BUSINESS ETHICS AND

CORPORATE GOVERNANCE

FRONT RUNNING


















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INDEX

Particulars

Page no.

About Corporate Governance

3

Definition of Front Running

5

Front Running in India

8

Articles

9

Front-Running in India Challenges Regulators

13

Solutions to the problem of Front Running

16

Bibliography

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Corporate Governance
Corporate governance refers to the set of system, principles and processes by which a
company is governed. They provide the guidelines as to how the company can be directed or
controlled such that it can fulfil its goals and objectives in a manner that adds to the value of
the company and is also beneficial for all stakeholders in the long term. Stakeholders in this
case would include everyone ranging from the board of directors, management, shareholders
to customers, employees and society. The management of the company hence assumes the
role of a trustee for all the others.
Principles of Corporate Governance

1. Rights and equitable treatment of shareholders: organizations should respect the rights
of shareholders and help them to exercise their rights by openly and effectively
communicating information and by encouraging shareholders to participate in general
meetings.

2. Interest of other stakeholders: organizations should recognize that they have legal
contractual, social, and market driven obligations to non-shareholder stakeholders, including
employees, investors, creditors, suppliers, local communities, customers and policy makers.

3. Role and responsibilities of the board: the board needs sufficient relevant skills and
understanding to review and challenge management performance. It also needs adequate size
and appropriate levels of independence and commitment.

4. Integrity and ethical behaviour: integrity should be a fundamental requirement in
choosing corporate officers and board members. Organizations should develop a code of
conduct for their directors and executives that promote ethical and responsible decision
making.

5. Disclosure and transparency: organizations should clarify and make public know the
roles and responsibilities of the board and management to provide stakeholders with a level
of accountability. They should also implement procedures to independently verify and
safeguard the integrity of the companys financial reporting. Disclosure of material matters
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concerning the organization should be timely and balanced to ensure that all investors have
access to clear factual information.
Why is it important?
Fundamentally, there is a level of confidence that is associated with a company that is known
to have good corporate governance. The presence of an active group of independent directors
on the board contributes a great deal towards ensuring confidence in the market. Corporate
governance is known to be one of the criteria that foreign institutional investors are
increasingly depending on when deciding on which companies to invest in. It is also known
to have a positive influence on the share price of the company. Having a clean image on the
corporate governance front could also make it easier for companies to source capital at more
reasonable costs. Unfortunately, corporate governance often becomes the centre of discussion
only after the exposure of a large scam.













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Meaning of Front Running
Front running as a securities malpractice/ crime is recognised and regulated by SEBI
under the SEBI (Prohibition of Fraudulent and Unfair Trading Practices Relating to
Securities Market) Regulations, 2003.
Front Running has not been defined by SEBI in a uniform manner, however, the
concept has been elaborated upon vide various regulations, circulars and judgments of
SEBI.
One such example is the SEBI Circular on Consent Orders as amended by Circular
CIR/EFD/1/2012) dated 25th May 2012 (Consent Order Circular) which has
defined front running as under:
Front running for the purpose of this circular, means usage of non-public information
to directly or indirectly, buy or sell securities or enter into options or futures contracts,
in advance of a substantial order, on an impending transaction, in the same or related
securities or futures or options contracts, in anticipation that when the information
becomes public; the price of such securities or contracts may change.
Front-running is an investing tactic that anticipates the impact of upcoming trades on
the price of a security. It is the illegal practice of a stock broker executing orders on a
security for its own account while taking advantage of advance knowledge of pending
orders from its customers. When orders previously submitted by its customers will
predictably affect the price of the security, purchasing first for its own account gives
the broker an unfair advantage, since it can expect to close out its position at a profit
based on the new price level.
The front running broker either buys for his own account (before filling customer buy
orders that drive up the price), or sells (where the broker sells for its own account,
before filling customer sell orders that drive down the price). The most common
example of front-running is when an individual trader buys shares of a stock just
before a large institutional order for the stock which will cause a rapid increase in the
stock's price.

