SEBI Informal Guidance on Receipt of Broking Income from Advisory Clients

[Rakshita Poddar is an Associate at Mindspright Legal in Mumbai]

India’s financial advisory market has been developing at a rapid pace in the last decade and this required financial regulators like the Securities and Exchange Board of India (SEBI) to introduce a comprehensive and transparent set of laws for scrutinising the conduct of the market participants like investment advisers. Accordingly, in 2013, SEBI introduced the SEBI (Investment Advisers) Regulations, 2013 (‘IA Regulations’) to regulate unregistered investment advisors. An investment adviser is defined to mean any person who is engaged in the business of providing investment advice in exchange for consideration. Such persons are required to obtain a certificate of registration from SEBI under the IA Regulations.

Exemption from Registration

Even so, the IA Regulations provides for exemptions from registration, among others, to certain persons who are already regulated by SEBI or some other regulatory authority. In regulation 4(g) of the IA Regulations, any stock broker registered under the SEBI (Stock Broker and Sub-Broker) Regulations, 1992 who provides any investment advice to its client incidental to their primary activity is exempted from registration as an investment advisor. The stock brokers can avail of this exemption only if they comply with the general obligations and responsibilities mentioned in chapter III of the IA Regulations.

The term ‘incidental to’ mentioned in the above regulation has been defined in Black’s Law Dictionary, 10th edition, as “subordinate to something of greater importance; having a minor role.” The Supreme Court in Royal Talkies, Hyderabad v. Employees State Insurance Corporation (1978) has observed that a thing is ‘incidental to’ another if it merely appertains to something else as primary. Surely, such work should not be extraneous or contrary to the purpose of the establishment, but need not be integral to it either. Further, the FAQs on IA Regulations state that ‘incidental activity’ with respect to stock broker means the provision of basic advice pertaining to investment in securities to broking clients.

Amendment in IA Regulations

There was substantial increase in investor complaints against investment advisers, including for charging exorbitant and extraneous fees without proper segregation of the services provided as well as conflicts of interest between advising and execution or implementation services. Therefore, in order protect the interests of the investors, SEBI floated various consultation papers from 2016 to 2020 proposing constructive changes in the IA Regulations.

SEBI amended the IA Regulations in September 2020 and inserted regulation 22A which states that an investment adviser may provide implementation or execution services to the advisory clients in securities market, provided that no consideration, including any commission or referral fees, is charged by it directly or indirectly.

SEBI’s Informal Guidance to HDFC Securities Limited

Recently, HDFC Securities Limited (a SEBI registered stock broker and investment adviser), by way of its letter dated November 2, 2020 requested SEBI for an interpretative letter under SEBI (Informal Guidance) Scheme, 2003 as to the applicability of the amended provisions of the IA Regulations. The query of HDFC Securities Limited was: “Can a trading member receive broking income from advisory clients for execution services?”

By way of its letter dated January 8, 2021, SEBI responded to the guidance sought and stated as under:

“3.2.1. The client has signed up with the same entity for both broking services and investment advisory.

3.2.2. As per the aforesaid provisions of Regulation 22A, an investment adviser may provide implementation services to the advisory clients in securities market. However, the client shall not be under any obligation to avail implementation services and thus, only after the advisory client has given consent to receiving implementation services in securities market, investment adviser or group or family of investment adviser can provide implementation services. Further, the investment adviser or group of the investment adviser shall not charge any implementation fees from the advisory client.

3.2.3. Hence, a trading member or its group entity cannot receive any broking income from advisory clients while providing execution services whenever such execution is emanating from advice offered by the trading member as an investment adviser.” [emphasis added]

The effect of this informal guidance is that an entity which has obtained two separate registrations with SEBI, as a stock broker and investment adviser, will not be able to charge broking income from the broking clients who are also its advisory clients and their trades emanating from the investment advice.

Since regulation 22A falls within Chapter III of the IA Regulations, the stock brokers who were providing incidental investment advice to their broking clients and were exempted from obtaining a separate registration under the IA Regulations will have to comply with the regulation. As broking income is a form of implementation or execution fee, such stock brokers will now be prohibited from charging broking income from their clients to whom they provide incidental investment advice, where the trades emanates from such incidental investment advice.

Conclusion

SEBI’s conclusion in the informal guidance may create compliance issues for the stock brokers and may hamper their business. Though the stock brokers are exempted from registration as investment adviser if they offer incidental investment advice, they are now obligated to comply with regulation 22A, which states that a stock broker cannot charge implementation or execution fees from their clients. Even if a stock broker proposes to provide incidental investment advice to its broking clients without consideration, regulation 22A will stand attracted and such an entity will still not be able to charge broking income from its clients.

On the one hand SEBI is exempting stock brokers providing incidental investment advice from obtaining a separate registration as investment adviser and, on the other it is hampering their business by prohibiting the stock brokers from charging broking income from their clients. In my opinion, it is crucial that SEBI consider exempting stock brokers providing incidental investment advice to their broking clients from complying with regulation 22A.

Rakshita Poddar

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