Lessons from Karvy fiasco: Solution lies in better implementation of rules

What's required is proper implementation of the rules and better coordination between market intermediaries such as stock exchanges and clearing members who play a key role in monitoring brokerages

The Securities and Exchange Board of India (Sebi's) preventive order on Karvy Stock Broking (KBSL) brings to light the loopholes that brokers exploit. 

Experts said mere tightening of the existing rules won’t provide a lasting solution. What’s required, according to them, is proper implementation of the existing rules and better coordination between market intermediaries such as stock exchanges and clearing members who play a key role in monitoring brokerages. 

The Karvy episode is not the first of its kind incident of misappropriation investors’ money by the brokers -- it is a half-a-decade-old issue, which keeps emerging because of lack of supervision of stockbrokers, especially regarding funds they receive from clients. 

To enhance supervision of stockbrokers, Sebi in September 2016 had come up a regulation to arrest the use of the proprietary account and directed brokerages to separate proprietary accounts from client accounts. 

It said that the transfer of funds between the two kinds of accounts will be allowed only in rare circumstances. It also mandated bourses to inspect brokers. And in case of a serious deviation from the internal audit report furnished by the broker, the latter has to reconsider the reappointment of the internal auditor. 

But despite all these measures, in several cases, it was observed that brokers continued trading through related-party transactions as this did not come under proprietary trading. And that was how brokers managed to misrepresent proprietary trading. 

In the past few years, defaults by brokers, such as Fairwealth, BRH Wealth Kreators, Guiness, Kassa Finvest, Ficus Securities, have led to heavy losses for investors and customers. 

To deal with the situation, Sebi asked exchanges, depositories and clearing corporation to devise a mechanism that would ring-fence the client money from brokers’ own ventures. 

Keeping such instances in mind, the market regulator in June further tightened the rules barring brokers from pledging client shares to raise funds. This was aimed at curbing misappropriation of funds by using the power of attorney of their clients. The regulator had set an August 31 deadline to wind up client securities accounts but later the deadline was extended to September 30. 

“The Sebi action sent out a strong message across the community which have been enjoying the flexibility of using client securities. There are many brokers, including the big ones, which are doing this for ages without having any right to use the client mortgage. I believe it’s a right move to explicitly prohibit the access to funds which belong to investors,” said Amit Tandon, founder and managing director of corporate governance and proxy advisory firm IiAS.

Though Karvy has not yet defaulted and the management has given comfort to banks that the group is adequately funded, the lenders are unwilling to take chances because of their high exposure of Rs 2,900 crore to Karvy’s companies.

The Securities and Appellate Tribunal on Friday had asked Sebi to hear Karvy and consider its plea for relief on the use of power of attorney on the grounds that it was causing losses to its existing clients. But Sebi refused any modification to its order.

Brokers, on the other hand, claimed that they haven’t been given sufficient time to comply with the Sebi directives. 

“Any regulation is continuously evolving. Sebi had put out various regulations concerning client money. In this case, the client pledge was created by the broker to raise funds which were later used for diversion. To arrest such a practice, Sebi has made it clear with its recent regulations that brokers cannot use client securities. I believe that this is initial teething trouble and can be tackled. If brokers are facing issues in the implementation, they can adopt a consultative approach with the regulator,” said Suresh Gupta, a former Sebi official. 

Experts suggested Sebi look into practical details and make additions to the existing rules, for example changing the net worth criterion as it has not been changed for 20 years and that it should be in line with mutual funds. Further, there has to be mandated disclosures on related-party transactions to clients. 

“Currently, AMCs are compulsorily required to disclose profit and loss account on their company websites. However, there is no such rule for brokers. An investor should know about certain details like the broker’s loans and debt. So like KYC, there should be a ‘Know Your Broker’ kind of mechanism to prevent them from default," said Jimeet Modi, founder and CEO, Samco Securities.

 The current framework

• Sebi bars trading members from pledging certain securities of clients to banks and NBFCs to raise funds even with their authorisation
• Asks to open separate client unpaid securities accounts concerning securities that have not been paid in full by clients
•  All the existing client securities accounts opened by trading members needs to be wound up
• This is other than three client accounts — 'pool account' client margin trading securities account' and 'client collateral account' 
• Securities lying with a trading member in client collateral account, client margin trading account and client unpaid securities account shall not be permitted to be pledged/transferred to banks/NBFCs for raising funds by the trading member