How Karvy Stock Broking Ltd tricked its shareholders

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Hyderabad: In 1983, five men, who were working as chartered accountants, decided to start their own business called Karvy Stock Broking Ltd (KSBL) in Hyderabad.

Karvy quickly grew into a giant financial services company in India, providing services such as equities, commodity trading, custody and wealth management. It was soon launched in various countries such as Bahrain, Dubai, Malaysia, the Philippines, and the United States.

In the mid-1990s, Karvy entered the brokerage and consulting business. Being there for many years, Karvy has earned the trust of a million Indians who have invested in the financial company.

However, this romance was soon to come to an end when in November 2020, the Securities and Exchange Board of India (SEBI) banned Karvy from buying and accepting new shares.

The reason? Karvy defaulted around 2,300 crore in client funds by pledging their shares with various lending banks. It took out a loan from the bank and then invested in subsidiaries, mainly in its real estate market.

Still confused? Ok, let’s go back to the basics to understand the whole process.

Brokerage process

We must first understand the concept of taking out a loan against an equity.

First, there is a Demat account that belongs to person X. X has not number of shares in their demat account.

A broker’s demat account, in this case Karvy, is known as a group account. A collective account is described as a place where all shares are first deposited and then sold or vice versa.

So to break it down, a person named B wants to sell his shares. And C wants to buy. According to the procedure, B’s shares will first go to Karvy’s pool account and then will be transferred to C’s demat account. Easy?

So let’s say that X wants to have a loan against his share. X transfers its share to Karvy’s pool account. Karvy then transfers to lending banks who take it as collateral and in return provide money. This money is sent to the pool account and possibly to the demat account of X.

Now, between exchanges, banks offer loans at a rate of a certain percentage (say 10%). Karvy then lends the loan at the rate of 18% (for example) to X. Thus, Karvy makes a profit of 8%.

And that’s how the brokerage process goes.

Are brokers free to take stock from their clients?

The answer is no. But there is a way to use a power of attorney (POA). It is a superpower or permission given to brokers by clients to make free decisions about their actions.

Now, with POA, the broker can withdraw shares at any time and sell them anywhere, but the money generated should then return to the client’s account. It’s the rule of thumb.

It’s risky if your broker isn’t honest.

The SEBI circular

Due to the growing abuse of the POA, SEBI issued a circular prohibiting brokers from using their clients’ shares. It entered into force on September 1, 2020.

Karvy’s Betrayal

In November 2020, Karvy Stock Broking Ltd (KSBL), from its pool account, took hundreds of shares from dormant demat accounts. Dormant demat accounts are those that have been inactive for many years.

With the help of POA, Karvy took the shares and presented them as collateral to banks such as ICICI bank, HDFC bank, Indusbank, etc. real estate business.

Karvy clearly violated market rules. It defaulted 2,300 crores on 95,000 inactive customer accounts.

When the problem arose, SEBI banned Karvy from taking on new clients and continuing to trade.

SEBI has also ordered National Securities Depository Limited (NSDL), which is a depositary of shares, to return the shares to separate clients with immediate effect. Nearly 90% of the shares have been returned to shareholders. But what happened to the remaining 10%?

Banks revolt against SEBI decision

Banks was left behind with just 10% of the shares and nothing to recover the money from the loan it gave Karvy. They then approached the Securities Appeals Tribunal (SAT) to challenge SEBI’s decision.

SAT is a statutory body developed under the provisions of Section 15K of the SEBI Act. He hears calls made under SEBI. The SAT is chaired by an officer who is either a serving judge of the Supreme Court, a retired judge of the High Court, or a serving or retired judge of the SC or HC who has completed seven years of service.

The SAT also has members capable of dealing with corporate law, securities law, economics, finance or accounting.

Soon after, the forensic audit was launched by the National Stock Exchange of India against Karvy. The case is only progressing and with no conclusion in the near future.

Recently, the Enforcement Directorate (ED) has identified additional assets and provisionally attached properties in the form of land, buildings, shares, cash, foreign currency and jewelry worth 110 crores of rupees under the Prevention of Money Laundering Act 2002 (PMLA), in the investigation of an alleged money laundering case against M/s Karvy Stock Broking Ltd (KSBL) and its Chairman Comandur Parthasarathy and others.

The ED had previously attached assets worth Rs 1984.84 crores in the same deal. C Parthasarathy and Group CFO Mr G Hari Krishna were arrested by the ED and are currently on bail.

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