Written by Zenobia Sood, The author is a law student pursuing BBA.LLB from Jindal Global Law School.
Introduction
The Securities and exchange board of India is the securities market regulator and is tasked with ensuring a fair playing field and taking requisite enforcement measures against market actors that deviate from the authorized conduct. There is a growing threat to the stability of the securities market from fraudulent and manipulative practices, such as insider trading, front running, and market manipulation. These fraudulent and manipulative activities have the effect of severely undermining the integrity of the market and harming the interests of the majority of investors. The Securities and Exchange Board of India (hereinafter known as “SEBI”) as per the SEBI Act, 1992, is tasked with preventing undesirable transactions in securities, enforcing securities laws and protecting investor interests.
However, with the advancement of technology, perpetrators are adopting modus operandi to conceal their illicit activities of securities manipulation, making it difficult for conventional means of enforcement redundant. Furthermore, funding arrangements involving disappearing messages in encrypted communication and mule accounts have made evidence collection to establish violations of the law neigh impossible. Against this backdrop, the SEBI introduced the draft SEBI (Prohibition of unexplained suspicious trading activities in the securities market) Regulations, 2023 inviting public comments.
This blog aims to explain and analyze the increasing threat of mule accounts used for illicit market manipulation. Further, it explores robust self-regulation of gatekeepers to fortify the SEBI regulation for tackling suspicious trading activities.
What is pump and dump scheme and front running?
A pump-and-dump scheme is a type of securities fraud that typically involves artificially inflating the price of a stock (pumping) through false or misleading statements, exaggerated claims, or promotional activities. The unsuspected investor relying on false and misleading information regarding the rise of the stocks buys the stocks. Once the share price levels after being artificially pumped up reach the desirable amount of buyers, the perpetrators dump or sell off their own shares at inflated prices. This activity of pumping and dumping of stacks leads to the collapse of stock prices leading to significant losses to the gullible and vulnerable investors who have been misled into buying stocks. Pump and dump schemes are orchestrated by groups of individuals or organizations who work together for the furtherance of the common intention of manipulating the market and making a profit at the expense of retail investors. Under the SEBI regulation, the practice of Pump and Dump is illegal and subject to severe penalties.
Similar to other types of market manipulation, front running is when a broker or trader uses their knowledge of clients' pending orders to place trades ahead of those orders and profit from the foresight.
This is how it usually goes:
Consider a scenario in which a sizable institutional investor, such as a mutual fund or pension fund, intends to execute a sizeable buy or sell order for a specific stock. The institutional investor will give their broker instructions to execute this transaction on their behalf. If a dishonest broker or trader has access to this order data, they may use it to make decisions before carrying out the client's order. They would purchase the stock before the customer placed a sizable buy order, believing that the client's order would stimulate demand and raise the company's price. The front-runner would then sell the stock at a profit once the price had increased. Front running is prohibited because it disadvantages the client and compromises the fairness and integrity of the financial markets by taking advantage of confidential information that is not available to the general public.
Mule Account: A Threat To Financial Markets
Mule accounts are typically available in the form of accounts belonging to family members and friends, dormant accounts, accounts that are being rented out, accounts that are being used for the benefit of/under the direction of others, etc. These accounts are used by entities as fronts, allowing them to remain anonymous while reaping the rewards of such trading activity. Mule account holders" are employed directly or indirectly by the people behind the front running operation in order to cover up their trails.
Masterminds of front running place buy or sell orders from the trading accounts of the mules as soon as they become aware of the upcoming orders in an effort to get ahead of the large clients' orders. The mule accounts assist the masterminds in hiding the audit trails and putting a layer between them and the front-run trades. It is imperative to note that, with technological advancements in disappearing end to end encrypted messages and option of message deletion have made regulatory mechanism of SEBI obsolete. Using the new technology, mule accounts are increasingly being used in front running and pump and dump schemes for making illicit profits this has poses a significant risk to the unsuspecting investors. This threat casts a responsibility on SEBI to weed out mule accounts in interest of investor protection.
Analyzing SEBI (Prohibition of unexplained suspicious trading activities in the securities market) Regulations, 2023
The main objective of these regulations is to prevent and prohibit Unexplained Suspicious Trading Activity (USTA) in the securities market. The draft regulations lay down the formula that unusual trading activity coupled with existence of material non-public information gives impression to suspicious trading activity. The draft regulations lays down guidance for rebuttal such as the information not meeting the test of MNPI, trading pattern is not repetitive and trading pattern does not give impression that there has been material change in the risk undertaken. As per the draft regulations Unexplained Suspicious Trading Activity is defined as suspicious trading activity by a person or a group of connected persons in a security or a group of securities executed in circumstances for which no reasonable rebuttal or explanation is provided.
