Karvy Default: For Once SEBI Acts Quickly To Protect Retail Investors’ Interest
On Monday, 2nd December, the market regulator, Securities and Exchange Board of India (SEBI) asked NSDL (National Stock Depository Ltd) to transfer investors’ shares that were pledged by Karvy Stock Brokers Limited (KSBL), back to their respective depository (demat) accounts. This is an excellent move at a time when there is hardly any good news for the average saver. KSBL, one of the largest market intermediary and brokerage firms, had helped itself to investors’ shares held in demat accounts opened with it and pledged them to borrow heavily. The loans were transferred to Karvy group entities, mainly to a realty company.
Karvy has borrowed money from a clutch of banks and finance companies—Bajaj Finance, HDFC Bank, Axis Bank, ICICI Bank, IndusInd Bank and Kotak Mahindra Bank, among others. Bajaj Finance rushed to the Securities Appellate Tribunal (SAT) against the directive today. SAT has ordered a stay on any further transfer of shares back to clients (this could affect over 7,000 of Karvy’s clients) and directed the regulator to hear the lenders’ concerns by tomorrow and pass orders by 10th December. KSBL owes Rs345 crore to Bajaj Finance and it has already issued a loan-recall notice to the firm.
All this is along expected lines. Corporate India, with their battery of expensive lawyers, is good at ensuring that the justice system works efficiently for them by getting stay orders or interim orders or simply delaying proceedings. It is rarely that the regulator shows the wisdom to go back to basics and act in line with its core responsibility. But its quick action on Monday evening ensured that the scale of equity, for once, was tilted in favour of retail investors, not forcing them to run from pillar to post to salvage their investments.
Under the preamble of the Securities & Exchange Board of India Act, SEBI is mandated with three principal objectives. Of these, the first is “To protect the interests of investors in securities”; the other two are to promote the development of the securities market and to regulate it.
At a time when the regulator has been rapped for closing investor complaints without even examining them, it is good to see SEBI put the interests of a large number of retail investors first by ensuring that shares, that were illegally pledged by Karvy, were returned to investors’ demat accounts.
The practice, so far, has been different. In a slow and unequal justice delivery system, the disaggregated retail savers (depositors or investors) are always the losers. The big players and their expensive lawyers not only dictate policy but, often, can steamroller courts as well. SEBI’s action, this time, has reversed the process and protected the small investor, even as multiple other issues are contested and thrashed out in court.
The money involved is enormous—over Rs2,013.77 crore—belonging to 82,559 investors. The remaining investors (of a total of approximately 90,000-95,000) would get their shares credited after paying what is due to KSBL. Simultaneously, SEBI escalated its action against KSBL by suspending its trading licence with immediate effect.
For the banks and corporates, who are crying foul, the money recoverable from Karvy is hopefully less than the value of shares pledged. Most of them would have multiple business relationships with C Parthasarathy, Karvy’s promoter-chairman, and his group entities; so their ability to enforce their rights and recover dues is significantly higher.
On 22nd November, SEBI cracked down on KSBL with a hard-hitting, ex-parte
, interim order
barring it from taking on new clients or using the Power of Attorney (PoA) provided by its clients. The order stunned the market, but answered the complaints of thousands of investors who weren’t getting their money back from the firm. The action was based on a fairly detailed investigation by the National Stock Exchange (NSE) which, prima facie
, established that KSBL illegally pledged clients’ shares to raise funds.
It did this by hiding facts from the NSE and NSDL by failing to report certain DP (depository participant) accounts and crediting funds raised by pledging clients’ shares to its own bank accounts which were further transferred to a realty company.
Without going into details of how this was done in a digital environment, in a physical world it would mean that KSBL violated the trust of its clients and stole their shares.
According to the market scuttlebutt, it appears that some investors may not have been entirely unaware of what was going on; but we will come to that later. Karvy’s initial reaction was, interestingly, defiant; probably because it got away unscathed in the IPO scam of 2006 after a SEBI order was set aside by SAT.
When Greed Rules
Coming to investors, sources say that some investors themselves have created the possibility of being cheated by their broker-DPs by allowing their shares to be pledged and earn from them.
They were told how idle shares lying in a demat account could be turned into a source of income, by lending them, especially to make margin payments. They hence allowed their shares to remain in the broker's pool account, to be pledged as a pool. This opens the door to the possibility of brokers misusing the shares. A former SEBI official points out that “this works well when the broker pays interest regularly and the investors have no complaints. However, when the interest stops, many of these investors feign ignorance and play innocent victims.”
Unless they can show that Karvy fudged information and did not send them regular reports, such investors, driven by greed, may end up paying for their foolish and risky behaviour. SEBI also is aware of this practice and had tightened the rules in June, requiring a tri-partite agreement with investors. Those who were party to it would be a different category. The investigation would also show whether banks had done their due diligence and ensured that shares they had lent against were recorded with the depositories. And whether they had sought an undertaking from KSBL that the shares belonged to it and were unencumbered.
However, the bulk of investors may, indeed, be innocent victims; they now have their investment protected and the ability to move their business elsewhere. The episode, however, raises serious questions that need to be addressed quickly.
Are Broker DPs Safe?
A former executive director at SEBI points out that brokers were allowed to become DPs to provide a seamless system and a one-stop service to investors. In practice, though, it has been a constant battle for investors to protect themselves from being cheated by market intermediaries.
The first major battle was the misuse
of the mandatory PoA that brokers insisted as a requirement for online trading. These used to give brokers sweeping rights to investors’ money and were, often, misused to decimate
their investment. Moneylife
was part of this long battle
all through a decade ago, to clean up the system.
Over time, SEBI has come up with stringent rules to restrict misuse and ensure that investors receive information and alerts through multiple channels about transactions in their account as well as investments.
Brokers are also forced to transfer excess funds available with them back to the client account every quarter. In June, SEBI said that clients’ shares couldn’t be pledged to raise funds after the Allied Financial Services episode. According to Business Standard, another three-dozen brokers are under SEBI’s radar.
And, yet, KSBL with over 234,000 customers, could indulge in such brazen and criminal misappropriation of assets of a large number of investors. This shows that circulars and rules that cast an increasing burden on investors to be forever vigilant are not the answer.
After all, it is SEBI which is relentlessly forcing even long-term investors to dematerialise shares. It has also failed to provide appropriate infrastructure to those who wish to hold physical shares to be able to dematerialise/ rematerialise them as required.
So, the onus of ensuring that shares in DP accounts are safe has to be with the regulator; its inability to keep up with the ingenuity of fraudsters cannot be at investors’ cost. In this context, SEBI’s decision to move quickly and credit shares back to investors’ accounts is a heartening move in the right direction.
(This article has been updated on Wednesday 9.45 with a few additional details)