Stock Fundamentals

Karvy case: How can investors protect themselves?

Lokeshwarri SK BL Research Bureau | Updated on November 27, 2019 Published on November 26, 2019

Here are some red flags investors need to watch out while giving giving Power of Attorney to brokers

The order passed by the Securities and Exchange Board of India (SEBI) against Karvy Stock Broking Ltd (KSBL) last week has shaken investors. Many are wondering whether they have any reason to be worried.

KSBL has made it clear it is business as usual for the company, and that it will be able to respond to all the allegations levelled against it. While the final word has not yet been said on the issue, there are many red flags for investors from this episode.

Through the order, SEBI has a) barred KSBL from taking on new clients, b) asked KSBL not to transfer securities to, or out of, its clients’ demat accounts, based on the power of attorney (PoA) given to it by clients — it has asked depositories not to entertain any such requests from KSBL, c) disallowed any transfers from the DP account named Karvy Stock Broking, which is the common pool account of the brokerage, except to the beneficial owners who have paid the full amount of the share, and d) asked exchanges and depositories to take disciplinary action against the brokerage.

This is an ex-parte ad-interim order, meaning it has been passed after hearing only one party and the final order will be passed only after hearing both the parties. The NSE will conduct a forensic audit of KSBL’s books and submit a more detailed report soon. KSBL has been given 21 days to reply to the allegations, following which a final order will be passed.

What did Karvy do?

The SEBI order alleges that KSBL did not reveal the depository account named Karvy Stock Broking Ltd in the filings made to exchanges from January to August 2019. This account was categorised as a client account. The shares held in this account belonged to clients, but KSBL pledged these shares and transferred the money to its own bank accounts.

Further, these bank account details were not provided to the exchanges. SEBI allows pledging of clients’ shares, but only to meet the obligation of the respective clients.

What is of greater concern is that KSBL has transferred securities, off-market, from beneficial accounts of clients who have not traded in recent times.

KSBL also appears to have put through transactions using its own group companies where the transaction value was not in line with the shares held by these entities. The report further cites that ₹1,096 crore was transferred to Karvy Realty between April 2016 and October 2019.

Two main issues

The order highlights two main issues. One, many brokers had been pledging partly-paid shares (bought by clients through margin trading) with NBFCs to fund the purchase cost. Since the brokerage charged the client an interest on such transactions, it could benefit from the spread between the NBFCs’ cost of lending and the sum charged to clients. The brokerage charged on these deals was an added inflow.

But SEBI barred such transactions through a circular issued this June that gave brokers time up to October 1 to wind down all such transactions. This has led to a fund crunch among brokers with inadequate capital, leading to a delay in delivering shares to clients.

The other more serious issue that the episode brings out is the misuse of the PoA (power of attorney) given by clients to brokers.

Misuse of PoA

The SEBI order has stated that there were nine related party accounts of KSBL through which the brokerage executed transactions that were far greater than the value of stocks lying in the respective demat accounts.

An industry expert explains that many brokerages tend to trade through a network of subsidiaries for values that do not match the physical holding of stocks. When it is time to make the delivery, the brokers seem to be using shares held in the demat accounts of their clients to make the delivery. This clearly amounts to fraud.

The order states that KSBL transferred shares worth ₹27.8 crore in an off-market transaction from demat accounts of 156 clients who have not executed a single trade with it. Also, securities worth ₹116.3 crore were transferred from 291 clients who have not traded with KSBL since June 1, 2019.

What can investors do?

This should send alarm bells ringing for investors. Most of us sign a PoA while opening a brokerage trading account, allowing the broker the right to transfer securities in and out of our demat accounts. Such PoAs are, however, not mandatory.

Experts say that it is up to investors to decide if they want to give such a PoA to the broker. It is mostly clients who call the dealer and trade through them who may need to give such authorisation. If the broker facilitates electronic trading and electronic delivery of shares from the demat account, such PoA may not be needed. When the PoA is not given by a client, a DP slip may have to be signed and given to the broker after every sale.

The contracts entered into while opening a trading account could differ from one broker to another. Therefore, it may be a good idea to contact your broker and review the contract you have signed with the company. Find out if you have the option to revoke the PoA or change it to state that shares can be moved from your demat account into only certain specified accounts such as the settlement account.

Be diligent

You should also be more diligent about checking all the communications sent to you by stock exchanges and the depository participant (DP). The exchange sends you messages at the end of the day giving details about the transactions executed by you. Make sure that these details match your records. The DP will send you a notification once the shares move into your DP account or if shares are withdrawn. Watch out for suspicious transactions and do not dismiss these alerts without a thorough scan. Try to tally the month-end statements sent by the DP with your records diligently and report any problems to the exchange and the DP.

Finally, make sure that the email ID, phone number and PAN card details are updated with the DP as well as exchanges. It is mostly dormant accounts that are not linked to valid emails or phone numbers that are vulnerable to such misuse.

Published on November 26, 2019
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