How Exchanges, Clearing Houses, Clearing Brokers and Banks are Permitting Frauds by Brokers
A long list of broker defaults, that have decimated investors’ savings in the past one year or so, have one thing in common. Investigation has always focused on what happens within the trading systems of exchanges and ignores the role of those who facilitate and enable the fraud perpetrated on investors. Massive losses are distributed among thousands of disaggregated investors, spread across the country, who do not have the ability and resources to fight back effectively. While it is easy to blame investors for being greedy and ignoring risks, those complicit in enabling fraudulent activity are getting away.
A legal system that is slow and expensive and (makes a virtue of disallowing American-style outcome-based fees) also works against investors and savers looted by financial fraud. What is worse, the Securities and Exchange Board of India (SEBI), the exchanges and other empowered intermediaries are also complicit in their failure to detect fraud soon enough. Consequently, when a broker fails, all of them get active and work at covering up their own negligence and failure. This takes the form of long-winded investigation and delays, seizing of books and computers, refusing to update investors and forcing them into individual arbitration proceedings, where they are invariably at a disadvantage.
Advocate PR Ramesh, who has spent over two decades with SEBI and the financial sector, brought the issue centre stage by pointing out that what Anugrah, Karvy, Allied and a dozen other brokers have done is beyond what can be termed as naïve investing or taking market risk;there is also a large element of fraud which has never received the attention it deserves. To summarise what he said: it is true that investors fell for the promise of high returns; but that is only a part of the problem. While investors must be willing to bear losses arising from speculation, they cannot be made to carry the can for outright fraud which is not being investigated as a criminal offence.
Advocate Ramesh has over two decades of experience in securities law and advocate Sumit Agrawal, also formerly from SEBI’s legal department, were addressing investors at Moneylife Foundation’s webinar on “What Was Wrong with Anugrah’s Promise & How Can Investors Protect Themselves in This Crisis?” which was attended by hundreds of investors. Here is a link
to the event.
The point that advocates Ramesh and Agrawal made in the discussion is that key players who tacitly support such fraud also ought to be held accountable. These start with SEBI (whose highly sophisticated market monitoring system never seems to work), the clearing corporation (which has framed rules to protect itself from liability without any accountability), the clearing brokers (large brokerage firms may be facilitating poor margins or misuse of client funds and securities) and, finally, banks and finance companies who are willing parties to defrauding investors with dubious arrangements that earn them fees. None of them has ever been called out or held accountable, until now. But, as advocate Ramesh pointed out, it is high time they were dragged to court and held responsible.
Role of Clearing Members
Of these, the clearing corporations (CC) are best protected. They are empowered to order clearing brokers to auction shares, invoke margins in the form of bank guarantees (BGs)/fixed deposits (FDs) and protect itself. The role of the clearing broker is important in the context of many recent failures. Let us look at Edelweiss Custodial Services (Edelweiss), which has played a controversial role in at least three recent broker defaults: Anugrah, India Nivesh (where Edelweiss took a Rs100 crore hit in April, when the broker shut down operations and is now litigating the matter) and VRise Securities.
The founder of Anugrah and Teji Mandi Analytics (TMA) have been blaming
Edelweiss for their problems. An email from Arun Gandhi, founder of TMA says, “The Clearing Member made ‘unnecessary and wrongful deductions’ from some accounts by selling their stocks.”
Our attempt to get answers from Edelweiss resulted in denials, partly incorrect information and then silence. We have no answer to a simple query: Did Edelweiss choose to sell investors’ shares to meet mark-to-market losses rather than invoke a BG that was provided. Instead, a spokesperson claimed that Anugrah was repeatedly warned about hitting loss limits (before the account moved to ICICI on 20 July 2020 and not early June, as we were informed by Edelweiss earlier) and pending corrective action, “we will take necessary action as per our risk policy.”
