Impact of Defaults by Stockbrokers: Are Investors the Biggest Losers?

[Shivam Tiwari is a final year law student pursuing B.A. LL.B (Business Law Hons.) at National Law University, Jodhpur.

This post was earlier published in the Indian Review of Corporate and Commercial Laws]

The Indian financial market has witnessed an increasing number of defaults by stockbrokers in the past few years. The Securities and Exchange Board of India (“SEBI”) has debarred brokers like Kassa Finvest Private Limited and BRH Wealth Kreators Limited from participating in the stock market. With the advent of Karvy Stock Brokers Ltd. (“KSBL”) into the scenario, the situation has not only become alarming for the investors, but also may prove to be a hurdle to the Government’s vision for financial market development.

An Overview

SEBI has, over time, introduced various rules and regulations to govern the functioning of the Indian stockbrokers. With the aim to protect the retail investor, SEBI has issued various circulars such as:

(a) the Circular dated November 19, 1993 on “Regulation of Transaction between Clients and Brokers (“1993 Circular”), restricting brokers from transacting through the client’s account, except in accordance with conditions provided in the said circular;

(b) the Circular dated April 17, 2008 (“2008 Circular”) on “Collateral Deposit by Clients and Brokers”, wherein stockbrokers cannot use the clients’ collateral for any purpose, other than meeting the respective client’s margin requirement or pay-ins, with the client’s approval;

(c) the Circular dated September 26, 2016 (“2016 Circular”) on “Enhanced Supervision of Stock Brokers/Depository Participants” where, in order to ensure transparency with respect to client’s securities, SEBI mandated bourses to put in place a mechanism to ensure that client’s fund balance and securities balance are uploaded by the brokers effectively; and

(d) finally, the Circular dated June 20, 2019 on “Handling of Clients’ Securities by Trading Members/Clearing Members” (“2019 Circular”) issued by SEBI, which summed up all the circulars applicable to stockbrokers in a comprehensive manner and, more importantly, completely prohibited the pledging of client’s securities by stockbrokers in any manner whatsoever, even with client’s prior approval.

Despite the above steps taken by SEBI, in the recent past stockbrokers have been found to violate applicable rules and regulations, the biggest defaulter being KSBL (to the tune of approximately INR 2000 crores).

In this regard, National Stock Exchange (“NSE”) submitted its preliminary report to SEBI wherein it was found that despite the fact that the clients and investors are the legitimate owners of the securities lying in their respective depository accounts, KSBL: (a) misused the power of attorney given to them by clients by surreptitiously selling their securities to generate funds, and later transferring those funds to their own account, and (b) resorted to subterfuge by not disclosing to the Depository Participant (DP) Account to the NSE. As a result, the NSE observed that KSBL violated, inter alia, the Code of Conduct for stockbrokers provided under Schedule II of the SEBI (Stock Brokers) Regulations, 1992 and all the above mentioned SEBI Circulars by transferring the funds to their own account, misusing client’s money for their personal gains and pledging client’s shares to raise funds without any prior approval from the latter.

Compensation from the Investor Protection Fund (IPF)

To tackle problems of default by stockbrokers, SEBI came up with comprehensive guidelines for an IPF, wherein it provided that investors’ claims arising out of a default of a broker or member of the exchange shall be eligible for compensation from the IPF. These claims are however subject to fixed compensation limits determined by the stock exchanges (minimum limit being INR 1 lakh and maximum being INR 25 lakh).  For example, if an investor loses its fund, which is worth INR 1 crore and, after realisation of stockbroker’s assets, he gets INR 50 lakhs as recovery for the loss and another INR 25 lakhs from the IPF, the investor will still suffer a loss worth INR 25 Lakh owing to the act of stockbrokers.

Other Remedies

– Arbitration: IPF guidelines also provide for an arbitration mechanism pursuant to which investors can make a claim for the balance amount, if the claim amount is more than INR 25 lakh.

– Consumer Protection Act, 1986: There was lot of ambiguity with respect to whether the investors can move the relevant consumer court against the stockbrokers for redressal of their grievances. By way of its letter dated July 9, 2015 to the stock exchanges, SEBI responded in the negative as regular purchase and sale of shares is in the nature of ‘commercial purpose’ and any dispute arising solely out of such commercial transactions does not fall under the purview of the Consumer Protection Act, 1986.

