At a press conference on 29th March, Madhavi Puri Buch, chairperson of the Securities and Exchange Board of India (SEBI), made a bold pledge that has gone viral. She declared, “There will not be another Karvy issue in our capital markets... If another Karvy-like instance happens, it will be on our dead bodies..." This is a significant challenge considering that 32 stock brokers have defaulted in the past five years (Read: 32 Stock Brokers Declared Defaulters by NSE in Last Five Years: Govt) causing investors to lose several thousand crore rupees.
Karvy Stock Brokers Ltd (Karvy) was certainly the biggest of these broker defaults and involved brazen fraud and diversion of funds. But the series of broker defaults, mainly on the National Stock Exchange (NSE) exposed several dubious practices involving misuse of investor funds. While NSE was clearly negligent, the regulator was also caught napping. But SEBI has been quietly working at plugging loopholes through a series of actions over the past year.
Its latest circular bars brokers and clearing members (CMs) of stock exchanges from pledging client funds with banks to obtain a bank guarantee (BG) for clearing corporations (CCs). The order (Read: Stock Brokers and Clearing Members Can't Create Bank Guarantee Using Clients' Funds: SEBI) became operational on 1st May, but existing BGs have been given up to 30 September 2023 to be wound down. SEBI has also put in place a monitoring system by asking stock exchanges and CCs to submit data pertaining to collateral, including BGs obtained by brokers and CMs every fortnight.
The new rules coincide with a detailed, 88-page final order against Karvy by whole-time member SK Mohanty on 28th April imposing a penalty of over Rs21 crore on Karvy and its founder C Parthasarathy and a few employees and also ordering two group entities—Karvy Realty and Karvy Capital—to return the Rs1,443 crore funds illegally transferred to it in three months.
For those who have forgotten the details, in November 2019, NSE, in its inspection, found that Karvy (Read https://www.moneylife.in/tags/karvy.html) had pledged clients’ securities and misused the power of attorney (PoA) of as many as 95,000 clients, in some cases by promising to pay interest and, in others, by stealing shares from dormant depository participant (DP) accounts. The amount involved was over Rs2,300 crore, but, since the pledged shares remained with Karvy, SEBI had acted with rare alacrity and ordered the DP to return the shares to investors. This protected 90% of Karvy’s clients whose shares were pledged with ICICI Bank, HDFC Bank, IndusInd Bank and Bajaj Finance. The money was transferred to several group companies, as mentioned in the SEBI order. It was another year before SEBI declared Karvy a defaulter, having been fooled by its fake assurances about selling assets to repay investors. SEBI’s final order in the Karvy case may sound tough but is merely cosmetic, since the Karvy group has no funds and the hefty penalties and funds are largely irrecoverable.
However, the series of steps initiated by the regulator to prevent the misuse of investor funds lying with brokers may actually have a positive impact. Investor money available with brokers is huge. SEBI’s consultation paper says, on 6 January 2023, India’s 1,355 stock brokers held at least Rs46,000 crore of investors’ funds, but they are not subjected to all the regulatory safeguards that apply to other financial institutions who accept client funds.
SEBI’s circular admits that brokers and CMs have been exposing the market and clients to risk by pledging investors’ shares with banks to procure BGs which they submit to clearing corporations to obtain better leverage and higher trading limits. This was repeatedly exposed in broker default cases that have been extensively reported by Moneylife (Read: https://www.moneylife.in/tags/brokerdefaults.html). We had pointed out that large clearing brokers, clearing corporations as well as banks were happy to collude in different ways to help enhance broker-leverage at the cost of investors. This often led to disaster.
SEBI has remained silent on the issue, while the Reserve Bank of India (RBI) buried the matter after a preliminary investigation, since the practice wasn’t rampant enough to pose systemic problems. A broker explained ‘funded FDs’ to me as follows. A broker will deposit Rs10 crore in a bank, and get a loan of Rs90 crore. The entire sum of Rs100 crore stays with the bank which issues a letter to the clearing house falsely confirming the availability of an FD without encumbrance.
This subterfuge gave brokers the necessary leverage to take larger punts in the futures market during a bull run as profits would be significantly higher than the borrowing costs. Since banks’ ability to issue BGs was limited by CC rules governing their exposure, funded-FDs allowed them to go beyond BGs and provided another income stream. Like Karvy, the defaults of Anugrah Stock & Broking Pvt Ltd., BMA Wealth, VRise (a large sub-broker) exposed illegal pledge of clients’ shares by brokers. Like in India Nivesh, where HDFC Bank refused to honour the Rs100 crore FD, in BMA Wealth, the same Bank refused to return investors’ shares illegally pledged by the broker.
Corrective Action
A series of actions have been initiated over the past year to plug the loopholes exposed by the broker defaults.
In October 2021, SEBI had asked stock brokers to make an asset-wise and client-wise disclosure of collateral received by them every day. The information is accessible to investors on web portals set up by clearing corporations.
In May 2022, SEBI directed CCs to ensure that collateral belonging to a client is used only towards obligations of that client based on information provided by stock brokers.
Stock brokers are also required to upload client funds’ data on stock exchanges which then compare ledger balances declared and initiate action if a shortfall is detected. Moreover, brokers are required to transfer funds arising out of a payout to their clients within 24 hours and running accounts have to be settled at least every quarter.
Explaining the latest action, SEBI says, the current framework still allows brokers and CMs to retain a part of the collateral provided by clients, before passing the balance to CCs during pay-in and the same happens while returning funds after a payout. Brokers used to convert these surpluses with banks, into BG or a fixed deposit receipt (FDR) which were placed as collateral with the CC enhancing leverage available to them.
SEBI now wants the funds to be deposited with CCs on an ‘as is’ basis, with investors having the option of withdrawing them at any time. If they remain with the broker, they can only be placed in low-risk, liquid, money market instruments. The mention in the consultation paper of brokers converting investor funds into BGs and FDRs is the only acknowledgement by the regulator that this was a fraudulent practice that worked against investor interest.
While SEBI’s actions to plug loopholes are welcome, it is a pity that all other stakeholders who colluded to inflict massive losses on investors get away scot-free. It is easy to blame investors’ greed for the losses they suffer; but there has been no attempt to segregate innocent victims who were defrauded by brokers like Karvy.
While the money they have lost runs into several thousand crore rupees, the much-touted investor protection fund of the near-monopoly NSE has only paid out Rs490 crore as compensation to investors between 2020 and 2023. The largest chunk of this has gone to victims of Karvy, who have been paid Rs414 crore (according to a reply in Parliament). Some investors have got together to file lawsuits but there is little hope of any judgement or justice on the horizon, given our slow judicial system.
Importantly, Ms Puri Buch’s challenge of ‘on our dead bodies’ will only work if the circulars are accompanied by constant and rigorous monitoring.
Implementation is the key - whether on dead bodies or otherwise (pun intended). We already, in most cases, plethora of laws/rules/regulations/policy decisions and circulars, etc. What we need is timely and rigorous implementation.
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