Further, that “Anugrah, at no point in time communicated nor instructed us to invoke their Bank Guarantee (BG).” In another message, the same person had said, “If a BG is given as collateral, there's no reason for us to not invoke unless BG itself is deficient.” In another email, the spokesperson said, there is “no incentive for a clearing member to make unauthorised sales” of client securities. But what if there are indirect incentives, such as evading responsibility for having hidden defective and deficient margins in the form of FDs and BGs?
Just a few weeks ago, I wrote a piece on how a 14-year old brokerage firm, India Nivesh Securities went belly up
in April and HDFC Bank has refused to honour a Rs100-crore FD because it was ‘funded’. While the matter is under arbitration, we have no clarity from SEBI or the Reserve Bank of India (RBI) on the legality of ‘funded FD’ and how it was accepted by the clearing broker (again Edelweiss) or issued by HDFC Bank. The National Stock Exchange (NSE) and its clearing house has strongly refuted our queries about a the existence of many more deficient FDs and BGs by elaborating its strict control systems.
As advocate Ramesh says, delays and litigation always work in favour of the regulator and bigger market intermediaries. The possibility of the BG also being deficient is a new twist which needs investigation, because there is no clarity on how a guarantee can be defective. We learn that NSE has sent a set of questions to Edelweiss; but, as always, nobody is forthcoming with answers.
There is a third case where NSE’s clearing corporation had even issued directions to Edelweiss to return
securities belonging to a banned sub-broker VRise in February 2020. Investors have complained that their shares were fraudulently submitted as collateral. Edelweiss has challenged NSE’s order before securities appellate tribunal (SAT) and advocate Ravi Hegde has filed an intervention petition on behalf of investors.
In VRise as well as Anugrah, there are allegations that Edelweiss allowed the brokers to ‘intermingle’ collateral provided by clients with that required from the broker for his proprietary trades. When the broker incurred losses in proprietary trades, client collateral has been sold by clearing member, knowing full well that the shares belonged to investor clients.
Advocate Hegde points out that the regulations of clearing corporations are explicit that a clearing member cannot ‘make improper use of client securities and funds’. More importantly, the regulations clearly say, “no clearing member shall exercise any discretionary power in a client’s account unless such a client has given prior written authorization…” Although the rules are explicit, here again, long-drawn litigation tends to work in favour of larger intermediaries.
Role of Banks and Lenders
The next set of intermediaries, who tacitly or inadvertently collude with dubious brokers, are banks. The best recent example is that of Karvy Stock brokers where SEBI acted quickly
to protect over 83,000 investors (although another 7,000+ were left in the lurch). Here, a set of banks—HDFC, ICIC Bank, Indusind Bank and Bajaj Finance had allowed Karvy to borrow money by pledging clients’ shares, putting the investment of over 90,000 investors at risk. This is the only time that SEBI pointed to their failure to do due diligence and moved swiftly to protect a majority of clients. Karvy has been very slow in paying back investors and some money/shares have been released recently after my follow-up.
Funded FDs, exposed by the India Nivesh case, are another fraudulent way of defrauding retail investors. Extending a short-term loan that is fraudulently shown as an FD for margin payments to make larger speculative punts endangers the market. We have seen no action from either regulator as yet and the extent of this problem is unknown. As for the defective BG, NSE strongly refutes such a possibility, even when a large clearing member has alluded to such a possibility.
A third example, involving HDFC Bank, is that of BMA Wealth, where HDFC Bank has refused
to return shares that were wrongly pledged by the defaulter broker. The Bank has written to investors that “it is well within its legal rights to sell shares pledged by the brokerage under the loan agreements.” It further claimed that BMA had ‘expressly represented’ that it owned the shares pledged. In doing so, it washes its hands off any responsibility to evaluate the brokers’ finances and verify whether the clients had agreed to pledge the shares.
Clearly, it is the law of the jungle that operates in the capital market rather than regulation. The biggest intermediaries hire expensive lawyers and drag matters through multiple legal forums until retail investors, who have already lost money, simply give up.
Until our market regulator and all those in regulatory and fiduciary positions (clearing brokers, clearing corporations, exchanges and banks) are made accountable, this will lead to a rapid erosion of investor confidence in markets.