What is There in the Investor’s Basket?

Investors seem to be the biggest losers in this game as they have limited recourse to their grievances against these defaulting stockbrokers. In all the matters related to stockbroker’s default, SEBI has ensured that such securities which were traded or pledged illegally must be restored to almost all the rightful investors. However, the problem arises where the stockbroker’s funds are inadequate to make good the loss of the investors.

The maximum number of investments in India are carried out through stockbrokers with the objective of getting favourable returns, but if the investments itself is at the stockbroker’s peril then it will be extremely challenging for the market to find investors. Moreover, investments through intermediaries are based on the notion that their protection is well regulated through SEBI and other regulatory mechanisms and, therefore, fewer chances exist of investors getting hoodwinked by the stockbrokers, but recent instances of default by the stockbrokers in past few years has led to serious apprehension by the former that their investments might dissipate. This has shaken the basic foundation on which a ‘client-broker’ relationship is based. Furthermore, investors also do not have any remedy against the brokers under the Consumer Protection Act, 1986, which further restricts the remedies available to the investors against the defaulting stockbrokers.

Suggestions

  1. Mandatory Corporate Governance Reforms:

Similar to public listed companies that meet a certain threshold, there should also a mandatory provision for an independent audit and appointment of at least one independent director on the board of stockbroker corporations in order to maintain transparency and accountability. For example, section 143(12) and Schedule IV of the Companies Act, 2013 (“Act”) obligate the auditor and independent director of the company respectively to report any fraud which it believes is being or has been committed. Moreover, the presence of an independent director on board will forestall any law-defying action intended to be taken by other board members.

  1. Increase in Base Minimum Capital (“BMC”) Requirements for Stockbrokers:

BMC is the deposit given by the member of the exchange against which no exposure for trades is allowed. These margins are required to be furnished by the members under the bye-laws, rules and regulations of the stock exchanges and it is meant for any contingencies in future or any other claims of the trading member for the due fulfilment of its engagements, obligations and liabilities arising out of or incidental to any bargains, dealings or transactions such as operational risk and client claims.

Since the market structure has undergone significant structural changes over the years, it is high time to revise the BMC requirement for stockbrokers as BMC was last revised almost 7 years ago in 2012 with the limit increasing from ₹ 10 Lakh to ₹ 50 Lakh. This will provide an additional recourse to the suffering investors in order to claim compensation from this margin deposit.

  1. Increasing the Liability on the Bourses:

Several circulars issued by SEBI in order to protect the interest of the investors also impose an obligation on the stock exchanges to ensure better compliances of all the laws formulated by them. On multiple occasions, SEBI has directed the stock exchanges to make necessary provisions in their bye-laws and regulations for the purpose of regulating transactions and handling of securities between clients and brokers, specifically under the 2019 Circular. There lies a responsibility on stock exchanges ensure compliance of rules and regulations by the stockbrokers and, if the former fails to fulfil such responsibilities, stringent liability must be fixed on them. This fixing of liability on the stock exchanges will ensure better compliance of the rules and regulations by the brokers and therefore less chances of such defaults in future.

  1. Know Your Broker

“Know Your Customer” (“KYC”) is a process by which identity of the customer is verified by business entities. It helps in ensuring that business’ services are not misused. Similarly, on these lines, customers should also be given an opportunity to verify the veracity of the broker’s reputation and financial condition in order to take an informed decision regarding the investment through an intermediary in order to avoid any flimflam in future.

Conclusion

Remedies available to the investors should be commensurate with the loss suffered by the investors or else they will be dissuaded and left with no option other than pulling back from making investments. Mere tightening of existing rules and regulations will not provide a conclusive solution to the investors. Rather the regulator must focus on proper implementation of the existing laws and ensure better coordination between the market players especially stock exchanges and clearing corporations as they play a key role in monitoring brokerages. Moreover, investors have been affected immensely by these defaults and, if such defaults continue to occur in future, it will be a colossal task for the stockbrokers to regain trust of these investors in the future.

Shivam Tiwari

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