SEBI’s Karvy Order: Tightening the Screws on Stock Brokers

Late on Friday, 22 November 2019, the Securities and Exchange Board of India passed an order in the case involving Karvy Stock Broking Limited (KSBL). The circumstances surrounding the order are atypical. The urgency of the situation is evident in the fact that the SEBI order, passed very late on 22 November, relies upon a “preliminary” report that it received from the National Stock Exchange of India Limited (NSE) that very day. Moreover, the order is on an ex parte ad-interim basis.

The crux of the matter is that NSE’s investigations indicate the use by KSBL of client securities to create pledges to generate funds for KSBL. This was allegedly done so without the prior permission or knowledge of the clients. Moreover, funds belonging to clients are said to have been transferred to a group company, Karvy Realty Private Limited. Shortcomings were observed in reporting of certain transactions and their outcomes that had hitherto led to the regulators being kept in the dark regarding such situations.

In a nutshell, the allegations indicate the use of client securities and client funds either for benefiting other clients or for KSBL itself (through proprietary trading or accounts). While the transactions tend to betray the nature of a client-broker relationship, SEBI also found that they violate a catena of regulations issued by SEBI and the stock exchanges to prevent such conduct that put the interests of the clients in conflict with that of the brokers themselves. SEBI’s order lists out the various circulars that have been violated by KSBL’s actions.

The trajectory of the regulatory restrictions surrounding stock brokers, as listed out in SEBI’s order, indicates that SEBI has progressively tightened the regime for stock broking. In particular are measures it took in June 2019. After highlighting the various circulars, SEBI found widespread violations on the part of KSBL:

17. Thus, the facts of this case need to be looked at in the light of aforesaid legal position regarding the handling of clients’ securities by the stock broker. In the present case, the report of NSE observes that KSBL has misused power of attorney given by its clients. KSBL has sold client securities in the market in disguised manner through own controlled entities and have used the funds for its own purposes. KSBL in order to hide its misdeed has not even reported this DP account no. 11458979, named KARVY STOCK BROKING LTD (BSE) in the submissions made by it to NSE from January, 2019 to August, 2019. It is only during inspection by NSE, this account came to notice. NSE report finds that there are numerous transactions in DP account no. 11458979, named KARVY STOCK BROKING LTD (BSE) whereby securities of the clients have been moved. Securities of clients received in pay out are transferred from the pool account to this account and also securities lying in the demat account of the client(s) are also transferred into and from this account misusing power of attorney given by the client.

18. The securities lying in the aforesaid DP account actually belong to the clients which are the legitimate owners of the securities. Therefore, KSBL did not have any legal right to create any kind of pledge on these securities. Even if the client securities were pledged, it should have only been for meeting the obligation of the respective clients which was not observed in this case. Considering the issue of misuse of clients’ securities by KSBL in unauthorized manner, for its own use and purposely not disclosing the DP account no. 11458979, named KARVY STOCK BROKING LTD (BSE) to the Exchanges in their reporting create a serious doubt on the conduct and integrity of KSBL.

Based on these findings, SEBI has prohibited KSBL from taking on new clients in respect of its stock broking business. Moreover, it has asked the depositories to monitor the movement of securities to and from the depository account of KSBL, and also to not act upon instructions given by KSBL on behalf of clients under powers of attorney.

A number of questions emerge. Based on the evidence thus far available with SEBI, the violations appear egregious, given the stock brokers’ responsibilities to keep their funds, securities and transactions distinct from that of clients, and also among different clients themselves. Moreover, there continues to be some ambiguity regarding the extent of the problem. There is reason to be believe that the present situation is not limited to KSBL, and that several other brokers face a similar predicament. The trajectory of the regulatory developments also indicates that the tightening regulatory regime may have led to the present implosion. In particular, this has been attributed to SEBI’s June 2019 circular that imposes considerable obligations on stock brokers in this behalf, which KSBL and others may not have been able to cope up with.

At the same time, the situation continues to be fluid. KSBL now has the opportunity to defend itself before SEBI within a period of 21 days. Since SEBI’s present action is based on NSE’s “preliminary” investigation, it is not clear what direction the matter will take once more facts are unearthed. More importantly, this could very well be the tip of the iceberg in what could turn out be a broader systemic problem unearthed.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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