Under the draft regulations section 4 there is a reporting requirement placed on stock exchanges and intermediaries to immediately notify SEBI of any Suspicious Trading Activity that is discovered or brought to their attention while conducting business. If there are good reasons to believe that someone or a group of linked people is using USTA, SEBI has the right to order investigations under section 5 of the draft regulations. The accused may refute the allegations by offering proof that neither the trades nor the trading pattern were irregular or based on material non-public information (MNPI).
The shortcoming of the draft regulation are elucidated below:
Subjective Characteristics of USTA: Determining what counts as "no reasonable rebuttal or explanation" may prove difficult due to the concept of Unexplained Suspicious Trading Activity's apparent subjectivity. It might be challenging for accused people or groups to argue their case against such arbitrary standards.
Limited Rebuttal Guidance: While the regulations list probable instances in which the accused could refute the allegations, the standards offered seem general and might not cover all possible situations. This vague instruction could result in erroneous interpretation and application.
Burden of proof: The burden of proof falls on the accused when they are required to present extensive documentary evidence to back up their assertions. This could be tough, especially if the data is intricate or hard to compile.
Subjective definition of Influencers: The regulations emphasize "Influencers"—those with the power to affect how investors behave. The criteria for identifying them and assessing their impact, however, can be susceptible to interpretation, which could result in unfair targeting or unforeseen outcomes.
Regulatory Overreach: Vast powers have been given to SEBI under the draft regulations to order investigations and take actions however, there is lack of clarity as to the extent of obligations of the intermediaries and stock exchanges. Further, there is a lack of clarity as to the extent of liability or the lack of it thereof in the case the stock exchange or the intermediaries fail to notify SEBI of the suspicious trading activity. The lack of clarity creates potential of regulatory overreach and issue of authority.
Role of brokers as Gatekeepers
Professionals like auditors, attorneys, brokers, and real estate agents are sometimes referred to as "enablers" or "facilitators" of illegal activity, the majority of their involvement is inadvertent. They might participate in activities that, on the surface, appear to be acceptable but they are covering up illegal business practices. Gatekeepers have dual potential as they can either promote or impede illicit financial flow. With the increasing role of gatekeepers, the potential of intermediaries to prevent illicit activities was recognized by enforcement agencies. The gatekeeper regulation was enacted to strategically position professionals to disrupt illegal activities by exercising due diligence whilst providing services, the gatekeeper regulation cast not only a moral obligation on professionals but a legal liability in case of failure to prevent illicit financial flow. Stockbrokers can act as gatekeepers in this scenario to prevent illicit financial flow. Stockbrokers play an important role by bringing together buyers and sellers and facilitating transactions.
Working closely with clients having sophisticated financial structures and high-value assets, they have the chance to spot suspicious trading activity. It is envisioned in the draft SEBI (Prohibition of unexplained suspicious trading activities in the securities market) Regulations, 2023, that stockbrokers should act as gatekeepers and help prevent securities fraud by weeding out mule accounts. Under section 4 of the SEBI (PUSTA) 2023 an obligation is cast on all intermediaries registered with the board to report suspicious trading activities. This has cemented the role of stockbrokers as gatekeepers in prevention of securities fraud
Stockbrokers can act as effective gatekeepers by: Conduct extensive due diligence: stock brokers should put in place reliable procedures to check the legitimacy of their clients’ identities and learn where their money comes from. This makes it easier to spot suspicious trading activity.
Reporting suspicious activity: stock brokers should immediately notify SEBI if they come across transactions or clients that cause them to suspect their involvement in unexplained suspicious trading activities.
Collaboration with authorities: stock brokers can work closely with law enforcement and SEBI to share information available to them due to their unique position as gatekeepers and assist in investigations related to potential illicit activities.
Self-regulation as the way forward
The importance of stockbrokers as gatekeepers cannot be understated however, as seen above the regulatory mechanism in itself is unable to tackle the problem of mule accounts being used for front running and pump and dump schemes. In World economic forum “Unifying framework” was developed in collaboration with industry leaders. The Unifying framework proposed was a value based self-regulatory approach designed to address the risks associated with gatekeepers in facilitating illicit activities. It also to promote a higher standard of ethical conduct above mere legal compliance. The framework encompasses three core principles of integrity, transparency and accountability, further it lays down five essential practices: establishing clear policies, promoting effective due diligence, fostering a culture of integrity through training and incentives, encouraging a "speak-up" culture, and facilitating collaboration across industries and sectors.
By encouraging adoption of the unifying framework and embracing self-regulation, enhance market integrity, and capitalize on the efficiency of honest markets. The framework does not propose to replace the binding regulations, it runs parallel to the regulations complementing and fortifying them. The draft SEBI(PUSTA) regulations have proven to be problematic and does not withstand scrutiny. With the present Lacunae in the law regarding stockbroker gatekeeper regulations, the adoption of self-regulation can effectively fill the vacuum till viable regulations are enacted to successfully curb illicit transactions in financial market.
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