Author: Abhyudaya Yadav
Fourth year law student at Dharmashatra National Law University, Jabalpur
I. Introduction
The Indian Capital market is among one of the fastest growing capital markets in the world. With the rise of investments in the stock market, market abuse and manipulative practices have also escalated correspondingly. Securities and Exchange Board of India (“SEBI”), the apex financial market regulator of India, time and again keeps a watchful eye over such market manipulations and abuse through various regulations framed under SEBI Act, 1992. SEBI (Prevention of Fraudulent & Unfair Trade Practices), Regulations, 2003 (“PFUTP Regulation”) & SEBI (Insider Trading) Regulations, 2015 (“Insider Trading Regulation”) are also one of the most prominent among them.
Fraud has been said to be among the most stigmatizing and punitive forms of liability imposed on modern corporations and agents of financial markets. PFUTP Regulation prohibits fraudulent trade practices under Regulation 3 and Regulation 4. PFUTP Regulation provides the definition of the term ‘fraud’ under Regulation 2 (c). In this piece, the author attempts to examine the definitional framework of the term ‘fraud’ and critiques its underlying flaw while laying emphasis on the legislative and judicial approaches in defining the term amorphously. The author further focuses on various anti-fraud provisions of the securities law of the USA and the approach of the Securities Exchange Commission (“SEC”) in this regard and attempts to understand the lack of coherency and clarity regarding the determination of the scope of fraud under the regime of Indian securities laws, by comparing the same with that of the American regime.
II. Concept of 'FRAUD'
The word ‘fraud’ has been defined under Regulation 2(c) of the PFUTP Regulation, and “includes an act, expression, omission or concealment which has been made, whether in deceitful manner or not, by any person or by any other person with his connivance or by his agent while dealing in securities in order to induce such another person to deal in securities irrespective of any wrongful gain or avoidance of any loss…”. The first part of the definition states a catch-all provision while the second part includes specific instances which are included as part and parcel of the term fraud.
Justice Gogoi, while interpreting the scope of the term ‘fraud’ in Shri Kanhiyala Baldevbhai Patel v. SEBI (“Kanhiyalal”), adopted a very liberal approach to this term. Paragraph 6 of his part of the judgment is extracted below:
“The definition of 'fraud', which is an inclusive definition and, therefore, has to be understood to be broad and expansive, contemplates even an action or omission, as may be committed, even without any deceit if such act or omission has the effect of inducing another person to deal in securities….. The emphasis is on the act of inducement and the scrutiny must, therefore, be on the meaning that must be attributed to the word ‘induce’.”
Justice Gogoi has outrightly rejected the necessity of deceitfulness while examining the conduct of fraud. Subsequently, while laying emphasis on the term ‘inducement’, he observed that the extent of ‘inducement’ differs significantly in criminal law & securities law. In the former category, in order to constitute an offense of fraud the representation or misrepresentation must be dishonest whereas in the latter category the necessity of dishonesty has been excluded by necessary implication in the PFUTP Regulation. Thus, as it is clearly established that the element of mens rea is not required, effectively, it requires SEBI to find a mere inference, rather than a proof that such an induced person would not have acted in the manner if such an inducement would not have been made.
Interestingly, the standard of proof adopted by Indian courts, in matters of fraudulent conduct, is the negligent standard test where the intention for establishing the conduct of fraud is not required. The acts merely on the basis of inducement would constitute fraud. The definition of the term ‘fraud’ would take within its sweep every tortious and reckless act of the actor whose actions have resulted into inducement. The term ‘negligent standard’ has not been used in any of the judicial pronouncements; nonetheless, American jurisprudence has expressly used this term.
III. American Jurisprudence on Fraudulent Conduct
It is well settled that much of Indian securities laws are influenced by its American counterparts. Therefore, it is significant to throw some light on American Jurisprudence in this regard. Anti-fraud provisions in the US securities law have been provided under Title 17, Code of Federal Regulations, Part-240, Rule 10b-5[i] which prohibits employment of manipulative & deceptive devices, and prohibits any conduct of fraudulent nature.
In the case of SEC v. Texas Gulf Sulphar Co., it was observed that in order to constitute fraud under securities laws of the US, fulfillment of the following two elements is necessary:-
Material mis-statements or half-truths, that are reasonably calculated to influence public investment.
Silence, when an independent duty to speak or pre-existing fiduciary relationship exists.
However, there has been substantial chaos regarding the necessity of the element of intention for establishing the conduct of fraud, in variegated circuit courts, till the Supreme Court’s decision in Ernst & Ernst v. Hochfelder (“Ernest”).
The Supreme Court in Ernest rejected the negligence standard for litigation under Rule 10b-5, and held the intention to deceive to be necessary while assessing fraudulent conduct. The court reasoned that the use of words like “manipulative, deceptive or contrivance” in Rule 10b-5, clearly intends to proscribe knowing or intentional misconduct. On examination of root words of the terms ‘manipulative’ & ‘deceptive’ i.e. ‘Manipulate’ & ‘Deceive’ respectively, the court observed that the conclusion of conscious wrongdoing is inescapable. An alternate argument that rebuts the prior proposition contests that if the intent was to exclude intention as a necessary element, the legislature would have excluded it by expressing implications in the statute as it did in other parts.
