Making Sense of the Karvy Quagmire

On November 22, 2019, the Securities and Exchange Board of India (“SEBI”) passed an ex parte-ad interim order against Karvy Stock Broking Limited (Karvy), a stockbroker and a depository participant registered with Sebi.

The order was based on a preliminary report by the National Stock Exchange of India Limited (NSE) which stated that Karvy had been in breach of several regulations vis-a-vis pledging and misuse of client securities.

It noted that the matter required urgent regulatory intervention and inter alia barred Karvy from taking any new clients and directed the depositories (NSDL and CDSL) not to act upon any of the instructions given by Karvy in pursuance of power of attorney given by its clients.

The preliminary report by the NSE alleges various wrongdoings on Karvy’s part. The central of these is that Karvy pledged client securities and transferred the proceeds from such transactions to its associate and subsidiary company- Karvy Realty.

The order puts this amount at about Rs. 1096 crores, which has since been disputed by Karvy. The order also observes that Karvy moved client securities to its own unreported account at several instances and cites these instances as misuse of the power of attorney (“PoA”) given by its clients. The order makes reference to multiple regulations and circulars dating back to 1993 issued by SEBI, which stand violated by the conduct of Karvy.

Since this is an interim order by SEBI and a forensic audit by the NSE is underway, it shall be prudent to reserve judgment until all the fact emerge. Instead, we shall focus on the recent clampdown by SEBI on the pledging of securities by brokerages and the impact it can have on the market participants. The SEBI order with respect to Karvy can provide as an apt platform in trying to understand this.

The expansion of discount broking and the increasing competitiveness in the broking business have resulted in brokerages coming up with novel ideas to make profits.

One of such practices is margin funding. It essentially entails a broker allowing clients to buy stocks for which they can pay later and the broker funds this by borrowing from lenders by pledging the securities bought using borrowed funds. The spread between the rate at which the lender lends to the broker and the rate at which the broker then lends to the client is the margin of profit that is made by the broker in such a transaction.

This practice was becoming increasingly problematic for the regulator as it oftentimes meant that brokers would not distinguish between paid and unpaid securities, which would translate into a charge being created on completely paid for securities, akin to what has been observed in the Karvy case. This also led to a situation where brokers could easily exploit the PoA given by clients to transfer shares from the clients’ account to a pool account or the broker’s own account, and pledges then could be made on such transferred securities. In Karvy’s case, Sebi has observed that proceeds from such pledges were used by Karvy to fund a subsidiary business.

SEBI has been trying to curb such practices and has been issuing circulars to that effect since 1993. In spite of such regulations in place, clients had been complaining for a long time that brokers were not transferring securities from the pool account to the client account within the stipulated time period.

In view of such complaints, a circular issued in 2016 further put restrictions on pledging client securities. It stipulated that brokers could only pledge securities of those clients who were indebted to the broker to the extent of such debt and also prescribed for delineation of such securities and the funds generated by pledging them from other clients’ or proprietary accounts. It also directed the brokers to keep records of authorisation given by the clients to pledge their securities.

It again issued a circular titled ‘Comprehensive Review of Margin Trading Facility’ in 2017, which laid out the rules that must be complied for providing margin-trading facility to clients. It re-emphasised on the separation of funds and securities of clients availing margin-trading facilities. However, complaints from clients continued to prevail and non-compliance was rampant.

Finally, in June 2019, SEBI issued another circular, which essentially bars brokers from creating pledges on client securities even with the authorisation of the clients and further stated that all securities already pledged must be unpledged before August 31, which was later extended to September 30.

A prima facie overview of the Karvy saga suggests that Karvy failed in unpledging these securities. It has been suggested that this was because the money was diverted to a realty company and since the realty sector has been undergoing a financial crunch, it was not able to realise the money from there.

In any case, it is clear that SEBI is finally coming down heavily on brokers to protect client interests. Furthermore, this has deep implications for various market players viz. brokers, clients and lenders.

Following this debacle, the depositories swiftly transferred the majority of the pledged securities to the clients. This was met by opposition with the lenders who claimed that they had no knowledge of Karvy’s misdoings and had advanced the loans in good faith and therefore, had the right to the pledged securities.

However, SEBI ordered that since Karvy was not the ‘owner’ of these securities, it could not have passed off better rights that it had. It also stated that the banks had the duty to verify Karvy’s title over the securities while they had merely relied on the representation made by Karvy, and that any relief the lenders sought would have to be pleaded before the civil courts.

As the issue is ongoing, it is likely that the lenders would appeal against the SEBI order on the grounds that the depositories and the DPs are responsible for ensuring that the pledger is indeed the beneficial owner of the securities since they are indistinguishable for the banks. However, the chances of status quo ante being granted by the higher bodies seem quite narrow.

The Karvy case has gained a lot of attention especially because of the scale of funds involved. In terms of implications, it could be the brokers who would be affected the most. While SEBI has had regulations barring brokers from pledging client securities unless the proceeds are used for the specific uses of the client, the June 2019 circular puts an end to this practice.

This means that any broker who wishes to provide this service will have to invest its own capital to provide such loans. This could translate into many small brokers going out of business or scaling down as margin trading brings a great chunk of profits to several brokers who might not have the capital to sustain the business at the same level.

Although not the focus of this article, another aspect of the order with respect to Karvy related to the misuse of PoA given by clients. In this regard, pool accounts held by the brokers have come under scrutiny. SEBI has put out a discussion paper titled ‘Usage of pool accounts in Mutual Fund Transaction’ proposing a halt in purchases and sales of mutual funds through pool or escrow accounts of brokers and online platforms. There have also been calls from some quarters to limit the broker’s role in the settlement of trades which could eliminate the broker’s access and control of the client account as securities would be transferred between clients and clearing corporations directly.

SEBI’s recent actions seem to be driven by an underlying theme to protect the interests of small retail investors by taking to task non-compliant brokers for violations that have been pervasive in the market since decades. This will greatly help in maintaining trust in the market and to encourage more participation especially since most people remain quite hesitant about investing their money in the stock market and still park their savings in banks and assets like gold and land. A shift in this trend can be monumental in strengthening and democratising the Indian stock market and the economy at large.

About the authors: The authors are third year law students of NLSIU, Bangalore.