[Harshit and Jay are students at Gujarat National Law University.]
On 18 May 2023, the Securities and Exchange Board of India (SEBI) released a consultation paper seeking public comments on the draft SEBI (Prohibition of Unexplained Suspicious Trading Activities in the Securities Market) Regulations 2023 (SEBI PUSTA Regulations). The consultation paper comes against the backdrop of increasing instances of contravention of the securities laws resulting in manipulative and fraudulent trade practices, insider trading, front-running etc. With the advent of new technology and novel methods, SEBI has recognised its difficulty in establishing sufficient evidence while prosecuting cases. Evasive tactics like using mule accounts, layering funds through a complex web of transactions, and using end-to-end encrypted mediums like WhatsApp, FaceTime etc., have rendered traditional sources of evidence collection like bank records and call data ineffective.
The SEBI PUSTA Regulations aim to deal with unexplained suspicious trading patterns around the presence of material non-public information (MNPI). The primary objective of the regulations is to bring charges against market participants based on a certain amount of rebuttable presumption, which may, however, be refuted by a satisfactory explanation. It is a significant departure from the established jurisprudence regarding evidentiary standards in insider trading and unfair trade practices. Through this article, the authors analyse the regulations and provide their comments critically.
Key Provisions of SEBI PUSTA Regulations
Unusual trading pattern
Regulation 2(1)(j) defines an unusual trading pattern (UTP) as a repetitive pattern of trades which involves: (i) a substantial change in risk over a short time period, and (ii) has resulted in abnormal profits or averted abnormal losses during the same period.
MNPI
Regulation 2(1)(f) defines MNPI as: (i) any information about a security which is not available generally and shall have a reasonable impact on its prices upon becoming available; or (ii) information about an impending order in a security on a stock exchange, which, when executed, will have an impact on its prices; or (iii) information about an impending recommendation of a security by an influencer to the public/followers/subscribers, which shall impact its prices upon becoming generally available.
Suspicious trading activity
Regulation 2(1)(i) defines suspicious trading activity (STA). STA will be deemed when an individual or a group of connected persons exhibit UTP, and such UTP coincides with the presence of MNPI.
For ease of explanation, STA = UTP + presence of MNPI.
Once an STA is established, a presumption of violation shall be raised, and SEBI will initiate proceedings against the persons/group of connected persons. The onus of proof will shift to such persons, and they will be liable for action unless they can rebut the presumption through sufficient explanation.
Rebuttal
The presumption of an STA can be rebutted by demonstrating any of the circumstances mentioned in Regulation 5(2) of the draft SEBI PUSTA Regulation. A rebuttal can be made by providing detailed documentary evidence proving that either the information was not MNPI, the trading activity did not exhibit any UTP or the trades were not based on MNPI.
Unexplained suspicious trading activity
As per Regulation 2(1)(k), when no explanation or reasonable rebuttal is provided to the presumption of STA, such trading activity will be deemed to be unexplained suspicious trading activity (USTA). Any person or group of persons engaged in USTA will be liable for action by SEBI under the Regulation.
In other words, it can be explained as USTA = STA + (absence of reasonable rebuttal/explanation).
A separate penalty provision is not provided in the regulations; therefore, reliance could be placed on Section 15HB of the SEBI Act 1992, which provides for a penalty extendable up to ₹1 crore, in cases of violation.
Analysis
The SEBI PUSTA Regulations will bring in a tremendous change in the manner SEBI conducts its investigation and prosecution. Once an STA is established, the onus of proof or the evidentiary burden will shift to the person who is accused of exhibiting such activity. The regulations will arm SEBI with raising a presumption of guilt even without establishing any causal link between the suspicious trades and the wrong it intends to curb. Mere suspicion of irregular trading patterns with no cause-and-effect relationship is not enough to raise a presumption. The suspicion must be accompanied by some circumstantial evidence, and a reasonable nexus must be drawn between UTP and MNPI.
