SEBI Penalizes BSE and ESN for Neglecting Karvy Stock Broking’s Misuse of Client Funds Worth Rs. 2300 Crores


Sebi penalizes BSE and NSE for overlooking Karvy Stock Broking’s misuse of client funds.

Sebi, the capital markets regulator, has fined stock exchanges BSE and NSE for ‘laxity’ in uncovering Karvy Stock Broking Ltd’s abuse of client assets worth Rs 2,300 crore (KSBL).

Sebi (Securities and Exchange Board of India) fined BSE Rs 3 crore and NSE Rs 2 crore in two separate judgments. The case concerns KSBL’s misuse of client assets worth Rs 2,300 crore, which belonged to more than 95,000 clients, by pledging them from a single Demat account. KSBL used the amounts received in response to the committee for its own purposes and those of its group companies. KSBL and its related entities used the money to raise Rs 851.43 crore from eight banks and NBFC.

The Securities and Exchange Commission (Sebi) found the exchanges negligent in early identification of the brokerage firm’s exploitation of clients’ securities in two separate orders. According to the Sebi ruling, firms have used a “casual attitude” when verifying the broker for the past few years.

According to the orders issued on Tuesday, “without any doubt, it was KSBL that misused the securities of the customers by pledging them without authorization, and was therefore liable for the loss caused by the pledging of the securities that it did not own, including a loss to investors as well as a loss to banks and NBFCs that lent funds to KSBL against securities that did not belong to KSBL”, the regulatory oversight of KSBL by stock exchanges, which is a member of both the BSE and NSE, has been recognized by Sebi.

There was “laxity” on the side of the exchanges, which led to the belated identification of KSBL’s misconduct, and the exchanges must be held accountable.

The orders reveal how Karvy took advantage of Market Infrastructure Institutes’ Information Reconciliation (MII) loopholes.

Stock exchanges and depositories are examples of IBD.

Karvy’s Demat account, which was reportedly marked as an ESB margin account, was used to make large-scale transfers of investors’ stocks.

In its 64-page judgment against BSE, Sebi said: “BSE failed to verify this account, which resulted in a oversight gap that allowed KSBL (Karvy) to continue to pledge customers’ securities via this account”.

“He escaped BSE’s assessment on two counts – the first being BSE’s inability to assess account nomenclature, and the second being BSE’s inability to investigate alerts on off-market transfers related to this account provided by NSDL with BSE”, according to the Sebi Judgment.

Because it was an account labeled ESB, this account escaped NSE’s evaluation.

According to the Sebi v. NSE judgment, “NSE reasonably believed that it was not its responsibility to carry out an inspection and evaluation thereof, given the manner in which the tasks were distributed in practice”.

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The ESB carried out a full inspection on Karvy for the 2016-17 financial year, according to Sebi’s management.

That same year, the regulator sent the ESB an email outlining a complaint against Karvy for failing to meet net worth requirements. Karvy had made loan and equity investments in group entities. Karvy has an extremely high debt of Rs.1000 crores despite having very little equity. Karvy’s net worth should have been negative as a result of this loan.

In the same year, the NSE discovered that Karvy was funding considerable funds (corporate guarantee totaling 1,917 crores) to a group company which was not engaged in the securities industry, resulting in a negative net worth from KSBL of 79.75 crore. According to NSE, the value of the company’s collateral was greater than the overall balance sheet value of 1338.21 crore as of 31-03-2016.

According to Sebi’s decision, BSE did not flag the negative net worth issues during the full assessment.

“It is important to recognize that Noticee (BSE) serves as a front-line regulator, and its commitment to inspecting brokers cannot be based on a checklist alone, especially when Sebi has raised a red flag and Noticee is aware of the NSE sanction imposed on KSBL. (Carvy). However, based on the inspection report for 2016-17 and the response of the Notice, I conclude that the inspection was carried out in a regular and mechanical manner, without taking into account the Sebi reference and the conclusions of the ‘ESN,’ said the Sebi v. ESB ruling.

In his complaint against NSE, Sebi said the Stock Exchange should have taken decisive action after NSE made serious discoveries about KSBL’s funding of huge funds for the group company.

“KSBL (Karvy) was able to avoid discovery of the client’s security covenant by misinforming the NSE that the account was a margin account for another exchange and did not relate to NSE transactions.” Accepting KSBL’s allegation that the account was an ESB margin account at face value shows the NSE’s lack of due diligence to ensure the necessary compliance.

“In the 89-page judgment against NSE,” Sebi said.

“The Noticee Due Diligence Standard (NSE) should be seen in the context of its role as a first-tier regulator and the onerous obligation entrusted to it to ensure a secure and reliable infrastructure for securities trading” , Sebi said.

Due to exchanges’ delay in detecting KSBL’s misuse of client securities, the regulator imposed sanctions. The guidelines follow a joint review of KSBL by Sebi, NSE and BSE in June this year. In November 2019, NSE recruited a forensic auditor and sent a preliminary report to Sebi, on the basis of which the regulator issued an interim order and later a confirmatory order on the non-compliances detected in relation to the pledging/ misuse of client assets by KSBL.

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Sebi instructed custodians to facilitate the transfer of securities from a single Demat account to the respective beneficial owners who paid for the securities in full under the supervision of the NSE in a 2019 decision. The securities were returned to customers after the order by Sebi. In December 2019, National Stocks Depository Limited said securities in the KSBL Demat account had been returned to 82,559 customers.

Additionally, the NSE announced in November 2020 that KSBL investors’ money and assets amounting to Rs 2,300 crore had been paid.

edited and proofread by nikita sharma


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