Burden of proof

Proposed regulation for unlawful trades will not work

A recent consultation paper from the Securities and Exchange Board of India (Sebi) on “Prohibition of unexplained suspicious trading activities” outlines the proposed regulations. The regulator has identified the practical challenges it faces in dealing with insider trading, front-running, and pump and dump scams. But the remedies it suggests may be impractical and a regulatory overreach. The paper deals with offences like front-running trades on the basis of “material non-public information” (MNPI), insider trading on the basis of unpublished price-sensitive information (UPSI), and with pump and dump schemes. For instance, employees of a financial institution like a mutual fund may know the fund intends to take a stake in a specific company. They could front-run by placing trades on their personal accounts before the institutional trades.

Other types of insider trading can be done by those who are privy to UPSI. Such information could, for example, be about good or bad results, or a large order, or change in management, and so on. “Pump and dump” schemes involve buying a stock and spreading rumours about good news in that company to “pump” up the price, and then “dump” shares by selling them at a profit. These are all illegal practices. They are perpetrated via collusion among multiple entities. The regulator’s contention is that it is often difficult to prove guilt. “Evasive and camouflaging tactics are used”, such as mule accounts, layering funds, and sharing transfers through a complex web of entities. Mule accounts can earn “white profits” if there is no apparent connection between the owner of the account and the perpetrators. Coordination is carried out through encrypted services such as WhatsApp.

Hence, traditional surveillance and evidence-collection methods such as examining call-data records and bank records may be ineffective in establishing the “preponderance of probability” of guilt. A further complication is that innocent traders and investors often get sucked into such deals at a secondary stage because they track the news and the price-volume actions. These traders can be confused with mule accounts, further muddying the trail. As a result of technological obfuscations, although Sebi often flags suspicious trading activities, it finds it hard to obtain conclusive evidence of guilt. The paper cites multiple cases where Sebi identified unnatural trades resulting in unusual profits, but was unable to prove guilt. It claims that in 2022, some 5,000 suspicious trading alerts were generated, involving 3,588 unique entities, with 97 of these entities appearing more than five times each in suspicious trades. But Sebi could not find conclusive proof of communication of UPSI or MNPI in most instances.

Under the proposed regulations, if Sebi does flag suspicious trading activities and believes MNPI or UPSI was involved, it will institute presumptive proceedings against the parties concerned. The burden of rebuttal of the presumption of violations would be placed upon the accused. This is where the proposal breaks down. It is impossible to prove a negative of this nature, and in any reasonable system, the burden of proof cannot be placed upon the accused. Such a regulation could result in an impasse where an accused party states that it did not know any UPSI or MNPI, or communicate with anybody, and Sebi insists otherwise, without being able to furnish evidence. Instead of such regulations, the regulator would do well to strengthen its surveillance and evidence-collection methods.