable for implementation of such an institutional mechanism for deterrence of potential market abuse, including front-running and fraudulent transactions in securities.
   	29 - The asset management company shall establish, implement and maintain a documented whistle blower policy that shall — (a) provide for a confidential channel for employees, directors, trustees, and other stakeholders to raise concerns about suspected fraudulent, unfair or unethical practices, violations of regulatory or legal requirements or governance vulnerability, and (b) establish procedures to ensure adequate protection of the whistle blowers.
   Insertion of a proviso to clause 2(b) in Part B of the Fifth Schedule Removing the compliance burden of recording face to face interactions	Provided that face-to-face communication including out-of-office interactions may not be recorded.

   In terms of the explanatory circular issued on August 5, 2024, the onus of enforcing any mechanism was on the Chief Executive Officer, Managing Director, officers of analogous ranks of the concerned entity and emphasises on an alert-based mechanism with a set procedure to generate, process and address alerts in a timely manner. The circular also specified that a whistle blower policy has to be made in compliance with Regulation 25(29) of the SEBI Mutual Fund Regulations, 1996.While all AMCs are expected to formulate written Standard Operating Procedures (SOP) for setting up the mechanism, AMFI in consultation with SEBI has issued an implementation standard to ensure a smooth set up of the institutional mechanism.
7. SOP issued by AMFI – The SOP issued by AMFI prescribes a phased manner regarding timelines in which the applicability of the Amendment shall take place for different AMCs.

The key highlights of the institutional mechanism required to be set up in compliance with the SOP have been summarized below:

• Alert Generation and processing of such alerts: AMCs are expected to make a level based alert generation system, wherein each suspicious alert is reviewed, examined and processed. The levels of such alerts would be as follows,
  1. Level 1 – Generating alerts basis the prescribed alert matrix and parameters set up by the Board. Certain alert matrix and parameters have been prescribed in the SOP, which have been linked to:
     1. Deviation from Participation Volume; and
     2. Deviation from Volume Weighted Average Price
     and which apply differently to large cap, mid cap and small cap sized funds.
  2. Level 2 – Identifying suspicious alerts from those filtered out after applying the Level 1 check that cross the thresholds prescribed under level 1. This involves identification shall be a two-step process. wherein, The first check is to would be to check the movement in price over a pre-determined time frame and exceeding identified ranges, based on whether the transaction was undertaken as a block deal or a bulk deal. and The second check is to determined whether the actual volume preceding the AMCs order exceeded the average volume by a pre-determined percentage. In the event would be basis the volume traded. If a trade qualifies both these checks, it would be categorised as a suspicious alert.
  3. Level 3 – Examination of suspicious alerts.
     
     In instances where the alert is flagged as suspicious after applying Level 1 and Level 2 filters, the authorized personnel are required to review available information, including recorded communications, chats and emails of specified employees, access logs of dealing room, entry logs of AMC premises and CCTV footages (if available) linked or suspected to be linked with the suspicious alerts and take immediate steps including informing SEBI, immediate restrictions on the concerned employees, specific actions against brokers (if involved) etc. AMCs are required to generate the alerts at least on a weekly basis and inform its Board of Directors and Trustees of such alerts and results of the examination conducted.
• Entry Logs: AMCs are expected to maintain entry logs for the investment team and other departments that are closely working with the investment team. It is also mandated that all dealing rooms of AMCs shall have biometric access in order to record all relevant information of access.
• Review of Personal Transactions of Specified Employees and their immediate relatives
• Mandatory leave and relieving of specified employees: Fund managers and dealers shall be subject to mandatory leave of at least 10 business days in a financial / calendar year (as determined by the AMCs), with not less than 5 business days leave at a stretch in each instance. Further, the head of human resources shall take all measures to ensure that all confidential information is adequately returned, and relevant undertaking have been signed by the exiting employee.
• The SOP also requires updation of all contract agreements for relevant employees of AMCs, which shall include compliance with all regulations. Further, the SOP prescribes setting up a whistle blower mechanism, escalation process, sharing of resources/information/infrastructure related to setting up the mechanism and annual compliance review by the audit committee or risk management committee.

SEBI's ongoing efforts demonstrate commitment to implementation of a robust regulatory framework to uphold market integrity and investor confidence. While the amendments may increase the regulatory burden on AMCs, they cater to a more important, urgent and unfortunately, recurring, issue of front running and other market abuses and are essential in maintaining trust and stability in the financial markets.

Footnotes

1 The official gazette notification of the SEBI (Mutual Funds) (Second Amendment) Regulations, 2024 can be accessed at https://www.sebi.gov.in/legal/regulations/aug-2024/securities-and-exchange-board-of-india-mutual-funds-second-amendment-regulations-2024_85459.html

2 The official SEBI circular can be accessed at https://www.sebi.gov.in/legal/circulars/aug-2024/institutional-mechanism-by-asset-management-companies-for-identification-and-deterrence-of-potential-market-abuse-including-front-running-and-fraudulent-transactions-in-securities_85468.html

3 TM/SM/IVD/ID15/23243/2022-23, https://www.sebi.gov.in/enforcement/orders/jan-2023/final-order-in-the-matter-of-front-running-trading-activity-of-dealers-of-reliance-securities-ltd-and-other-connected-entities_67621.html

4 WTM/GM/EFD/56–58/2020–21, https://www.sebi.gov.in/enforcement/orders/dec-2020/final-order-in-the-matter-of-front-running-by-manish-chaturvedi-and-others-_48484.html#

5 TM/AB/IVD/ID3/16889/2022-23, https://www.sebi.gov.in/enforcement/orders/jun-2022/final-order-in-the-matter-of-front-running-various-funds-of-fidelity-group_59536.html

6 WTM/SM/ISD/ISD-SEC-3/24180/2022-23, https://www.sebi.gov.in/enforcement/orders/feb-2023/interim-order-cum-show-cause-notice-in-the-matter-of-front-running-of-the-trades-of-axis-mutual-fund_68546.html https://www.sebi.gov.in/enforcement/orders/feb-2023/interim-order-cum-show-cause-notice-in-the-matter-of-front-running-of-the-trades-of-axis-mutual-fund_68546.html

7 WTM/AN/ISD/ISD-SEC-2/25934/2023-24, https://www.sebi.gov.in/enforcement/orders/apr-2023/interim-order-in-the-matter-of-suspected-entities-front-running-the-trades-of-life-insurance-corporation-of-india_70658.html

8 WTM/AN/ISD/ISD-SEC-2/30088/2023-24, https://www.sebi.gov.in/enforcement/orders/mar-2024/confirmatory-order-in-the-matter-of-suspected-entities-front-running-the-trades-of-life-insurance-corporation-of-india_82404.html

9 The report of the Committee on Fair Market Conduct can be accessed at https://www.sebi.gov.in/reports/reports/aug-2018/report-of-committee-on-fair-market-conduct-for-public-comments_39884.html

10 SEBI v. Shri Kanaiyalal Baldevbhai Patel (2017) 15 SCC 1

11 The consultation paper issued by SEBI can be accessed at https://www.sebi.gov.in/reports-and-statistics/reports/may-2023/consultation-paper-on-institutional-mechanism-for-asset-management-companies-for-deterrence-of-possible-market-abuse-and-fraudulent-transactions_71440.html

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.