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The Karvy Demat Scam rocked the financial landscape, exposing loopholes and vulnerabilities in the system. Founded in 1983, the Karvy Group initially garnered trust and prominence but eventually succumbed to deceit and malpractice. This article delves deep into the layers of the Karvy Demat Scam, unraveling its complexities and ramifications.

About the Broking firm:

Karvy Group was established in the year 1983 and was headed by C. Parthasarathy as Chairman. The group at one time had more than 30,000 employees, spanning 900 offices in about 400 cities and towns. Karvy Stock Broking Limited was a non-govt company, incorporated on 30 March 1995. It was a public unlisted company and was classified as a company limited by shares. The company was registered in Hyderabad (Telangana) Registrar Office. Karvy Group is a financial services company in India. It was involved in providing financial services like equity, commodities trading, depository and wealth services and distribution of other financial products. Besides this it also has branches in Bahrain, Dubai, Malaysia, Philippines, and the United States.

Understanding some basic concepts and terms:

Before moving onto the scam, the readers should be familiar with some basic concepts and terms frequently used in the article. Following is the list of the same:

1. Demat Account as well as Dormant Demat Account:

A demat account helps investors hold shares and securities in an electronic format. It is also known as a dematerialised account.

A dormant demat account is particularly a demat account wherein there aren’t any transactions taken place lately as to selling or buying of shares for a brief period.

2. Pool Account:

A Pool Account, often referred to as a “Client Pool Account” or “Beneficiary Account,” is a facility provided by brokerage firms and financial institutions in India. It’s designed to streamline and simplify the process of investing in securities, primarily in the context of initial public offerings (IPOs) and equity shares.

Suppose A, a shareholder having shares in his demat account wants to sell shares to someone, the shares shall firstly be transferred to the pool account from his demat account and further it will be transferred to the buyer’s demat account after the transaction is complete.

3. Power of Attorney:

A power of attorney (POA) is a document that gives another person the legal authority to act on your behalf as per the terms mentioned in the document. In the case of a demat account, the POA gives the online broker the legal authority to take certain decisions on your account. This may sound like a breach of privacy or security, but a POA is entirely safe. It only provides the broker with limited authority and is a normal practice in India.

4. Pledging of Shares for loan and the process regarding the same:

Shareholders may pledge their shares and securities in order to obtain a loan. Pledging securities from your demat account involves a straightforward process, typically facilitated by your Depository Participant (DP) or broker.

Suppose, A needs a loan and is having some shares in his demat account, he will contact a broker for loan who in turn will contact a financial institution. The broker will then pledge the shares of A and obtain loan from the Financial Institution and charge brokerage to A.

5. Unpaid Shares Account:

Suppose a buyer who is need of shares does not pay money to the broker, then as per SEBI’s circular, the shares should be transferred to an account called unpaid account, and the broker firm cannot use the same shares for pledging purposes.

Decoding the Scam:

1. What did Karvy Stock Broking Limited (KSBL) did:

The KSBL had committed scams in two ways. One which involved POA and one without the involvement of the same.

  • Firstly, we shall understand one with POA’s involvement:

KSBL had a wide range of clients which included both dormant and active ones. It did a proper scrutiny of its clients’ demat accounts and found the ones which had been dormant and had share balances in them.

As KSBL had the Power of Attorney of the shares, it transferred the shares from the dormant demat accounts to its pool account and later contacted the banks to obtain loans for the same.

The banks, who were on the presumption that the shareholders had asked for the loan and with the POA being signed between KSBL and the Shareholders, had granted the loan to KSBL.

KSBL used the loan proceeds for their own operations and thus transferred the proceeds to their real estate subsidiary, Karvy Reality India Limited.

This had become a routine exercise for KSBL, and it used to slip from the SEBI’s radar because of the POA signed which acted as a veil against their demat scam.

  • Secondly, we shall understand one without POA’s involvement:

Firstly, shareholders sell their shares through KSBL, then KSBL used to transfer their shares to KSBL’s pool account. However, there were some cases wherein buyers wouldn’t pay for shares they wanted to buy.

