Last month, SEBI issued a consultation paper seeking to regulate unexplained suspicious trading activity as the use of untraceable or encrypted communication media and innovative ways of carrying out trades is posing a difficulty for the regulator to gather evidence and punish offenders. Under this new proposed framework, if a person or a group exhibits unusual trading patterns (UTP)—repetitive abnormal gainful dealings in securities involving substantial change in risk taken, around the presence of Material Non-Public Information (MNPI)—it will be considered to be Suspicious Trading Activity (STA) and thus a deemed violation of securities laws. If such person/s do not offer effective rebuttals, it will be called Unexplained STA and an order may be passed. MNPI has been defined as information that is not generally available but which upon being so has reasonable impact on price of securities of a company (similar to the definition of UPSI in insider trading laws), any information about an impending order which would reasonably impact the price of a security when executed, or any information about impending recommendation in a security by an influencer. For example, if a trader repeatedly executes large orders and gains from such trades (UTP) right before the publication of quarterly results by a company (MNPI), then it will be a deemed violation (STA). If effective rebuttals are not offered to the satisfaction of SEBI (USTA), then an order can be passed.

For SEBI to pass orders against an entity, there should be circumstantial evidence and preponderance of probability. Unlike establishing proof beyond reasonable doubt, preponderance of probability requires a fact to be sufficiently probable on weighing varied probabilities. SEBI has been finding it difficult to gather enough evidence to tilt the balance of probabilities in its favour. The use of novel encrypted ways to transmit inside information and execute trades means that attempts to gather evidence through traditional methods like call data records are coming up short. This gave birth to the proposed regulation, entirely dismissing the requirement to gather evidence and prove the existence of any breach in the first place. Now, SEBI only has to prove the existence of some MNPI and existence of the trade around that period. There is no requirement to connect the trader to the knowledge of or access to MNPI, as is the procedure with insider trading cases.

While the necessity of a proposal to amend the current framework to ensure conviction cannot be overstressed, the current approach is fraught with concerns. Shifting the burden of proof and presuming guilt on mere suspicion might be antithetical to the principles of fairness and justice. SEBI uses the Supreme Court's observations in various cases to note that the concept of 'unfair trade practice' can be construed widely and as a regulator, SEBI is entrusted to create a level playing field. However, spreading the net wide to catch some offenders is bound to inconvenience everyone. Genuine traders might get unfairly caught in the deluge of 'show cause' notices. While many genuine traders may be able to rebut the presumption, it may lead to avoidable loss of time and increase in litigation costs. Further, given the subjective nature of rebuttals, some genuine traders may have orders passed against them leading to a loss of reputation. For example, a genuine trader will rethink before taking any positions before publication of quarterly results of a company, as repetitive positive trades might deliver a show cause notice along with profits. An algo trader might be wary to execute trades, worried there might be some MNPI that they were never aware of. The mere fact that additional risk is taken to get high rewards should not lead to an automatic presumption that the person is guilty. It might be helpful to make some changes to the proposal to ensure such genuine traders are not affected.

Further, the current proposal has some undefined terms which may bring in inconsistency and subjectiveness into the adjudication process. SEBI has not defined 'repetitive' trades, 'short period of time', and 'abnormal gain' while defining UTP, and change in level of risk is subjective. This would allow for a high degree of adjudicator discretion, which might lead to confusing orders and lead to protracted litigation. It is recommended that SEBI defines these terms or provides certain illustrations within the framework.

This deemed presumption of guilt is a rebuttable presumption. A quick glance through some of the rebuttals provided in the consultation paper makes one realise the uphill task it is for an alleged offender. One of the rebuttals is that the information on which the trades are allegedly based on is not material or such information was already in the public domain, and thus the information is not MNPI. In the proposed framework, SEBI informs the alleged offender what it considers to be MNPI, but there would be no analysis on whether the said offender had any reasonable basis to know that information or connect them with the same. It might be difficult for an alleged offender to objectively state that some information is not material, especially when SEBI would have analysed the same prior to issuing the show cause notice. Even in cases of insider trading, whether something is UPSI or not is a foregone conclusion in most of the cases. The defence mostly rests on whether they had access to such information or not. Another rebuttal is that the trading pattern is not repetitive. By keeping certain components of a presumptive deeming provision subjective, SEBI is casting an extremely tight net which might entangle genuine traders. Further, an alleged offender is required to submit detailed documentary evidence to substantiate any claim. In some instances, a change in trading pattern can be simple decision to undertake additional risk anticipating greater rewards. Maintaining records to substantiate each decision is not only onerous, but sometimes not possible. Thresholds of suspicion should be kept so high as to avoid Type I errors of logic, to prevent convicting an innocent person.

In light of the kind of violations and the difficulty SEBI is facing in procuring evidence, such presumption of guilt may be required. However, care has to be taken to ensure that genuine market participants are not unfairly affected by this new framework. A balanced approach is the way forward.

[Note: This article originally appeared on Economic Times, and can be accessed here.]

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