Explained: How Karvy Stock Broking Circumvented Sebi Regulations, Hijacked Investors’ Money

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On November 22, the Securities and Exchange Board of India (Sebi) banned Karvy Stock Broking Ltd (KSBL) from taking on new business for allegedly embezzling money and securities belonging to its investors to fund its real estate arm, Karvy Realty.

While Sebi says Karvy transferred Rs 1,096 crore to his real estate business, market estimates indicate the sum involved could be around Rs 2,000 crore. It is learned that the regulator is also investigating a similar manipulation involving thousands of crores by several other brokerages, which could potentially create a crisis of confidence in the stock market.

What did Karvy do?

Sebi took on Karvy for breaking standards, including transfer of shares from the client to himself, and by promising client shares to raise funds, which he diverted to his real estate arm. Many clients over 2.40 lakh of Karvy have complained to the regulator about money and securities not arriving in their trading accounts. Karvy allegedly abused client accounts without informing them or reporting it to the custodian or the exchange.

The securities deposited in the accounts of the depositary participants (DP) belong to the clients, who are the legitimate owners. KSBL had no legal right to pledge these securities. If securities of clients are pledged, this should only be done to meet the obligations of the respective clients.

In a report submitted to Sebi, the National Stock Exchange of India (NSE) said that KSBL had abused the power of attorney given by its clients to clandestinely sell client securities through entities controlled by it, and had used the funds for its own purposes.

To hide its wrongdoing, KSBL did not report the DP account (#11458979) in its NSE submissions from January to August 2019. This was only detected during inspection, the NSE said.

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How much money was at stake?

Sebi’s order stated that a net amount of Rs 1,096 crore had been transferred by Karvy Stock Broking to Karvy Realty. However, the scam is expected to be worth around double that amount or more – the NSE’s preliminary investigation of August 19 was conducted for a limited purpose and only covered the period from January 1, 2019.

As clients turn to exchanges for money and securities allegedly embezzled by Karvy from their accounts, Sebi is reportedly investigating similar embezzlement of funds from client accounts by other brokerages. The Sebi (Brokers and Sub-Brokers) Regulations 1992 specify that the broker in securities must “separate his own funds or securities from the funds or securities of the client”, and must not use “the securities or funds of the client for his own account”. for the purposes or for the purposes of any other client”.

So how does this system work?

Major stockbrokers such as Karvy, finance companies and banks offer online trading on both the NSE and the Bombay Stock Exchange. These brokers have trading platforms that allow their clients to trade stocks online, buy debt securities, mutual funds, commodities and currencies, and participate in public offerings. The client opens a demat account with a custodian and a bank and, in some cases, gives power of attorney to the brokerage firm to act on his behalf.

Securities received in payment, against which payment has been made by the client, must be transferred to the client’s demat account within one business day after payment. Securities held in the “client’s unpaid securities account” must either be transferred to the client’s demat account upon fulfillment of the client’s funds obligation or be disposed of in the market within five trading days of the payment.

Were there any regulatory gaps?

Sebi further strengthened the relevant portions of its 1992 rules through a circular dated June 20, 2019.

He said: “As of September 1, 2019, client securities held by Trading Members/Clearing Members…cannot be pledged to banks/NBFCs to raise funds, even with client permission. ” In addition, customer securities already pledged will be unpledged no later than August 31, 2019 and returned to customers after fulfillment of the payment obligation.

The circular states that in the event of a customer defaulting, brokers will be required to hold the securities for up to five days, after which they may liquidate the securities.

Exchanges and Sebi had actually started tightening standards for brokers several months before the June 20 circular.

In December 2018, Sebi standardized account books and records to facilitate inspections and comparisons. The following month, brokers were asked to provide weekly reports on securities and daily client balances, international securities identification number (ISIN) and DP accounts.

In March 2019, a custodial and exchange ledger reconciliation exercise was initiated. Between April and June, Sebi ordered depositories – National Securities Depository Limited (NSDL) and Central Depository Services Limited (CDSL) – and depository participants to provide details of all pledge brokers.

A leading market expert said Karvy committed “theft” by breaking laws and standards. This expert compared Karvy’s action to a bank promoter withdrawing depositors’ money for personal use.

Industry sources have said that it is no longer possible for brokers to pledge client securities except to the Clearing Corporation of India (CCIL) and clearing members i.e. at the within the trading system. The instances of pledging outside the system date from the period before Sebi’s June circular, they said.

Will investors lose money?

While Karvy allegedly abused the securities of thousands of his investors, industry sources say that at present there are no defaults – and the value of the securities pledged is greater than the money withdrawn by the broker. Government sources have confirmed that investors’ money will not be lost.

Market sources have indicated that if there are insufficient funds available from Karvy, investors can get their money through NSDL insurance or from the Investor Protection Fund (IPF) set up to guard against member defaults. exchanges (brokers).

However, some exchange officials have told The Indian Express that the IPF cannot be used to offset investors’ losses, if any, in this case because even if securities have been withdrawn and placed pledge, there was no exchange – and “IPF money can only be used in the event of an exchange”.

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