IV. Critical Analysis
In this part, the author critically analyzes the legislative and judicial approaches while developing the concept of ‘Fraud’ under Indian securities laws. The definition of the term ‘Fraud’ in PFUTP Regulation is devoid of justification on various jurisprudential parameters which are set out below:
1. Civil Sanctions or Criminal Liability
As noted earlier, the conduct of fraud has to be backed by intention under US anti-fraud provision, whereas in India the intention is not required to be proved. The Indian regime adopts the ‘negligence standard’, which is a victim-centred concept (fraud), and includes negligent statements or conduct, even in the absence of any intent to deceive.
According to this standard of proof, an inquiry into an actor's intention is irrelevant and fraud falls under the category of tortious liability. Further, the deterrent approach of SEBI, while formulating regulations and its adjudication process, justifies the characterization of fraud as a criminal offense. In the case of S Gopalkrishnan v. SEBI, the court observed that SEBI, while inquiring into the conduct, generally takes intent and motive into consideration to establish the conduct of fraud. However, on the other hand, the Apex Court, while holding mens rea not to be a necessary element for establishing fraud under PFUTP Regulations, diluted it to the extent that the intent is no longer recognizable.
The white-collar crimes and economic offenses, though not being violent like traditional criminal offenses like murder or riot, generally require some form of intent. Fraud has been said to be a morally richer concept than negligence since it has greater normative ambitions. Therefore, the standard of proof, which rests on negligent or tortiously reckless acts, serves no justification and further magnifies the penumbra of proper characterization of fraud (Whether Civil or Criminal).
2. Inconsistency of Anti-Fraud Provisions, and Insider Trading Jurisdiction in India and the US Securities Regulation Regime
The law of insider trading in the USA is a part of general laws relating to fraud. Rule- 10b-5 of Part 240 of Title 17, Code of Federal Regulations enables the SEC and Federal Courts to apply general anti-fraud provisions to insider trading. On the contrary, in India, insider trading and fraudulent practices are kept under different regulations.
For establishing a case of insider trading, Securities Appellate Tribunal (“SAT”) in RakeshAgrawal v. SEBI has held that in the light of objects set out under the SEBI Act, 1992 and Insider Trading Regulations, insider trading without a motivating factor is not punishable. Thus, essentially, if it is established that a person who has indulged in insider trading had no intention of gaining an unfair advantage, the charge of insider trading does not sustain.
The SEBI’s adjudication of securities regulations and theoretical underpinnings concerning securities regulations are greatly influenced by SEC and US securities law. The same can be witnessed in the matter of circulation of unpublished price-sensitive information (UPSI) through WhatsApp messages with respect to Ambuja Cements Ltd., where the court emphasized on the American Concept of ‘Heard on Street’ was recognized, though not expressly but discussed in detail. Thus, the legislative and judicial approach of stark deviation from the American approach finds no concrete justification. The absence of any robust alternative approach is further creating ambiguity.
3. Legislative Ambiguity
The first limb of the definition of the term ‘fraud’, i.e. catch-all provision, is devoid of clarity and jurisprudential justifications. It states, “fraud includes any act, expression, omission or concealment committed whether in a deceitful manner or not by a person,... whether or not there is any wrongful gain or avoidance of any loss.” On meticulous examination of the definition, we would find that the legislative intent was clear in excluding intention to be a necessary element for constituting fraud when it uses the phrase ‘whether in a deceitful manner or not’. Further, there is no need of proving any inequitable gain as it states ‘whether or not there any wrongful gain or avoidance of any loss’.
There is no negative element, such as malafide intention or undue profit, in the catch-all provision, thus one simply cannot deduce as to what exactly fraud entails merely on the basis of inducement, since fraud is not a mere tortious act. The court noted in Kanhiyalal that the provision has been given the widest amplitude, and therefore takes within its sweep every inducement which brings inequitable results however it failed to describe as to how inequitable results will come in absence of any intention or bad faith.
It is pertinent to note that static definitions of fraud can be made only at a general level. Human ingenuity will always find ways to bypass the rigors of law by inventing new methods, and the inevitable arrival of new behaviors will always try to expose fault in the definition. The need for flexible definition arises with the growth in technology and inventiveness. The social realities of the financial market exert pressure on securities regimes to provide for an open-textured definition. Though open textured definition will expand the scope but the scope for complaint of intolerable ambiguity and vagueness will also be magnified, just like the definition as provided under PFUTP Regulation.
V. Way Forward
The lawmakers should not be permitted to provide a definition that enlarges the scope so vaguely that it becomes difficult for tribunals and courts to make principled distinctions. The point being that if the law does not appear to make principled distinctions of the concept or it displays predictability with respect to the person on which sanction for fraud is to be imposed, then the project of regulating security fraud will lose morals. Therefore the need for the drafting of regulations and rules governing securities fraud becomes imperative.
[i] 17 C.F.R. § 240.10b-5 (1992).
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