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This information can be obtained legally through monitoring the bids and asks on the
market and the investing transactions of institutional investors. It can also be obtained
illegally, such as when the research analysts of an investment bank pass insider
information to the brokerage arm of the business, or when a money manager takes a
position in a stock before convincing a client to make a large investment in that same
security.

Example for Front Running is when a stock broker finds out a report will be released
which will, in the future, drive up the price of a share. The broker purchases the share,
waits for the report to be released, and then sells his personal shares to his clients at an
inflated rate. Also analysts and brokers who buy up shares in a company just before
the broking house is about to recommended the stock as a strong buy are practicing
front running. It is illegal for brokers or asset managers to practice front-running using
trading information about their own or another broker's clients, and this is punished
by the Securities and Exchange Commission

Front running could happen in all types of stocks, be it large-cap, mid-cap or even
small-cap. However, mid-cap and small cap (companies with relatively low market
capitalization) stocks are more susceptible to front running due to their lower float
and liquidity. Also if there is a large order, a small-cap or a mid-cap stock could
fluctuate far more than a large-cap stock. Hence, the extent of profit a trader could
make by front running in case of mid-cap or a small-cap stock could be far higher
than with a large-cap stock.

Front running is tempting for those with access to inside information. In most cases,
the practice is highly unethical and may be illegal due to the obvious information
advantage of industry insiders compared to equally capable investors outside the firm.



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Punishment for Front Running
Section 51 (2) of the Securities and Exchange Commission Act of no 36 of 1987 (as
amended) states that a person who is found guilty shall be liable on conviction after summary
trial by a Magistrate to of imprisonment of either description for a period not exceeding five
years or to a fine not less than Rs 50,000 and not exceeding Rs 10 Million or to both such
imprisonment and fine.
























