In one of the biggest cases of funds misappropriation by a broking firm, market regulator Sebi has banned Karvy Stock Broking from accepting new clients. It has also instructed depositories NSDL and CSDL to not honour Karvy's instructions where clients' power of attorney (PoA) trades are involved. PoA is a regular practice that authorises the broker to debit the shares directly from the client's demat account to settle a trade. Market experts say brokers often misuse clients' PoAs to transfer latter's money or securities into their own account to execute proprietary trades, something the market regulator prohibits. While it has not been proven in the case of Karvy yet, Sebi's statement does suggest so.
Here's an explainer on what Karvy has allegedly done and what recourse is available for investors:
Prop trades -- the heart of the matter
Proprietary trade is when a financial firm dabbles into stocks with its own money to earn extra revenues other than the commission fee coming in from clients. As per Sebi's statement, Karvy moved clients' pledged shares (against which they receive margin funding from the broker) to its own account via off-market deals and transferred a net amount of Rs 1,096 crore to its group company, Karvy Realty Private Limited between April 1, 2016, and October 19, 2019.
"Brokers are quite powerful in India. They are not only exchange members but also depository participants. Exchanges are supposed to send you SMS/email when shares are transferred based on details provided in your master report. Who prepares that master report? DPs. They can easily change the registered number or email while they transfer your shares to their pool account through which they execute prop trades," explains Ghanisht Nagpal, convener of Delhi Investors Association.
Sebi has strictly defined the do's and don'ts of prop trading. Among recent measures, in June, it came out with a circular making it mandatory for brokers to transfer the pledged securities to their clients' accounts within one day of receiving the payment. In case the client defaults on the payment, brokers can hold the securities only up to five days post which they are supposed to liquidate the securities in the market and recover dues.
"Under no circumstances, shall the securities of the clients received in pay-out be retained by the trading member (Brokers) beyond five trading days and be used for any other purpose," said Sebi.
Besides, it categorically specified that the securities lying with brokers for non-receipt of payment from clients cannot be used by the broker as collateral margin for any of the proprietary trades. Also, it can not be pledged with financial institutions such as banks or NBFCs. Brokers were supposed to release such pledges by August 2019 or give a valid reason to continue it. The deadline was further extended to September 2019. The move has hit most brokers who were increasingly involved in such practices and don't have enough funds to revoke these pledges.
So far as idle cash or unutilised securities in the trading account are concerned, brokers are required to transfer it to the client's bank account once in 90 days.
"Changing the settlement of funds and securities to a monthly basis could be one of the key control measures to curb the misuse of clients' monies," advises independent market analyst Ambareesh Baliga.
On PoAs, Baliga says that clients should ensure that their POAs are specific and limited purpose. "All DP holdings and transaction statements must be reconciled each month."
What should existing investors do?
A lot of complaints against Karvy has flooded Twitter. Experts advise investors to formally approach the respective exchanges and Sebi for the resolution. If a broker is declared a defaulter, investors get their money back via Investor Protection Fund. However, the compensation is limited to Rs 25 lakh per investor per defaulting broker.
"If securities are transferred without express or tacit permission from the investor's DP account, the Depository would be responsible to make good. However, if there is proof of such permission, for example, blank signed DP slips left in the custody of the Depository Participant and if that is used to fraudulently withdraw, then Depository would not be responsible. It would become a case of fraud and will have to be dealt with using other legal remedial routes," explains Baliga.
Nagpal suggests that investors should open their demat account, or depository participant account with a bank-based brokerage while trading account with other brokerages. Baliga advises the same. "To play it safe one could have the DP account with a bank. However, this may entail issuing delivery instructions whenever there is a trade."
Alternatively, investors should prefer only those brokers whose main business is client transactions. "They should not be having a proprietary desk or other unrelated capital intensive business," says Baliga.
Ultimately, investors should be active enough to observe unusual activities happening in their accounts. If there are delays in payout backed by lame excuses or unexplained debits in DP account which is corrected after being pointed out (as it happened in the case of Karvy), these are clear signs to move out.
"Such instances tend to happen in accounts which have been idle for long. Thus if you plan not to trade for a longer period of time, you could request your depository to freeze your account. And it can unfreeze when you would like to put in trade again. This doesn't affect any corporate action such as dividend, bonus, splits etc in your portfolio," says Baliga.
Notably, earlier this year, investors had filed a criminal case against various companies and executives in the Karvy Group, and Abhijit Bhave, the chief executive officer of Karvy Private Wealth, a division of Karvy Stock Broking. It was alleged that Karvy Private Wealth had transferred funds to builders causing losses to its HNI clients. Karvy had issued a statement clarifying that it did not cheat any investor; losses happened "owing to unfavourable market conditions" post the NBFC crisis.
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