Trading on thin ice: The Jane Street Crackdown & “Intent” in Offences of Market Manipulation

Introduction: Market Manipulation, Arbitrage and the Fine Line

In the light of the Jane Street crackdown, a recent article at CNBC, looked into the thin line between the act of arbitrage and that of market manipulation. Arbitrage trades are frequently done with respect to shares and commodities. Arbitrage involves making use of “market irregularities” to make a profit. Quite simply put, the difference in trading prices between two markets, can be used to buy the concerned share at a low price from one market, while (almost) simultaneously selling the said shares at a high price in the latter market. On a smaller scale, the concept seems fairly simple, allowing the “arbitrageur” to make a quick profit, quite literally. Market manipulation to the contrary, has been christened by courts as an “unwarranted” interference. As observed in this case, such manipulation undermines the integrity and efficiency of the market.

It is perhaps this distinction that spares arbitrage trading from strict illegalization, in that, arbitrage often contributes as a key player in increasing market efficiency. More importantly, arbitrage trading marches towards its own death, i.e, ends by itself. With excessive arbitrage trading in a particular gap, the gap is slowly closed, an equilibrium or near-equilibrium is achieved, and the scope for further arbitrage in that gap is reduced or eliminated. A self-remedying mechanism at play. Such an element is absent in acts of market manipulation, which are aimed at undermining efficiency.

Market manipulation is therefore deemed illegal under the SEBI Prohibition of Fraudulent and Unfair Trade Practices Regulations, 2003 (“PFUTP Regulations”). It may manifest itself by hindering the free and fair functioning of the market. As inferable, and as the aforementioned CNBC article goes on to say, the difference is thin, and the difference lies in the intent (“mens rea”).

This article aims to focus on the relevance of mens rea for market related offences. More importantly, this article seeks to delve into the difficulties associated with the proof of such mens rea and looks into other factors that helps courts navigate the legitimacy of such transactions, in the light of the Jane Street issue.

Is Intent Sine Qua Non?

Both with respect to the Jane Street crackdown, as well as the general law governing issues of market manipulation, the main Regulations are 3 and 4 of the PFUTP Regulations. It would be therefore prudent, and efficient to restrict our analysis of intent to these sections itself. Regulation 3 prohibits specific fraudulent deals in securities, whereas Regulation 4 imposes broader prohibitions against manipulative, fraudulent, or unfair trading activities without prejudice to Regulation 3.

Regarding the application of Regulations 3 and 4 to any trading activity, there are a number of questions that have to be considered - the essentiality of intent or mens rea as a pre-requisite; the scope and threshold of mens rea required; whether the laws of mens rea apply to such market offences as rigorously as they apply to other criminal offences, and so on. The Supreme Court case of SEBI v. Kanaiyalal Baldevbhai Patel, becomes crucially relevant in answering a few of these questions. The judgement highlights the difference in the standard of intent/mens rea requisites for a criminal offence, as compared to offences under Regulation 3 and 4, particularly regarding intent for acts of inducement.

The judgement goes on to observe that, for the impugned act (of fraud or manipulation of market-etc.) to be hit by Regulations 3 and 4, “mens rea is not an indispensable requirement”. Instead, the Bench postulates the test of “preponderance of probabilities” as the right standard to determine whether the impugned act is an offence or not. It is to be understood that such lack of insistence on requirement of mens rea in such offences, is not because mens rea is not relevant but mainly due to the difficulty in ascertaining such mens rea and the insufficiency of mens rea for offences related to market dealings. This deviation from the intent-oriented penalization of trading activities is not a first. SEBI’s crackdown on PwC involved similar issues, and concerns regarding the disposal of mens rea were raised, as to whether such an approach viable, and fair? Examining a different jurisdiction, where the intent-based approach is predominantly used would be helpful.

