[Gayatri Puthran is a 3rd Year B.B.A., LL.B. student at the Jindal Global Law School]
In a bid to promote ease of doing business, the Securities and Exchange Board of India (‘SEBI’) on 2 September 2020 by way of its circular titled ‘Disclosures on Margin obligations given by way of Pledge/ Re-Pledge in the Depository System’ (‘Disclosure Circular’) dispensed with certain disclosure requirements under the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 2011 (‘Takeover Regulations’). Regulation 29 of the Takeover Regulations mandates the disclosure of share acquisitions in certain circumstances, and includes the encumbrance of shares within the ambit of ‘acquisition’. This requirement, has now been done away with under the new pledge/ re-pledge mechanism. Marking a definitive shift from the previous title transfer collateral mechanism to the new pledge/re-pledge system which would be implemented by 1 September 2020, the circular marks a significant leap to advance investor’s interests and espouse a better securities market by revamping the entire payment, clearing and settlement system. Brokerages and investors alike, however, have expressed certain reluctance to this shift.
This post delves into the guidelines for the new pledge/ re-pledge system. In this regard, it evaluates SEBI’s effort to safeguard investors from infirmities in the previous regime. Further, it analyses the response of key stakeholders to the same.
Under the previous regime of title transfer collateral agreements, the general practice was for a client to provide power of attorney to brokers in order to facilitate meeting margin requirements. This power of attorney would enable brokers to transfer securities from the client’s demat account to their collateral account. This power was misused by brokers by using shares of inactive clients to provide margins for active clients, funding other businesses through those shares, and collecting dividends of inactive clients. Conclusively, a broker’s access to a client’s securities led to various loopholes and weaknesses in the previous system.
On February 25, 2020, SEBI released guidelines (under section 11(1) of the Securities and Exchange Board of India Act, 1992) for margin obligations given by way of pledge/re-pledge, after extensive consultations with stock exchanges, clearing corporations, and depositories. Aiming to curtail misuse and misappropriation of a client’s securities by trading members (‘TM’), clearing members (‘CM’) and depository participants (’DP’), the new system accepts collateral from clients by way of a margin pledge (the process will be elaborated below). The procedure for pledging is laid down under section 12 of the Depositories Act, 1996. Regulation 79 of the SEBI (Depositories and Participants) Regulations, 2018, elaborates on the same, which involves concurrence between the pledger, pledgee, depository participant, and the depository.
After several delays and extensions granted by SEBI in light of the Covid-19 pandemic, and allowing both the old and new regimes to co-exist during the month of August, the new system finally came into force from 1 September 2020 onwards. This is despite the fact that market players asked for further extensions to acclimatize to the new system.
New Pledge/ Re-Pledge System
The February guidelines prohibit title transfer collateral agreements that were previously the norm. This means that TMs and CMs can no longer transfer the title of a client’s securities to their own demat accounts – under the new system, clients’ securities will never leave their demat accounts. Compliance with the new guidelines means that TMs and CMs are to open separate demat accounts tagged as ‘client securities margin pledge account’ to accept margin pledges. Placing accountability and investor security at center stage, the guidelines prescribe that the entire trail of pledging and re-pledging from the client to the TM, TM to the CM, and CM to the clearing corporation (‘CC’) will be visible in the pledger’s demat account. A TM/CM can only re-pledge securities to the CM/CC through its ‘client margin pledge account’, thereby eliminating the risk of misuse by using one client’s securities as a margin for another client.
The guidelines further prescribe arbitration as the mode of resolving conflicts between all parties involved. Additionally, while clients can still grant power of attorney to TMs/CMs, under the guidelines this will no longer be considered to fulfill margin requirements.
These guidelines introduce a stringent system to subvert infirmities in the previous regime: CCs must amend their byelaws in compliance with the new procedure, intimate SEBI on the status of its implementation, and conduct half-yearly internal audits to monitor compliance.
In the previous regime of title transfer collateral agreements, the transfer of title led to instances of misutilization and misappropriation by brokers of client’s securities (by using client’s collaterals to meet settlement obligations for other clients or to raise funds for themselves). In 2019, SEBI banned Karvy Stock Broking for engaging in such practices. Therefore, an entirely new system was calibrated to ensure investor security.
Market and Stakeholder Reception
Rolling out of the new system amidst the pandemic has prompted several stockbrokers and depositories to air concerns about lack of preparedness. A member of the Association of National Exchanges Members of India stated that “…90 per cent of brokers are not ready to start the new mechanism on pledge or re-pledge because of the pandemic”. Key personnel from several notable financial services companies remarked that: first, new margin requirements would raise costs for active clients; second, imposing the new system has led to confusion and uncertainty which will be negatively affect the market; and third, market players currently lack operational and infrastructural preparedness to comply with SEBI’s February circular. An implementation of the new system has already led to slowdowns in operations and settlements: the pay-in process was completed at 5pm instead of the regular time of 10:30 am on 3 September. SEBI denied requests for extensions till the end of September to implement the new system, despite being informed of market unpreparedness during talks with the National Securities Depository Ltd and the Central Depository Services India Ltd.
SEBI’s intention to protect investor interests and promote the ease of doing business – gauged from the disclosure circular and the February guidelines – is commendable. These parameters are the cornerstone of the well-being of any country: securing investor trust and confidence is crucial for inflow of investments, which in turn encourages business growth, thereby increasing employment and standard of living. This is especially important during the pandemic, which has already destabilized Indian markets and impacted investment flows. The guidelines have paid close attention to loopholes in the previous system and suggested a well-thought out alternative – this alternative prevents misuse of the power of attorney, creates transparency in the entire trail of pledging and re-pledging securities, and firmly centralizes ownership and title of the securities with the investor himself.
However, the execution of the same is riddled with flaws. By overhauling the entire system, changing in background software, providing only a one-month adjustment period, ignoring pleas of key market players, SEBI has thrown a wrench in the smooth transitioning within the securities market. By paying heed to brokerages and depositories, SEBI could have granted another month for these players to familiarize themselves with the new system, understand operational issues, and come up with solutions. A rapid change in the entire system will cause further instability in the market, which is especially undesirable given the already volatile markets during the pandemic.
SEBI’s new pledge/re-pledge system satisfactorily addresses the loopholes in the title transfer collateral mechanism. When coupled with the disclosure circular, which relaxes disclosure norms, the new system promotes security in financial markets, prioritizes investor confidence and trust, and curbs avenues of possible misuse by intermediaries like brokerages and CCs. It is at the juncture of implementation however, that SEBI falls short. By not heeding to the requests and reports of market players, the shift from the old system to the new has been implemented hastily and without due regard to operational qualms and infrastructural capabilities. Going on forward would require consistent communication between SEBI and TMs/CMs/CCs to smoothen out the system and prevent further loss of investor confidence.
– Gayatri Puthran