[Shubhankar and Dhaval are students at National Law University, Delhi.]
The increasing influence of social media platforms on financial markets brings its fair share of pros and cons. On one hand, information sharing and the creation of discourse through these platforms regarding the financial markets significantly contribute towards increasing transparency in the market. However, on the other hand, one cannot disregard the fact that social media has also been a notorious tool in manipulating human behaviour and acting as a vehicle of disinformation.
In order to curb such instances of market manipulation and the spread of disinformation, in January 2022, certain amendments were made to Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations 2003 (PFUTP Regulations). After this amendment, in March 2022, SEBI conducted search and seizure operations on entities which were reportedly operating 9 telegram channels having over5 million subscribers to whom they were providing recommendations regarding certain selected listed scrips. As per SEBI, these channels had led to the creation of artificial volume and price rise as the investors were induced to deal in the said scrips.
In this piece, the authors have attempted to analyse the recklessness standard introduced by SEBI through the 2022 amendment in the context of the market manipulation done through social media. The authors have then put under scanner the US jurisdiction wherein this standard is already well established. Thereafter, the authors have given suggestions for the future course of action in this regard.
Measures Taken by SEBI
The most significant change that has been brought forth by the 2022 amendment to the PFUTP Regulations is widening the scope of what comes under the ambit of manipulative, fraudulent or an unfair trade practice. The relevant regulation in this regard is Regulation 4(2) which enlists the activities of dealing in securities which shall be deemed to be manipulative, fraudulent or an unfair trade practice.
Through the 2018 Amendment, as per Regulation 4 (2)(k) the standard applied was “disseminating information or advice through any media, whether physical or digital, which the disseminator knows to be false or misleading and which is designed or likely to influence the decision of investors dealing in securities”. On the contrary, after the 2022 Amendment, the same regulation has now been worded as “disseminating information or advice through any media, whether physical or digital, which the disseminator knows to be false or misleading in a reckless or careless manner and which is designed to, or likely to influence the decision of investors dealing in securities”. Prior to this amendment, it was the burden of SEBI to prove intent as to whether the disseminator knew the information or advice to be false and misleading. However, in seminal cases like that of Securities and Exchange Board of India v. Shri Kanaiyalal Baldevbhai Patel and Others, the Apex Court had held, “to attract the rigor of Regulations 3 and 4 of the 2003 Regulations, mens rea is not an indispensable requirement and the correct test is one of preponderance of probabilities”. The Securities Appellate Tribunal (SAT) judgment in S. Gopalakrishnan v. Sebi held “the contention that the term ‘mens rea’ should be broadly construed and recklessness should be equated to be a part of the term ‘mens rea’ is erroneous”.
Post the 2022 amendment, the regulation effectively means that if the said act has been done in a reckless or careless manner without having the ‘knowledge’ that the information is false or misleading then such act shall be deemed to be manipulative, fraudulent, or unfair trade practice. With the introduction of the recklessness standard, it is essential to understand its position within the jurisdiction where it is well established i.e., the US.
Position in the US
To see the influence of social media on the securities market in the US, it is essential to note that in January 2021, retail investors hiked the stock price of Gamestop through a coordinated attempt on Reddit. This alleged coordinated market manipulation led to a 1700% increase in the price of the stock and attracted the attention of several regulatory authorities. The US Securities and Exchange Commission (SEC) published an investor alert highlighting the risks associated with short-term investing and tips available on social media. In the alert, the SEC stated that the fraudsters might resort to pump-and-dump schemes, scalping or touting to manipulate the share price of a company’s stock. Previously, the SEC had even suspended trading accounts of companies that had engaged in suspicious social media activity.
Section 10(b) of the Securities Exchange Act 1934 is the key statutory provision regarding the regulation of manipulative and deceptive devices in any national securities exchange. The provision makes it unlawful to “use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [U.S. Securities and Exchange] Commission may prescribe”. This anti-fraud provision has been enforced by the SEC under Rule 10b-5. Rule 10b-5 has been the widely used anti-fraud provision which prevents market manipulation by prohibiting misrepresentations, devices, schemes, and artifices to defraud. In order to prove a violation of Section 10(b) and Rule 10b-5, recklessness would constitute as scienter.
Recklessness as defined in Sundstrand Corporation v. Sun Chemical Corporation (Sundstrand) is “highly unreasonable [conduct], involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care’ which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it”. The court in Sundstrand further went on to expound that the aforementioned definition of recklessness “serve[s] as a proper legally functional equivalent of intent, because it measures conduct against an external standard which, under the circumstances of a given case, results in the conclusion that the reckless man should bear the risk of his [conduct]”.
Section 17(a) of the Securities Act 1933 is another key anti-fraud provision. However, it is relatively less relied upon by the SEC and the private plaintiffs than Section 10(b) and Rule 10b-5. While prima facie Section 17(a) and Rule 10b-5 appear to be similar, unlike Rule 10b-5, Section 17(a) does not require scienter. This essentially means that SEC or private plaintiffs can use the route of Section 17(a) in situations wherein it is not possible to state a cause of action under Section 10(b) or Rule 10-5. At the same time, it is necessary to clarify that in criminal cases, proof of scienter is required under Section 17(a).
An individual is held liable under Section 17(a)(2) if they have engaged in the sale of securities while directly or indirectly omitting to state a material fact necessary, leading to market manipulation. This standard has been succinctly laid down in SEC v. Shanahan. Therein it was held that under Section 17(a)(2), the defendant has to act in a manner in which a reasonably prudent person would have acted under the given circumstances. Therefore, the defendant, while communicating any information regarding the purchase and sale of securities, has to exercise reasonable care. An appropriate investigation must be conducted by the defendants before releasing statements to investors or the general public.
According to the authors, within the Indian context, the newly introduced standard of recklessness must be applied in the same sense as provided in Sundstrand. This is because the Sundstrand standard is neither too high (as was prior to the amendment) nor too low (as discussed ahead). Further, the key feature of the Sundstrand standard is that it does not include within its purview simple acts of negligence. If the Indian courts while interpreting the recklessness standard were to extend it to include even an act of simple negligence, SEBI would be vested with overbroad powers to conduct search and seizure operations against these social media channels for any information shared through them regarding financial markets. It is essential to note that the purpose of bringing in this standard is to prevent manipulation of market and not impose a blanket ban on all such information sharing. A balance needs to be struck between preventing market manipulation and achieving informational symmetry that happens through these social media channels.
The introduction of recklessness standard by the SEBI is definitely a welcome move as it will assist the securities tribunals in curbing instances of dissemination of false and misleading information through social media. While this tweak in the standard of PFUTP Regulations will have a deterring effect on the disseminators, the SEBI should also lay down additional rules to be followed by the disseminators. Every individual recommending any investment strategy must disclose the risks, liabilities, conflict of interests and material sources associated with the financial instrument.
Further, in many countries as per the current trend, ‘fusion centres’ or ‘fusion cells’ are being created for homeland security. These centres or cells are essentially hubs wherein the data and capabilities of heterogeneous actors are jointly synergized for certain objectives. It is not necessary that such centres only involve members from intelligence or law enforcement agencies, but even private companies or independent experts could be roped in for this. Further, this model could be adapted to include stakeholders from the financial sector. Such fusion centres or cells could help in an efficient dissemination of information to its participants on a need-to-know basis. It goes without saying that this could be one of the long-term goals as several factors such as the appropriate modes of participation to ensure data protection etc. would have to be decided.