The many facets of front-running and insider trading 

SEBI (Securities Exchange Board of India) has levelled charges of front-running against two big institutions that many Indians are invested with – LIC and Axis Mutual Fund (we wrote about what to do with your Axis mutual funds in May 2022). Front-running and its close cousin – insider trading – were quite widely prevalent in the days of yore, before SEBI drafted elaborate regulations to keep such practices at bay. But what do today’s investors need to know about these malpractices? Here’s an explainer. 

Information is power

Share prices move based on expectations and events. Therefore, in investing, information is power. If I have advance information about something that will impact a company’s stock price, I can make some easy money. Or I can save myself some money. Let me share some interesting stories from the past, before the regulations about misuse of information were made water-tight. 

A company Chairman would send a telex from his office in Eastern India to the Bombay office, asking the local branch manager to place an order for some shares in his company with a designated broker. In those days, you did not have to disclose the buyer’s name until the contract was written.

Even after that, you could sell off the shares without getting them lodged in your name. Share certificates in their physical form were delivered with transfer deeds signed by the seller. In essence it was like a bearer share and registration was needed only when ‘book closure’ was announced. This Chairman knew of the half yearly results in advance and would take suitable action based on the numbers that would be announced.  Once the results were announced, the price would move and our Chairman would make a neat pile. There were no insider trading regulations then. 

Another company I knew always used to have their Board meeting for results at around 2 pm. Board members would be hosted for lunch at 1 pm.  In the conference room, the files with the papers would be kept by 12.30. So, you came in early, had a peep at the numbers and then walked down to the antechamber where a ’direct’ line was available and call your broker and make a trade. Once again, some quick money.  This was not unlawful then.

Similarly, in the early nineties, there was an investment professional who would plan his fund’s buys and sells for the day by the previous evening. He would inform his friend who was a broker about the trades he was going to make the next day. The broker would make trades right at the opening, before our friend put in the orders for the fund. Once our friend put in the orders, the price would move given the size of his orders. The broker would cash in on the spread before the end of the day and share the proceeds with the friend. 

As a sell side research analyst, I have faced this dilemma. A fund manager wanted to know the call before I published a report so that he could buy/sell for the fund accordingly. He did not benefit personally. The brokerage revenue would go to that firm which gave him information and news ahead of others!  It also gave him an edge over competition.

Some research houses are influential and their buy/sell recommendations have an immediate impact on the stock price. So, if you got a one-day advantage, you could make some gains.

Under the radar

Today, there are a plethora of laws that make it unlawful to use any unpublished information to profiteer from shares. Any act of buying or selling of securities based on advance unpublished information is front-running.

There are instances of front-running by domestic mutual funds that SEBI has meticulously documented and the persons have been named and shamed. Whether they have been made to disgorge all their unlawful gains, one does not know. 

But in the market place, there are still people in the know who can give you stories even after such regulations and investigations. There can still be instances of front-running that may remain outside of the regulator’s radar.

For instance, we all get news from time to time, that some share is bought by a celebrity investor. Automatically, the prices shift up. Now, if I have advance information about the celebrity’s buying plans, I can make some quick money here too. What I have done is to deny the seller the benefit of the same news and he has lost as a result. He may not have sold at the same price, if he had the same information that I had. 

Insider trading is disruptive to price discovery. An insider trader and a broker combination can distort prices. This causes a loss to the participants. The problem here is that generally, the user of insider information can quantify his gains.  The counterparties may not be able to do so, because it is an unidentifiable universe and there are many parties to the trade.  

In most cases, it is difficult to establish that a buyer or seller did have ‘insider’ information. The regulator / exchanges look for unusual trades (either in terms of volume spikes or large lots changing hands) before an event – this could be results that are away from expectations, an acquisition, a stake sale or any other corporate action that has an impact on price. Once that is done, they identify the names behind the big trades and then probe further.

Today, every trade is tagged by name. In the past, the names would be decided much after the trade. In those days, in the mutual fund industry, if there was a buy trade and by end of the day if the closing price was away from the traded price, the fund could decide which scheme to put the share in! 

The process of the regulator establishing a front-running case is quite cumbersome. Even after establishing it, punishments are challenged. And it can be years before any punishment is meted out. Very often, the punishment is a simple debarment from trading for a couple of years and ‘disgorgement’ of the gains made and some penalty is extracted.

In the US, the punishment often includes a prison term and the power is with the SEC itself. In India prison terms are rare. Often, we see that the Appellate Tribunal itself overturns SEBI punishments!

Front-running happens at various levels. It could be some company insider who simply trades in a few hundred shares through some friend who could even be in a totally different city. And on any given day, normal trades also keep happening. If the volumes are small and spread over various names, it will not even appear on the radar. I am sure this keeps happening.

Protections

As an investor, we often buy a stock and, in a few days, some corporate action results in a price drop. We can hardly go and stake a claim against some insider who sold with insider knowledge about the bad news. Our only protection is to stick to our own process for buying and selling, analyzing to see if the event is transitory or structural. 

I would rather see SEBI getting more powers and if someone is found guilty of insider trading, ensure that the person cannot ever work with a SEBI registered entity for his life. When everyone is playing by the rules of the game, the front-runner is a cheat who robs the rest of the players to have higher gains, which his investment skills would not give him.

Also, there should be ‘naming and shaming’ of those who get caught in insider trading. As investors, we simply take it as part of market practices. I have seen some cases where such front runners and price manipulators are now celebrated by the financial media. The world loves money, never mind how it was made.

SEBI now offers generous rewards to whistle-blowers who report on insider trading. It can go up to Rs.10 crores. Further, today, AI is a big weapon with which regulators to try and catch insider trades. We need to change our attitudes to insider trades. It is a crime as bad as any. It is theft of public money. The investors are collective losers. 

Let me close this discussion with an anecdote. You are in a crowded elevator. You overhear two bankers talking about a hostile takeover bid that is likely to be announced next week. This news is not in the public domain. You realise that one of the companies’ shares can gain even 50% on the public announcement.

What do you do?

As per law, you are in possession of “Unpublished Price Sensitive Information”. If you go and buy, you are guilty of insider trading. So it is best to resist any temptation and get on with life. It may not seem like a crime. But it is, so you need to respect the rules of the game and play accordingly.