Ideally these shares should have been transferred to the unpaid account and should not be used for further pledging against obtaining a loan. However, KSBL would make use of the shares to obtain loans from the banks. And further, as usual, the proceeds would then be shifted towards their subsidiaries and would be used for their own operations.

Hence this type of scam was also done by KSBL, wherein even without POA’s involvement KSBL would illegally use shares to obtain loans.

2. The Scam getting exposed:

On June 20, 2019, market regulator SEBI came out with a circular on handling client securities which said that brokers could not pledge client securities to raise loans for themselves which till then was an established market practice.

SEBI had set a deadline of September 30, 2019, for brokers to segregate client funds and securities but when Karvy Stock Broking Limited failed to do so by the given deadline, investors complained to SEBI, which then asked NSE to investigate the matter.

The scam then came to light after a limited purpose inspection of KSBL conducted by the NSE in 2019 revealed that KSBL had not revealed a DP account and credited the funds raised by pledging of client securities to 6 of its own bank accounts instead of the stock broker client account. SEBI found out that Karvy had defaulted by pledging the securities of its customers.

3. Action taken against the Karvy group:

In December 2019 soon after the scam came to light, SEBI worked with DPs and stock exchanges to transfer securities back to KSBL clients from Karvy’s Demat account back into their respective accounts.

SEBI ordered the ban of the stock broking firm as well as its promoter C Parthasarathy from the stock market for seven years.

The market regulators also charged high penalty on KSBL and Parthasarathy. SEBI also restrained Parthasarathy from holding the post of director, key managerial position or associating himself in any capacity with the listed public company for a period of 10 years.

SEBI also ordered Karvy Reality (India), or KRIL, and Karvy Capital (KCL) to return the loan proceeds which were diverted to them by KSBL within a period of three months. In case of failure to return the money, the markets regulator has directed the NSE to take control of KRIL.

4. Number Facts about the Scam:

  • SEBI found out that Karvy had defaulted almost above Rs. 2300 crore of investor funds by pledging the securities holdings of its customers.
  • It was estimated that over 95000 clients were affected by the Karvy Demat Scam.
  • In its final order in the Karvy Broking case, market regulator Securities and Exchange Board of India (Sebi) on Friday imposed a fine of ₹13 crore on the brokerage firm, and a ₹8 crore penalty on its former chairman C. Parthasarathy.
  • Nearly 90 % of the scam money was repaid to the clients of KSBL.
  • Also fines of Rs. 3 Crores and Rs. 2 Crores on BSE and NSE respectively for the lax approach shown on the brokerage firm in monitoring the proceeds.

Conclusion: 

The Karvy Demat Scam demonstrates how weak rules can be manipulated and how leakages can be exploited for earning illegal profits. Also, the investors should always be alert and cautious and should never trust their broker firms blindly, howsoever reputed the firm is. In the instant case, one can see that how a well reputed broking firm like Karvy misused their clients’ shares which left the market in a shock. From compliance point of view, one can say that the banks were in for some fault as well due to the negligence to check whether the loan proceeds were used righteously.

In a Nutshell, we can say that to prevent such types of scams from taking place, there should be stringent rules and regulations so that the scams can be detected and treated at the initial level.

Auditors’ Role in Scam detection and Treatment: 

To some extent we can say that the audit team of Karvy Group would be equally responsible for the scam to take place as they should have been vigilant enough to detect the scam. There were criticisms as to the integrity of auditors being compromised and also bringing into question the professionalism of the auditors. As an Auditor there should have been constant monitoring on the pool account of KSBL and also periodic review of the dormant accounts if allowed. Questions should have been the loan proceeds and also enquiries should have been done to the clients as to whether the loans were actually needed or whether the firm were misusing the POA. Another point which should be noted that the auditors should have proactively checked the nature of loans granted and checked their security type, that is whether the loans were secured or unsecured.

Hence, we can conclude that in order to curb any scams’ magnitude, there should be credible controls in place and regular monitoring so that the scams can be minimized and treated before growing in magnitude.

****

Authors:

Umesh Vishwakarma | Director  

Swapnil Pawar | Associate Consultant  

Email: blogs@bilimoriamehta.com | Contact: +91 98709 25375

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