[By Aniket Panchal & Shubhankar Sharan]

The authors are students of Gujarat National Law University.

 

Introduction

An interesting chain of events transpired centered on Edelweiss (a registered Professional Clearing Member (“PCM”), against whom appeals were filed in response to directives from the Member and Core Settlement Guarantee Fund Committee (“Committee”) of NSE Clearing Ltd (“NCL”). These directives ordered Edelweiss to reinstate securities that were disposed of in violation of the Securities and Exchange Board of India (“SEBI”) Circular and NCL Regulations. The contentious issue arose when Edelweiss, providing clearing and settlement services, sold collateral worth Rs. 460 Crore from broker and trading member Anugrah to fulfill clearing obligations.  

The central issue here was that the PCM liquidated the securities of the Trading Member’s clients to offset the trading member’s debit balance. The Committee found Edelweiss on the wrong side, underlining a failure to ensure that clients’ securities were used solely for meeting their obligations, thus violating NCL Rules. Similarly, accusations regarding the misuse of client securities emerged in appeals involving other Clearing Members, including Yes Bank and SMC Global.  

The Edelweiss order sheds light on the pressing issue of intermediary misconduct in handling client funds.  In light of this, the authors examine SEBI’s previous initiatives in curbing such malpractices and then discuss the roles of clearing members and the ambit of powers vested with NCL.  

Past to Present: SEBI’s strides in countering misuse of client funds 

Throughout the course of its existence, SEBI has actively tried to curb the menace of misuse of clients’ funds by Stock Brokers (“SB”) and Clearing Members (“CM”). A string of circulars has been released to further the objective. The premise was set by its 1993 circular, which prescribed maintenance of separate accounts of Member Brokers and their clients. It set the course for future actions against misuse. A brief leap in time necessitated SEBI to release another set of circulars in this regard. More importantly, all of them have been laid out prima facie to combat misuse of funds and client collaterals. Several actions in the form of alerting and monitoring mechanisms and enhanced supervision over SBs have been devised by SEBI. Not to mention, SEBI has been proactive in not only outlining the measures but also prescribing guidelines for implementing those measures. A look at some of the circulars, as mentioned in the SAT Order, underscores the principle highlighted in the 1993 Circular.  

Precisely, the Circular dated 20 June 2019 proscribes the usage of clients’ funds by SBs for themselves or any other client (as provided in Securities Contracts (Regulation) Act 1956 (“SCRA”) and Securities Contracts Regulation Rules, 1957 (“SCRR”). Lastly, some of the immediate circulars dated 11 November 2022 and 12 December 2023 fortify SEBI’s position on misuse of clients’ funds. The former deals with handling clients’ securities by Trading Members (“TMs”)/CMs, while the latter lists the criteria for receipt/payment of funds by SB and CMs from/to clients. An essential requirement that stands out is establishing clear time frames for completing the transactions with clients. 

Stock Exchanges, too, have been on the heels of SEBI. NSE circulars, for instance, reproduce the intent of the SEBI circulars. A case in point can be that of its June 2023 circular, wherein it established detailed guidelines for immediate actions against misuse of clients’ funds. “Enhanced Supervision” principles form the bedrock of implementing those administrative guidelines. The administrative actions referred to in the circular are in addition to pre-defined measures against Trading Members, as existing in the NSE circular no. 82/2022.  

Several cases have been reported on misutilization of clients’ funds, of which the case of Karvy Group takes most of the light. The concerned company was involved in creating a labyrinth of transactions in order to misuse clients’ securities. Subsequently, it was expelled by the NSE and deregistered by SEBI on account of misutilizing clients’ funds and securities. 

Analysis

PCM and CM – Cut from the same cloth?  

On this count, the main contention of Edelweiss was that based on the bye-laws of NCL, a PCM cannot be considered as a CM; therefore, circulars issued by SEBI/NSE/NCL will hold no applicability on the PCM. As a corollary, it was argued that the word “constituent” under NCL bye-laws can only encompass trading members with which a PCM has an agreement and not the end clients of the trading member. Based on this, it was contended that a PCM has no duty of care to a TM’s clients. Edelweiss urged that the clients of trading members do not have any legal or beneficial ownership over their shares once the trading members transfer the same to a PCM. 

To rebut Edelweiss’s contention that a PCM is not the same as a CM, the tribunal referenced two provisions of the Futures & Options (“F&O”) Regulations. Firstly, the definition of F&O CM defines it as a member of the Clearing Corporation and includes all categories of clearing members. Secondly, a PCM is defined as a clearing member admitted by the relevant authority. Based on this, the tribunal noted that a PCM is nothing but a type of CM.  