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Front Running in India
HDFC Mutual Fund recently came under the Security and Exchange Board of Indias (SEBI)
scanner for front running. The dealer was banned from trading. Front running involves a
trader in a securities firm acting on prior information that is almost equivalent to insider
trading. Can this activity be curbed?
It spooks the investor
The biggest pension funds who want to invest into Indian markets worry about front running.
Their prime concern is processes and how Indian AMCs (asset management companies) are
keeping themselves clean. This is getting to be a reputation problem and it looks like this
problem cannot be stopped, at least for now.
Control
That totally depends on the processes. Front running is like day trading. So if the processes
are strong and the dealer is tracked at all levels from the time he gets the information to the
time he executes the trade, it will be easy to catch him if he is front running. Example: If he
knows a fund is going to buy one lakh shares of stock A, he will put his order minutes before
the funds order goes through. If the dealer were to be made incommunicado then there is
no way he can relay this information. SEBI has put up an investigative report on how the
front running exactly took place inside HDFC MF on its Web site.
Anticipate Human Behaviour
Most funds say that the systems and processes are proper but one individual can beat these
systems by being unethical. The argument is unacceptable. If systems are proper that means
front running should not be possible. There will always be some individuals who will try to
beat the system. Processes have to be continuously upgraded to catch these people.
What the Law Says
Front running is not insider trading but comes close to it. It comes under the charge of
prohibition and protection of fraudulent and unfair trade, SEBI Regulation 2003 (prohibition
and prevention of fraudulent and unfair trade relating to securities market). Penalty for the
crime will mean a ban from dealing in the market and a monetary penalty of Rs. 25 crore or
three times the trade committed by the investor.
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Articles
1. SEBI to bring front-running under fraudulent and unfair trade practices
regulations
MUMBAI: In a major move to curb illegal activities, securities market regulator. Sebi is
bringing front-running by individuals under the ambit of fraudulent and unfair trade practices
(FUTP) regulations, reviving an old rule it had abandoned a decade ago. The regulator is also
bringing Collective Investment Scheme (CIS) activities under the FUTP umbrella after
investors cried foul over losing money to ponzi schemes.
Front-running is an unethical activity whereby a person uses confidential information to buy
or sell shares in a company ahead of a large order so as to benefit from the subsequent price
movement. SEBIs nine-member board, which is meeting on August 12, is likely to discuss
front-running norms, among other things, said a source. SEBIs current FUTP regulations
only cover intermediaries, leaving out individuals. But a first legal case involving individual
in front-running, which SEBI has been fighting in recent months, has made the regulator sit
up and take a review of its norms.
"If there is a lacuna in the regulations then it needs to be plugged to enhance the reach of the
regulator to proceed against any person," said RS Loona, managing partner of Alliance
Corporate Lawyers and a former executive director of SEBI.
SEBI has been forced to review its FUTP regulations after the Securities Appellate Tribunal,
on November 9, 2012, set aside its order penalising three individuals for alleged front-
running activities. The tribunal had said that in the absence of any specific provision in the
regulations prohibiting front-running by a person other than an intermediary, the regulator
can't hold individuals guilty.
Interestingly, the FUTP regulations in 1995 barred front-running activity by 'any person',
covering both individuals and intermediaries. But the amended regulations of 2003 covered
only intermediaries, leaving out individuals. SEBI now intends to plug this loophole by
reviewing the norms.
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Soon after SAT overruled SEBIs orders on front-running late last year, its chief UK Sinha
had said that FUTP rules needs to be improved.
The FUTP norms will also treat fund-raising activity by those entities which doesn't register
as collective investment schemes with SEBI as fraud, said the same person quoted above.
This will enable the regulator to impose monetary penalties on such entities. In recent
months, investors have been duped of thousands of crores by ponzi schemes, especially from
the eastern part of the country.
Besides the review of FUTP norms, the SEBI board is also likely to discuss the
implementation of the recent Securities Laws Ordinance which gives the regulator more
powers. The new law empowers SEBI to attach immoveable properties as well as bank
accounts of those violating securities laws. Besides, it also gives the stock market watchdog
powers to carry out search and seizure operations.
The board will discuss framing of rules for search and seizure activities, said the person
quoted earlier. SEBI will also have to set up new cells for attachment and recovery of dues,
similar to the lines of income tax department. "Search and seizure is a draconian power which
impinges on right to privacy. Therefore, till now, the SEBI Act, 1992 required exercise of this
power with the approval of judicial magistrate. Now that these powers would be exercised by
SEBI, strict rules are required to regulate the exercise of this power to prevent any possible
misuse," said MS Sahoo, a former member of SEBI.







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2. Tribunal quashes SEBI penalty order on 3 traders for front-running
Mumbai, Dec. 20 2012
The Securities Appellate Tribunal has set aside SEBIs order on front-running against three
entities, Sujit Karkera, Shilpa Kotak and Purushottam Karkera.
SEBI fined the three Rs. 60.73 lakh, Rs. 54.19 lakh and Rs. 4.66 lakh respectively.
SAT ruled that though the transactions were in the nature of front-running, the three entities
being traders could not be charged for front-running under Regulation 3&4 of Prohibition of
Fraudulent and Unfair Trade Practice Regulations (FUTP) as the regulation was meant for
intermediaries.
Follows early order
This, said SAT, followed its decision in the case of Dipak Patel dated November 9, where it
had ruled that only intermediaries could be charged for front-running and not individuals.
When a specific provision is available in respect of violation of the regulations, it is
necessary to apply the specific regulation. In the present case, the general provisions
contained in Regulation 3 of the FUTP Regulations cannot be applied to the facts of the case
since it is squarely covered by specific provision contained in regulation 4(2)(q) of the FUTP
Regulations. There is no specific provision in the Act, rules or regulations prohibiting front
running by a person other than an intermediary.
Expert views
Since the appellants are not intermediaries they cannot be held to have violated the
provisions of Regulations 3 and 4 by indulging in front-running, said SAT and set aside the
SEBI order. Experts said that front-running was a fraudulent and unfair trade practice.
And fraud had been given an inclusive definition under Regulation 4 of FUTP which
included all or any of the18 acts or omission that amounted to manipulation of the price of
the security.
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The SEBI FUTP Regulations in Regulations 2 and 3 define anti-fraud provisions very
widely. Without prejudice to such anti-fraud provisions, Regulation 4 further prohibits
fraudulent and unfair trade practice involving fraud and provide an inclusive list of such
prohibited practices. Being an inclusive list, the meaning has to be widely derived
particularly given the anti-fraud intent of the FUTP Regulations, said Tejesh Chitlangi of
Finsec Law Advisors.
SEBI had fined the three entities for front-running in the scrips of Aurobindo Pharma Ltd,
ICICI Bank Ltd and SBI based on information obtained from Suresh Menon a trader of
Citigroup Global Markets Mauritius Pvt. Ltd.













