Karvy case and the games brokers play

The ongoing battle between Karvy Stock Broking Ltd and the market regulator, the Securities and Exchange Board of India, has been nothing short of a racy potboiler. It initially went along familiar lines with the corporate broker, KSBL, using its financial muscle to pull strings, influence media and attempting to get reprieve from the SEBI order placing restrictions on its business.

But just when investors were beginning to give up hope about getting back their assets, in a sudden heroic burst, the BSE, NSE and MCX suspended KSBL’s broking licence and NSDL transferred majority of client’s shares, stuck in KSBL’s pool account to the clients’ depository accounts.

One cannot but cheer this move by the exchanges and NSDL in putting investors’ interest above everything else. This quick action has provided relief to 82,559 clients out of 95,000, whose shares worth around ₹2,300 crore had been unauthorisedly transferred into a pool account by KSBL, by misusing the Power of Attorney given by its clients.

If the exchanges and NSDL had not acted when they did, it is quite likely that the battery of lawyers employed by the broker could have found some means to get access to the use of the clients’ PoA, which may have resulted in clients waiting for years to get their securities back, if at all.

The recent SEBI action in the NSEL case, against the commodity arms of top brokers including Motilal Oswal and Anand Rathi is a case in point. Though the brokers were found guilty of the charges and told to cease commodity broking business, the five-year delay in giving the order made it quite ineffective. The brokers had already created new companies to carry on commodity trading business.

The banks and NBFCs who have given loan against the clients’ shares are of course up in arms over NSDL’s move since they claim that they have the right over the shares pledged to them. Since KSBL has pledged shares that does not belong to it, it is debatable if the financial institutions will be able to gain possession of the securities.

The argument that the financial institutions were unaware of the true owners of the securities also sounds a trifle far-fetched as SEBI had put out a circular this June stating that shares lying in client collateral account, client margin trading account and client unpaid securities account should not be pledged with banks and NBFCs by brokerages. It surely behoves the large financial institutions to follow regulatory guidelines closely.

The Karvy saga

For those who joined in late, SEBI had barred Karvy Stock Broking Ltd from taking on new clients and from using the Power of Attorney given to it by clients to transfer shares from demat accounts, towards the end of November 2019.

The Karvy order is mainly a fallout of the SEBI circular issued in June, in which brokerages had been asked to transfer shares to the clients within one day of receiving payment. In case of default, the broker had been asked to sell the security in the market after five days. SEBI had also asked brokers not to pledge partly-paid securities with financial institutions. Brokers had been given time until October 1 to unwind such loans taken against clients’ partly-paid shares.

KSBL had, however, failed to comply with SEBI’s diktat on ring-fencing clients’ securities from its own and had continued to pledge these securities to raise funds for its other ventures. Two, it has misused the PoA given by clients to transfer shares held in clients’ demat accounts to meet delivery requirements in proprietary trades.

But KSBL is not the only broker found non-compliant. SEBI is reportedly investigating many other brokers too for failing to comply with its rules on separating client assets from its own.

An ongoing battle

The move against Karvy is a part of a long-drawn effort of SEBI to tighten the scrutiny over brokers’ misuse of client money and putting through unauthorised trades. Proprietary trading, wherein a broker trades for himself, accounts for a significant chunk of a brokerage’s business. These trades account for more than one-third of total derivative trades and over 20 per cent of cash volume on exchanges.

With brokers trading for themselves as well as for their clients, the lines demarcating the client funds and securities from those belonging to the broker had been becoming blurred for some time now. It has become a common practice for brokers to use client money for intra-day proprietary trades and transfer the money back to client accounts by the end of the day.

Similarly, shares belonging to clients were being pledged, used as collateral for proprietary trades and even used to meet proprietary trade deliveries. Some of these malpractices were highlighted in the SEBI order against Allied Financial Services and 10 other entities, passed this February.

Unauthorised trades

SEBI has also received numerous complaints about trades being put through clients’ accounts, without receiving authorisation from the clients. This was being done to probably generate higher brokerage or to transfer loss-making trades from proprietary trading accounts to client accounts.

To stem such trades, SEBI had taken several measures including asking exchanges and depositories to send post transaction SMS and email to clients and displaying a ticker on broker/DP website regarding the trades. The brokers were also asked to maintain evidence regarding the client placing the order in the form of physically written and signed request from the client, telephone recording, emails, mobile phone recording or any other legally admissible record.

Precaution helps

The market eco-system can, however, become robust only if the stock brokers and clearing members become serious about their fiduciary duty in protecting client assets. The broking units should have strong rules and policies to ensure this.

SEBI has mandated that all active stock brokers or clearing members should conduct an internal audit on a half-yearly basis and submit the same to the exchanges. It is now necessary to review the conduct of these internal audits, whether the auditors are carrying out the review properly, if exchanges are acting on issues flagged. Stipulating that these internal audit reports should also be submitted to SEBI, may help too.

Given the difficulty in ring-fencing proprietary trades from client trades, it may be a better idea to ask such self-trades to be done through a subsidiary company.

Finally, the world of stock trading is a Wild West and the rules are bent until they are twisted out of shape. It is up to each investor to take the necessary precaution in direct trading, especially if they want to do margin trading. They need to keep tab on the shares in the demat account, check all the messages from depositories and exchanges and verify their physical shares at least once a month. If they do not want to share the PoA with the broker, they can transact electronically through SPEED-e facility of NSDL.

Those who are risk averse can of course use the mutual fund route, which does not bring with it the hassles of dealing with brokers.

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