In any case, the whole discussion, at best, was academic since the tribunal found Edelweiss was registered as a CM and not as a PCM. As stated in the Order too, it is by virtue of the recent amendment to the Securities and Exchange Board of India (Stock Brokers) Regulations, 1992, that a PCM got defined under Section 2(ca). the reason being that, as per the Schedule appended to the Regulations PCM requires higher net worth than other sub-categories of CM. Otherwise, any member having clearing and settlement rights is a CM.  

Interestingly, Edelweiss drew parallels between a PCM and a Senior Counsel to further its contention that PCM bears no liability to the trading member’s client. The analogy rested on the premise that Senior Counsel’s accountability lies only with the instructing advocate and not the end client. Likewise, PCM shall be answerable only to trading members (its client) and not the trading member’s client (end client). The same did not hold water since the tribunal noted that even a Senior Counsel will be subjected to disciplinary proceedings before the bar council if he misappropriates the end client’s monies.  

Edelweiss evading its duty of care to Trading Members’ clients highlight the traditional understanding of fiduciary responsibility in financial transactions. This argument, if accepted, could have had broader implications for the protection of end clients in financial markets. The Tribunal’s rejection of the Senior Counsel analogy suggests a recognition of the unique responsibilities that financial intermediaries, including PCMs, may have towards end clients. It also underscores that analogies must be appreciated in an appropriate legal context, no matter how persuasive.  

Does NCL have the power for restitution?  

The appellants challenged NCL’s power to direct restitution. The argument emphasized that restitution, akin to disgorgement, cannot be considered a penalty. It was stated that NCL derives its rule-making authority from the SCRA. Therefore, NCL cannot independently broaden its rules beyond the SCRA and SCRR statutory framework, which requires SEBI approval and due consideration of objections. 

Specifically, it was argued that they were penalized under Chapter V of NCL Rules (F&O Segment), a self-contained code unaccompanied by any specific provisions for restitution or disgorgement. Therefore, it was contended that there is an absence of inherent or omnibus powers comparable to SEBI under Section 11B, SEBI Act 1992.  

Responding to this, SAT held that the Committee has the power to impose penalty based on the disciplinary jurisdiction of the Committee under Rule 1 of Chapter V (NCL F&O Rules). The pivotal inquiry then centered on the expansive scope of the term “penalty” and whether it included the authority for restitution. It was drawing from key legal precedents like Directorate of Enforcement vs. M/s. MCTM Corporation Pvt. Ltd. & Orsi and State of U. P. vs. Sukhpal Singh Bal, that the interpretation emerged that “penalty” is a term of broad significance, encompassing directives that may include the restitution of shares. 

In this sense, the tribunal seems to have found merit in the respondent’s contention that one of the cardinal principles of interpreting securities laws is to enhance investor protection and to safeguard the securities checks against mischief of misappropriation of the investor’s securities (Para 15).  

One noteworthy ruling was delivered last week in IIFL v SEBI, where it was concluded that there was no wrongdoing in the alleged misuse of client funds by IIFL and, hence, no mixing of client funds. IIFL Securities was directed to pay a reduced penalty of 20 lakhs for not adhering to client account nomenclature.  

While the finding may differ in the above case, it is palpable that the market regulator is not taking the menace of misuse of clients’ funds lightly. The SEBI has been constantly vigil to curb the practice, as marked by its constant efforts.  

In 2020, SEBI implemented an online system to monitor the movement of client securities collected by brokers as collateral and raise alerts with Stock Exchanges if diversion of clients’ securities is noticed. Although the effectiveness of this system remains to be evaluated, there is an uncertainty regarding its ability to detect the potential misappropriation of client funds by clearing members. 

Conclusion 

As the retirement of SAT’s Presiding Officer looms, a flurry of significant judgements is being issued, marking the conclusion of an era under the reign of Tarun Agarwala, J. The seminal case raised substantial questions about the responsibilities and liabilities of Professional Clearing Members and the power of regulatory bodies like NCL to enforce penalties and restitution. The act of SAT emphasizing the interpretation of securities laws to enhance investor protection is crucial. This perspective resonates with the broader goals embedded in the preamble of the SEBI Act and International Organization of Securities Commissions (“IOSCO”) Principles – protecting investor interests and preventing misappropriation. 

Lastly, while the SAT order provides a final word on this matter, the ultimate determination of it will rest in the hands of the Supreme Court since Nuvama (formerly Edelweiss) has stated in its disclosure made under Regulation 30 of LODR that they are contemplating an appeal before the Apex Court.