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Front-Running in India Challenges Regulators
In an interesting turn of events, the Securities and Exchange Board of India (SEBI) has
announced that it needs to review its regulations that deal with front-running.
The Securities Appellate Tribunal (SAT) recently set aside an SEBI order barring a portfolio
manager of a foreign institutional investor from trading in the market for abusive trading
strategies that violated SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to
Securities Markets) Regulations, 2003, or FUTP.
Dipak Patel was the portfolio manager of Passport India Investment (Mauritius) Limited, a
sub-account of Passport Capital, LLC, a foreign institutional investor registered with SEBI.
Passport Capital LLC is a San Francisco-based, federally registered investment adviser with
the U.S. Securities and Exchange Commission.
SEBIs investigation revealed that Dipak Patel had passed on advance information about
trading activities of Passport India in the securities market to his cousins from 2007 to 2009.
Dipak Patels cousins had executed several synchronized trades to match Passport Indias
dealings and benefitted from the price fluctuations caused by the large buy-sell orders of
Passport India. Based on detailed analysis of the trading activities and the banking
transactions between Dipak Patel and his cousins, SEBI barred Dipak Patel and his cousins
from trading, and also ordered the cousins to deposit the profits amounting to Rs 1,12,68,659
(approximately US$205,000) to the National Stock Exchange.
On appeal, SAT overruled the SEBI order and observed that the orders were placed at market
price; there was no clear evidence of manipulation of the market, and FUTP regulations on
front-running apply only to intermediaries. Hence the alleged fraud on the part of Dipak Patel
may be just one involving his employer, SAT stated, noting that the employer had terminated
Patels services after an internal investigation.
At CFA Institute, our members strictly follow the CFA Institute Code of Ethics and
Standards of Professional Conduct, and we believe that front-running transactions by anyone
based on knowledge of upcoming trading, as occurred in the Patel case, is unethical and
prohibited by the Code and Standards. High ethical standards are critical to maintaining the
publics trust in financial markets and in the investment profession.
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Globally, the International Organization of Securities Commissions (IOSCO) core objectives
of securities regulation is to ensure markets are fair, efficient, and transparent which is
closely linked to protecting investors from misleading, manipulative, or fraudulent practices,
including insider trading, front-running or trading ahead of customers, and misuse of client
assets.
How Is Front-Running defined by Regulators across Different Jurisdictions?
Interestingly, we found that different jurisdictions interpret front-running differently. For
example, the Hong Kong securities and Future Commission defines front running as the
unethical practice of a broker trading an equity based on information from a research analyst
before passing the information to his or her clients. Singapore Exchange (SGX), on the other
hand, states that a Member, Approved Trader or Registered Representative shall not trade in
contracts for its own accounts or for an account associated with or connected to that Member,
Approved Trader or Registered Representative, if that Member, Approved Trader or
Registered Representative also has in hand Customers orders (including discretion orders) to
do the same at the prevailing market price or at the same price.
The U.S. Securities and Exchange Commission recently approved a proposal from the
Financial Industry Regulatory Authority (FINRA) to expand the front- running policy to
apply to all securities and other financial instruments and contracts (in addition to the existing
options and security futures) that overlay the security that is the subject of an imminent block
transaction and that have a value that is materially related to, or otherwise acts as a substitute
for, the underlying security. Specifically, FINRA proposed to expand the front-running
policy to cover trading in an option, derivative, security-based swap, or other financial
instrument overlying a security that is the subject of an imminent block transaction.
According to FINRA, firms are permitted to trade ahead of a customers block order when
the purpose of such trading is to fulfill the customer order without potential for abusive
trading practices, and when the customer has authorized such trading, including that the firm
has disclosed to the customer that it may trade ahead of, or alongside of, the customers
order. This is technically known as warehousing.
The purpose of such detailed definitions by regulators in each of the above jurisdictions is to
ensure that regulations are designed to prevent fraudulent and manipulative acts and
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practices, to promote just and equitable principles of trade, to remove impediments to, and
perfect the mechanisms of, a free and open market, and to protect investors and the public
interest.
As stated in the CFA Institute Asset Manager Code of Professional Conduct, managers are
responsible to maximize client portfolio value by seeking best execution for all client
transactions and give priority to investments made on behalf of the client over those that
benefit the managers own interests.
Unfortunately, the FUTP regulations of SEBI need more clarity in how it defines front-
running instead of relying on broad terms such as unfair trade practice or market
manipulation, as in the case of Dipak Patel and Passport India. SEBI has to determine
whether this is a clear case of front-running.
The basic question is whether Dipak Patel and his cousins behaved ethically. Was this a case
of collusion given the volume of bank account transactions among the group? If front-
running is restricted to merely intermediaries, per the FUTP definition (as interpreted by
SAT), is the sharing of confidential trading information ahead of the employer and making
gains consistently for two years legal and ethical in the context of just and equitable
principles of securities market trade practices?
The test of true market integrity goes beyond regulatory enforcement. The solution is more
deep-rooted in the culture of adhering to ethical principles and conduct by market players.
Against this backdrop, it is not surprising that in the CFA Institute Global Market Sentiment
Survey 2013, a staggering 71 percent of participants from India responded that the lack of
ethical culture in firms is the primary contributing factor driving the lack of investor trust.
Perhaps it is the understanding of how to behave ethically, and the consequences of unethical
behavior, that must serve as the starting point.




