The Hindu Business Line : The holes in deep pockets

GATES law says, "If there isn't a law, there will be". The Indian stock market has always been considered a goldmine for the investing masses provided one was savvy enough to do the right things at the right time.

But some brokers got a bit too savvy and ended up on the wrong side of the law forcing the market regulator SEBI to draft the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 1995 SEBI (FUTP) Regulations. It was this law that was tested before the Securities Appellate Tribunal in the Madhukar Sheth vs Securities and Exchange Board of India (2004 49 (I) CC 384) case.

The build-up

Madhukar Sheth (MS) was a share broker in all senses of the term. He had his own clientele and was trading in shares on their behalf. Harinarayan Bajaj (HB) along with one of his family members took a liking to the shares of a battery manufacturer near a temple town in Andhra Pradesh.

From a low of Rs 91 in the first week of October 2000, the price of the share reached Rs 320 in March 2001. Then the downward trend started and by mid-March 2001 it had reached a nadir of Rs 78.50.

Trading volumes accompanied the share prices in their downward descent forcing SEBI to order an inquiry into the bizarre developments. The result was that HB and Co were found to be dominant traders in the shares under discussion and had created a false market for the shares.

Logically, the fault came on MS too for having aided and abetted HB in his misdemeanours. It was said that he had not exercised due skill and care while dealing with HB. He permitted HB to a continuous carry forward of trades which enabled him to build up a huge position in shares which were simply not there.

The total balance that was due because of this indiscretion was a whopping Rs 12.33 crore. With no payments forthcoming from either HB/MS, MS was suspended from trading. MS also did not smell foul play when a normal enquiry would have revealed that HB's son was a big-time defaulter to BSE.

Defence

MS claimed that he was doing what was told to him in the normal course of business. When he first met HB, he got the now-popular "Know your customer" form filled up. His visits to HB gave him the impression that he was well-to-do since he was staying in a posh area in Mumbai.

Also, he had been trading with HB for some time and did not experience any difficulty in getting margins, payments for shares sold/setoff, and so on. SEBI did not buy this argument and suspended MS from the bourses for two years. An aggrieved MS approached the Securities and Appellate Tribunal (SAT).

The ruling

SAT observed that the prices and volumes of the shares traded should have made any layman raise his eyebrows. When viewed against the floating stock of the company (43-lakh shares), volumes of 10-15-lakh shares/day as against an average of 50,000 should have rung the alarm bells to any broker worth his salt.

It was found that a coterie of brokers was responsible for the abnormal gyrations in the prices. SAT found it difficult to believe that experienced brokers like MS could find everything as white as snow in the background of these developments. By giving astronomical exposures to HB without a reality check on his capacity, MS had not been diligent.

SAT observed that the area where a person lives cannot be considered to be the final word on his capacity to pay up when due. Significantly, SAT observed that assessing the diligence of clients is an ongoing process and cannot be done one-time looking at the house he lives in or the car he drives. MS's argument that it was the duty of the surveillance department to caution the brokers was not accepted by SAT.

In a fitting finale to the drama, it was discovered that even MS had traded in the shares of the company and had defaulted in his obligations. MS tried to outsmart SAT by requesting that the ban on him be imposed from the day he started trading than from the date of the SEBI order which SAT dismissed.

Exception reporting

The market regulator watchdogs over 23 stock exchanges, 5,000-plus listed companies, 9,368 brokers, 37 asset management companies, 11 security custodians and 54 venture funds. Although a tall task, it is cases like these that prove the regulator's efficiency. It also proves if there is something that defies what would have been in normal circumstances, one can safely conclude that there is something amiss — "exception reporting" in the language of the bean-counters. They could take a cue from such cases.

(The author is a Hyderabad-based chartered accountant.)

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