[By Arnav Maru]
The author is a fourth year student of Maharashtra National Law University, Mumbai.
Karvy Stock Broking Limited (“Karvy”), a registered stockbroker, recently found itself in the crosshairs of the Securities and Exchange Board of India (“SEBI”) for perpetrating one of the biggest cases of financial misconduct involving misuse of client securities. Karvy was founded in 1995 with its head office in Hyderabad and had a net worth of over Rs. 650 crores as of March 2019. It served over 12 lakh clients, of which at least 300,000 were active clients. The fraud affected around 95,000 of its clients and involved a massive sum of Rs. 2,300 crores. While the fraud in question is not the first of its kind, the sheer magnitude of the amount involved makes it extremely relevant. This post will talk about the fraud under three major headings: understanding the law involved, how this law was subverted in the present case, SEBI’s action, and its effect on the various stakeholders.
Understanding the law involved
Put briefly, Karvy misused securities lying in dormant and unpaid accounts of its clients to pledge them with five lenders to secure loans of Rs. 2400 crore. This transaction was executed through a misuse of the power of attorney granted by clients in favour of Karvy. Securities of clients availing the margin trading facility with Karvy were majorly affected. A brief overview of the law regulating the use of power of attorney and the securities held in unpaid and margin trading accounts is outlined in the following paragraphs.
A power of attorney (“PoA”) is executed by the client in favor of the stockbroker/depository participant to authorize the broker to operate the client’s demat account and bank account to facilitate the delivery of shares and pay-in/pay-out of funds. This may be a general PoA (one that grants a blanket authority), or a specific one (only confers authority for limited and outlined purpose). The PoA provided to brokers is specific and is for the trade settlements. Its use is limited to the transfer of securities from the demat account of the client for authorized purposes.
SEBI, in its circular dated April 23, 2019 [i] laid down guidelines for the execution of PoA by the clients in favour of the stockbroker after noting irregularities and misuse of the document. Brokers were mandatorily asking clients to execute irrevocable and general PoAs in their favour, and then using them to execute unauthorized trades in their client’s names. SEBI mandated brokers and depository participants to comply with the guidelines laid down. SEBI limited the scope of the PoA to, first, the transfer of securities held in the beneficial owner account of the client towards stock exchange related margin and delivery obligations, second, pledging of the securities in favour of stock broker for the limited purpose of meeting the margin requirements, and third, to apply for various products like mutual funds, public issues, rights, etc. pursuant to the instructions of the client. Furthermore, it explicitly prohibited PoAs that facilitated off market trades, a charge that Karvy has been found guilty of.
The usage of pool accounts and margin trading facility is common practice in the securities market. A pool account is a demat account of the stockbroker, which is used to facilitate pay-in and pay-out obligations. A pool account of a brokering firm typically includes unpaid securities (brought using a margin and not yet paid for by the client) and securities brought by clients not yet transferred to their demat accounts. When a client makes a purchase of shares, the clearing corporation sends it to the pool account of the broker, who has to then transfer it to the demat account of the client as per prevailing SEBI guidelines. Lastly, a margin trading account is one where the broker lends money to the client to enable him to purchase shares. This loan is collateralized by the shares that the client purchases, and comes with a periodic interest rate. The amount that the broker lends to a client may come from a bank that lends money to the broker. Client’s shares pledged with the broker could be validly pledged with the banks as a security until recently. SEBI, vide its circular dated June 20, 2019 [ii] restricted brokering firms from pledging client securities as collaterals even with a due authorization from the client. The most serious wrongdoing on part of Karvy was an illegal pledging of this sort.
Facts of the case
The National Stock Exchange (“NSE”) conducted a limited purpose inspection of Karvy upon noticing certain irregularities in pledging of client securities. This inspection was conducted on August 19, 2019 for a period starting from January 1, 2019 and a preliminary report was submitted to SEBI on November 22, 2019. SEBI, on the same day, through whole time member Anant Barua, pronounced an order [iii] highlighting the findings of the report and the entire misfeasance by Karvy. The first fault noticed by NSE on part of Karvy was the non-reporting of a depository participant account in its filings. Second, Karvy transferred the funds raised by pledging client securities to six of its own bank accounts, rather than the accounts of its clients, and further did not report these six accounts as it was required to. The order stated that the securities pledged by Karvy to the lenders belonged to its clients and therefore should not have been pledged as collaterals. SEBI highlighted a series of circulars that lay down client securities are not be used for any purpose other than for meeting client margin requirements. As stated earlier, this position was further made stringent when any pledging of client securities was barred, even with an express permission from the client.
How do PoAs and the use of margin trading and pool accounts fit into the above stated facts? As is the business practice, and as has been highlighted above, the securities brought by clients are first transferred into the pool accounts of the stockbroker and then subsequently into the demat account of the client. The securities brought by clients using the margin trading facility of Karvy were transferred from the pool account of Karvy to the stockbroker account that Karvy failed to report. Secondly, securities lying in client accounts that were dormant for a certain while were transferred to this unreported account through a misuse of the PoA. Since, Karvy had a wide ranging authority conferred on it through the PoA granted in its favor by clients, it was able to first transfer the securities from client accounts to its own account, and then subsequently create a pledge and give a false undertaking as to its rights on the securities.
Implications of SEBI’s Order dated November 22, 2019
SEBI passed an order against Karvy for perpetrating the fraud. Karvy, however, was not the only entity affected by this action of SEBI. The key stakeholders included the five major lenders, 95,000 clients whose shares had been misused, and the intermediaries including the NSE and National Securities Depository Limited (“NSDL”).
Seemingly, the worst affected stakeholders in this case are the lender banks. Karvy defaulted on its repayment in the month of November after which the lender banks wanted to invoke the pledged shares. The order by SEBI restored all the client securities back to the client demat accounts, rendering the lenders with no collateral to their exposure of Rs. 2,400 crores. The lenders made representations to SEBI and the pursuant decision [iv] was rendered on November 29, 2019. The lenders, inter alia, asserted that they should not suffer as a result of misdoings of Karvy, that they acted within the bounds of the law, and that SEBI’s order of November 22, 2019 is contrary to established contract law. They prayed for SEBI to restore the pledge and order NSDL and NSE to pay damages, as they were in the wrong as well. SEBI observed that the banks were at fault for not conducting proper due diligence as to the true ownership of the pledged shares, and that a valid and lawful pledge had never been created for SEBI to restore in the first place.
As far as the investors are concerned, SEBI was able to provide relief to around 85,000 clients of Karvy, leaving 11,000 people still in a state of uncertainty as to their securities. Their fate still remains under the shadows, as a full inspection by NSE is still underway. Similarly, the lenders have sought restitutive payments from the intermediaries vis NSDL and NSE as they unilaterally created third party rights in securities pledged with the lenders.
The case presented various challenges for SEBI, primarily because it involved multilateral and overlapping interests. The scale of the fraud brought the dispute into the public eye and therefore every move had to be carefully measured to prevent the already dwindling investor confidence in the securities market. Secondly, whether the lenders in the present case will be able to secure any relief still remains to be seen. As such, no other remedies other than a contractual claim for damages, or an application to the NCLT for insolvency of Karvy remains in sight. Both these measures defeat the entire purpose of collaterals pledged with the lenders. In the author’s view, the tough stance taken by SEBI would have a rather positive ripple effect, urging brokers to toe the line and limit laid down by SEBI, and nudging the banks towards conducting a more thorough scrutiny.