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Solutions to the problem of Front Running
SEBI gets notified for the purpose of phone tapping, which the government ought to
do
SEBI has huge surveillance information and knows on a prima facie basis where front
running has occurred
Shift the burden of proof in such cases on the organisation to prove that there was no
insider trading or front running. Create a presumed guilty until proven innocent
Create a separate whistle blower framework that ensures secrecy and rewards. Of
course how SEBI will ensure secrecy in such a porous organisation is anybodys
guess. Dont mandate a compliance officer to act as a whistle blower. Incentivise him.














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Bibliography

http://www.wisegeek.com/what-is-front-running.htm. [Last Accessed 15 February 14].

http://www.thehindubusinessline.com/markets/stock-markets/tribunal-quashes-sebi-
penalty-order-on-3-traders-for-frontrunning/article4222484.ece. [Last Accessed 15 February
14].
Front-running; an Unethical Behavior". [ONLINE] Available at: http://cel.candor-
holdings.com/wp-
content/uploads/2013/10/front_running_an_unethical_behavior_09apr_2012.pdf#page=1&
zoom=auto,0,800. [Last Accessed 15 February 14].

Front running in India. [ONLINE] Available at: http://www.forbes.com/2010/08/20/forbes-
india-is-it-insider-trading.html. [Last Accessed 15 February 14].

(2011). Front running an illegal practice prevalent in stock markets. [ONLINE] Available at:
http://articles.economictimes.indiatimes.com/2011-06-08/news/29634084_1_cap-lakh-
shares-stock-price. [Last Accessed 15 February 14].











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