1. The Karvy order is mainly a fallout of the SEBI circular No. CIR/HO/MIRSD/DOP/CIR/P/2019/75 issued on 20th June 2019

Since last one year, SEBI has brought in a number of new regulations to improve the health of the broking industry. One of the circulars was issued by SEBI on 20th June 2019, which results into fallout of many broker firms, the bigger one is the Karvy. The Karvy order is mainly a fallout of the SEBI circular issued in June, in which: –

(a) Brokers firm had been tasked not to pledge partly-paid securities with any financial institutions and the Brokers has been given time until October (which was extended from initial timeline August) to unwind such loans taken against clients’ partly-paid shares.

(b) Broker had also been asked to transfer shares to the clients within one day of receiving payment. In case of default, the broker had been asked to sell the security in the market after five days.

Karvy had, however, failed to comply with SEBI’s circular and had continued to pledge client’s securities to raise funds for its other ventures by misusing the POAs given by clients to transfer shares held in clients’ demat accounts to meet delivery requirements in proprietary trade (pl refer point number 3 for more detail to understand the term  proprietary trade).

2. Activities of Karvy Stock Broking firm against which the exparte ad interim order was issued by SEB in November 2019: –

a) Karvy Stock Broking transferred without authorisation the securities worth Rs 2,300 crore of more than 95,000 clients into one of its pool demat accounts, misusing the Power of Attorney given by its clients during opening of demat account with Karvy. The details of such pool demat account was never disclosed by Karvy in its filings with the stock exchanges.

b) 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.

c) Securities of clients (inactive clients) were also pledged with financial Institutes by Karvy to generate funds for group entities.

 3. Proprietary Trade and Circular of SEBI:

Basically, when a broker allows its clients to buy more stocks than the money in their accounts for many days, the broker, instead of using their own capital to fund the transaction, will pledge the client’s security which is unpaid, with another Bank/NBFC (“financial institution”) and in turn utilise those funds. This not only means higher brokerage income as the trade size is bigger, but also an interest income – differential of the rate charged by such financial institution and what is charged to the client.

A new regulation that was brought in June 2019 barred brokers from pledging client securities to other financial institution. Many brokerage firms were using this route to do their margin funding business.

Starting June, brokers have to put their own capital, which means they can lend only their own free cash, which isn’t much for most brokerage firms. The regulation also required all brokers to unwind any such already existing positions with Financial Institution by end of September 2019, which meant that the broker had to return funds to the Financial Institution and then release the pledge on the shares. This has affected several brokers, especially those whose business model revolved around margin funding.

The new regulation specified that the securities lying with brokers for non-receipt of payment from clients can neither be used by the broker as collateral margin for any of the proprietary trades nor it can be pledged with financial institutions. 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. Consequently, this move has hit most brokers who were continuously involved in such practices and don’t have enough funds to evoke these pledged securities.

4. Rights of Financial Institution on Pledge shares:

Karvy has pledged shares that does not belong to it, it is debatable if the financial institutions will be able to gain possession of such securities. Since, the circular was issued by SEBI in June 2019, can the financial institutions claim that they were unaware of the true owners of the securities?  It is again debatable situation. This even surely encourages the large financial institutions to follow regulatory guidelines closely.

5. Current status of the matter: 

Financial Institution submitted that it was common industry practice to lend against pledged shares and there was no reason to disbelieve Karvy’s claim that it owned these shares.  SEBI, on the other hand, argued that its circular dated 20 June was very clear in asking brokers not to pledge client securities for funding purposes and to unwind such pledges by the end of September. In such a scenario, the lenders should have enhanced their due diligence.  The Securities Appellate Tribunal (SAT) on Wednesday set 12 December as the deadline for SEBI to pass the final order in the pleas by some financial institution against its move transferring pledged shares to clients of the Karvy.

6. Be aware of contents of POA signed by you during opening of a demat account:

Given the convenience, it is beneficial for the investor to issue the POAs while opening demat and trading account. It allows the broker to access your demat account to release shares when they are sold. It also facilitates easy receipt and payments. Without the POAs, the investor would have to sign a delivery instruction slip that has to be physically submitted to the broker on time for release of shares.

Brokers have been misusing the POAs, which gives them access to clients’ securities, for years now, the investor should ensure that their POAs are specific and limited purpos. It should allow specific transactions only such as transferring shares that are sold through the broker on an exchange. It should exclude certain transactions such as off-market transfer of shares, pledge of holding etc. All stock holdings and transaction statements must be reconciled each month by every investor.

Sometime, the regulations may appear harsh, it is certainly a complex balancing act, making rules for evils who look at every possible way to break rules for monetary gains compromising Investors’ interest.

For any query /clarification in this respect please contact at csaman13@gmail.com.


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January 2021