“SEBI’s latest circular addresses illicit practices by stock brokers pledging clients’ funds without consent. Learn about the regulations, implementation, and the backdrop of the Karvy Stock Broking Limited scam.”
SEBI’s New Circular Aims to Curb Illicit Practices of Stock Brokers Pledging Clients’ Funds and Shares Without Consent
To put an end to the illicit actions of depositaries and clearing agents who pledge securities from their clients’ Demat accounts without their authorization and then divert the funds to other companies, measures need to be taken. On April 20, 2023, SEBI released a circular that clearly addresses the issue of Stock Brokers (SBs)/Clearing Members (CMs) using client funds to obtain Bank Guarantees (BGs) from banks, which exposes the market and clients’ funds to risks. After consulting with various stakeholders, SEBI has decided to implement measures to protect the interests of investors, which are outlined in the circular.
From May 01, 2023, SBs/CMs will not be allowed to create any new BGs using clients’ funds and Existing BGs created using clients’ funds will be phased out by September 30, 2023.
The regulations outlined in this framework will not apply to the proprietary funds of SBs/CMs in any segment, nor they will apply to SB’s proprietary funds that have been deposited with CM in the role of a client.
Stock exchanges and clearing corporations are required to confirm compliance with the regulations outlined in the circular during their periodic inspections and reporting. They must also establish sufficient mechanisms to handle cases where SBs/CMs do not adhere to the provisions of the circular by the specified dates. and they are also responsible for assessing the status of the BGs issued using clients’ funds by SBs/CMs, and monitoring the phasing out process to ensure that the circular is implemented without disrupting services for clients. To this end, stock exchanges and clearing corporations will establish periodic reporting mechanisms for SBs/CMs.
The stock exchanges and clearing corporations have been instructed to:
a). Inform stock brokers and clearing members, and post the circular on their websites.
b). Make changes to the applicable bye-laws, rules, and regulations to put the above regulations into effect.
c). Report the implementation status of the circular’s provisions to SEBI in their monthly development reports.
Furthermore, stock exchanges and clearing corporations are instructed to provide SEBI with the following collateral information on a fortnightly basis starting June 01, 2023.
Karvy Stock Broking Limited Scam:
The reason behind SEBI’s recent circular can be traced back to the Karvy Stock Broking Limited scam, which prompted SEBI to take action in 2019. This scam had raised red flags and alerted SEBI, leading to the regulator’s previous circular. Let’s take a closer look at what happened in the Karvy case.
Hyderabad-based Karvy Group’s flagship Karvy Stock Broking (KSBL) illegally pledged securities belonging to over 95,000 clients and raised more than Rs 2,300 crore via loans against shares (LAS) from multiple banks and financial institutions which triggered a massive financial scam. KSBL transferred shares from inactive Demat accounts of clients into its own Demat account and used these stocks as collateral to obtain loans. The funds were then diverted to other Karvy group companies, including Karvy Realty.
The Securities and Exchange Board of India (SEBI) issued a circular in June 2019 prohibiting brokers from pledging client securities for their own loans. Despite a deadline of September 30, 2019, for brokers to segregate client funds and securities, KSBL failed to do so, prompting investor complaints to SEBI. On November 22, 2019, SEBI issued an order banning KSBL from broking services and found that the firm had transferred Rs 1,096 crore to Karvy Realty between April 2016 and October 2019. SEBI also instructed the National Stock Exchange (NSE) to conduct a forensic audit and work with depository participants and stock exchanges to return some of the illegally transferred securities to investors’ accounts. In January 2020, the Union corporate affairs ministry directed the Registrar of Companies Hyderabad, to investigate the Karvy group’s financial fraud, and the chairman of Karvy was arrested for allegedly defaulting on a bank loan happened after the scam was uncovered.
The Karvy scam is a stark reminder of the importance of strong regulations to prevent fraudulent activities in the financial sector. SEBI’s swift action in banning KSBL from broking services and initiating a forensic audit shows that regulators are committed to protecting investors and holding financial firms accountable for their actions. The Karvy case also highlights the need for investors to be vigilant and cautious while investing and to choose reputed and trustworthy financial service providers.
SEBI/HO/MIRSD/MIRSD-PoD-1/P/CIR/2023/061 , 25.03.2023