The Securities and Exchange Commission, and the Commodity Futures Trading Commission (Market Regulatory Authorities of the United States), have since long focused on intent, to determine the legitimacy of trading actions. Ms. Gina-Gail S. Fletcher, an academic expert in the arena of market manipulation and regulation, and Professor of Law at Duke University School of Law, argues that such an approach is “fundamentally flawed” and is “untenable”. She advocates for an effects-based penalization approach instead.

This difficulty can also be observed in the UK jurisprudence, wherein there is a high standard of intent to be demonstrated for such acts of market abuse, owing to the criminal nature of these acts. These offenses are rarely enforced, owing to such legal hurdles in showcasing adequate and relevant proof.

India seems to be ahead of the curve in this regard, by emphasizing the dispensability of intent as the sole adjudging factor. In fact, the Kanaiyalal judgement, notes the observations of the Supreme Court in SEBI v. Kishore R. Ajmera, and states that even “proof beyond reasonable doubt” is not an indispensable requirement., It is this clean intent that companies largely rely on, to prove the legitimacy of their transactions, and when such intent is quite inconvenient to prove, companies are placed in a very precarious position. This is aggravated by the uncertainties of the market, particularly regarding market innovations and heavy algorithm based trading.

All of the aforementioned begs the question, if not intent (the element that draws the line of distinction between manipulation and legitimate trading), then what?

The Interim Order issued by SEBI regarding Jane Street, repeatedly (Paragraph 15.50.1; Para 20; Para 28; Para 52) emphasizes the lack of “economic rationale” in the impugned trading activity , as an indicator of fraudulent intent. Using this as proof of manipulation might also be problematic. Mere lack of viability, or economic benefit from the trading, cannot without doubt point to the offensive intent of the trader. This could be an overreach, which may lead to the penalization of mere experimental trading methods or innovative models. Therefore, over-reliance on the economic inexplicability of trades, particularly in the context of high frequence trading, might serve to be a blunt instrument to detect and prove market manipulation.

Yet again, it might be beneficial for us to look back at the Kanaiyalal case for some guidance on other factors to determine legitimacy. The court determined the impugned trading activities to be “in breach of the code of business integrity in the securities market”. Such a conclusion was reached at, after considering the following factors in the then case’s factual matrix.

a) Volume of shares traded;

b) Number of days when trading of such nature was carried out;

c) Proximity between the sale and purchase of shares; and

d) Reoccurrence of such transactions.

The Court noted that keeping such factors in the mind, there is a strong “irresistible” conclusion that the impugned conduct stood in breach of market integrity. For offences such as these, of a strong economic and market related nature, the standard for determining such offences must be rooted in economics as well. Intent as a requisite should be decentered, while the impugned trading activity along with its ripple effects on the market should be considered to determine the true motive and rationale behind such acts. Further, in the Kishore Ajmera case, the court strongly reiterated that the proof of manipulation can be built on inferences gathered from “pattern of trading data, nature of transactions” etc. While intent itself cannot be fully dispensed away with, it is beneficial to arrive at conclusions of mens rea through such thorough economic analysis of the transactions, and the impact of said transactions on the market.

Way Forward – A Blank Road?

As of 22nd July, the ban on Jane Street has been officially lifted, on the condition of a $567 million deposit, to continue trading. SEBI has stated that the activity of the firm will be closely monitored while the investigation takes place. While these events unfold, the question arises regarding the consistency, clarity and surety of the law governing such transactions, rather, the interpretation of such law. Such questions can only be answered with time. These issues highlight the uncertainty lurking with respect to penalization of offenses such as market abuse. Clarity, specificity and certainty are the cornerstones of any criminal legislation, and the same seems to be lacking with respect to securities law.

In this era of algorithmic trading, with more complex, yet beneficial- tricks and trading patterns emerging, the role and method of regulation evolves as well. Jane Street has claimed that the impugned activity was merely “basic arbitrage trading”. Such issues highlight increasing tensions between modern day market innovation, and regulatory certainty. It would be beneficial for a benchmark to be set, through this case, to balance rights of entities in market innovation, investor protection, and the integrity of the market itself, and most importantly bring clarity in the interpretation of the law.