Further, jurisprudence could be imported from the landmark judgement given by the Supreme Court (SC) in the case of Balram Garg v. SEBI, wherein it was held that trading pattern merely in the presence of any non-public material information cannot be enough circumstantial evidence. Cogent material must be produced to establish the communication or possession of such information. Further, the SC in the case of Seema Silk & Sarees v. Directorate of Enforcement, held that “reverse burden as a statutory presumption is permitted, but it can be raised only when certain foundational facts are established by the prosecution.” The SEBI PUTSA Regulations seek to prosecute the accused by raising a presumption merely on suspicion without establishing any foundational facts or producing any cogent evidence on record to back it up.
Specific challenges with the regulations have been explained below.
Standards for reverse onus of proof are not clearly defined
Once SEBI establishes an STA, it will raise a rebuttable presumption of guilt on such a person or group of persons undertaking the trading activity. The burden to provide a reasonable explanation to rebut the presumption will lie upon the accused. This shifting of burden is called reverse onus. However, in cases where there is a reverse onus, it becomes increasingly important to have clearly defined standards which would trigger the shifting of the evidentiary burden on the accused. It is an established principle in law that when the burden of proof shifts, the standards must be clearer and objective to function as safeguards.
However, the SEBI PUSTA Regulations fail to establish clear standards for STA. The definition provided for UTP is ambiguous. The term ‘substantial change in risk’ in Regulation 2(1)(j) is vague and could virtually cover all trading activities in its ambit. Further, the term ‘abnormal profits or abnormal losses’ is subjective and not clearly defined. Abnormal returns in the securities market are a common phenomenon and do not necessarily accompany any unfair trade practice. Providing a rebuttal for the same would be burdensome on the accused. An exemption must also be provided for algo trading. With the current definition of UTP, all algo trades could be classified as UTP since the primary objective of such trades is to generate abnormal returns through repetitive trades in a short time period with the help of algorithms and AI.
Providing a ‘detailed documentary evidence’ to rebut the presumption may be impossible
The standard of evidence that is required to rebut the presumption of STA is very onerous on the accused. Proviso to Regulation 5(2) states that the person shall present a ‘detailed documentary evidence’ to substantiate any claim. In the securities market, providing a trail of documents proving that the trading pattern was not UTP or that the person did not act on MNPI can be impossible. It will be challenging for the accused to rebut a presumption by proving a negative or proving the inexistence of certain scenarios.
Incorrect reliance is placed on domestic and international legal provisions
In the consultation paper, SEBI has relied on international and domestic laws to prove that the law allows raising a certain level of rebuttable presumption to bring charges. It has quoted Section 11 of the Securities Act 1933 of the United States of America. It raises a rebuttable presumption on underwriters and directors in cases of misstatements or material omission in the registration of a public securities offering. The presumption can be rebutted by using the defence of due diligence.
Further, SEBI has also relied on Section 68 of the Income-tax Act 1961 (IT Act) which provides a presumption about the assessee's income if no explanation is offered about the source of cash credits found in its books.
However, such reliance on domestic and international provisions is incorrect as the nature of the activity regulated by these legal provisions is entirely unrelated. The provision for rebuttable presumption under the IT Act is provided in the parent legislation itself; however, no such provision exists in the SEBI Act. The draft regulations may be challenged on the grounds of unconstitutionality.
Conclusion
In its current form, the SEBI PUTSA Regulations have the potential to be misused by the regulator and can have chilling effects on legitimate trading activity in the capital market. It is the authors’ opinion that the standards that will trigger the reverse onus of proof should be unambiguous, objective and clearly defined to act as safeguards. The definitions of UTP and MNPI should be crystallised further and must provide quantitative standards. SEBI should further clarify and explain why it considers specific parameters in the definition of STA as an outlier event, so much so that it is sufficient to trigger a reverse onus of proof and shift the evidentiary burden on the accused. The standard of evidence required to rebut the presumption by the accused must also be lowered so as not to restrain any legitimate trading. Further, the regulations must also provide for establishing a causal nexus between STA and MNPI based on some foundational facts, and mere suspicion should not be enough to raise a presumption of guilt.