Impact of Defaults Committed by Stockbrokers: Are Investors the Biggest Losers?
[Shivam Tiwari is a final year student at National Law University, Jodhpur.]
The Indian financial market has witnessed an increasing number of defaults by stockbrokers in the past few years. Recently, Delhi-based Ficus Securities Private Limited defaulted to the tune of INR 50 crores by siphoning off funds and securities of its sub-brokers and clients. The Securities and Exchange Board of India (SEBI) has also debarred brokers like Kassa Finvest Private Limted and BRH Wealth Creators from participating in the stock market. With the advent of the puissant entrant i.e. Karvy Stock Brokers Limited (KSBL) into the scenario, the situation has not only become alarming for the investors, but also may prove to be a hurdle to the government’s vision of making India a USD 5 trillion economy by the end of financial year 2024-25.
The SEBI has, over time, introduced various rules / regulations to govern the functioning of the Indian stockbrokers. With the aim to protect the retail investor, the SEBI has issued various circulars such as:
the circular dated 19 November 1993 on “Regulation of Transaction between Clients and Brokers", restricting brokers from transacting through the client’s account except in accordance with the conditions provided in the said circular;
the circular dated 17 April 2008 on “Collateral Deposit by Clients and Brokers”, wherein stockbrokers cannot use the client's collateral for any purpose other than meeting the respective client’s margin requirement/pay-ins with the client’s approval;
the circular dated 26 September 2016 on “Enhanced Supervision of Stock Brokers/Depository Participants”, where, in order to ensure transparency with respect to client’s securities, the SEBI mandated bourses to put in place a mechanism to ensure that client’s fund balance and securities balance are uploaded by the brokers effectively; and
finally, the circular dated 20 June 2019 on “Handling of Clients’ Securities by Trading Members/Clearing Members” (2019 Circular) issued by the SEBI, which summed up all the circulars applicable to stockbrokers in a comprehensive manner and, more importantly, completely prohibited the pledging of client’s securities by stockbrokers in any manner whatsoever, even with client’s prior approval.
Despite the above steps taken by the SEBI, in the recent past, stockbrokers have been found to violate applicable rules and regulations, the biggest defaulter being KSBL (to the tune of approximately INR 2,000 crores).
In this regard, the National Stock Exchange (NSE) submitted its preliminary report to the SEBI wherein it noted that despite the fact that the clients/investors are the legitimate owners of the securities lying in their respective depository accounts, KSBL: (a) misused the power of attorney given to it by its clients by surreptitiously selling their securities to generate funds and later transferring those funds to their own account, and (b) resorted to subterfuge by not disclosing to the depository participant account to NSE. As a result, the NSE observed that KSBL violated inter alia the code of conduct for stockbrokers provided under Schedule II of the Securities and Exchange Board of India (Stock Brokers and Sub-brokers) Regulations 1992 and all the above-mentioned SEBI circulars by transferring the funds to their own account, misusing client’s money for their personal gain and pledging client’s shares to raise funds without any prior approval from the latter.
Compensation from the investor protection fund (IPF)
To tackle problems of default by stockbrokers, the SEBI came up with comprehensive guidelines for IPF, wherein it provided that investors' claim arising out of a default of a broker/member of the exchange shall be eligible for compensation from the IPF. These claims are, however, subject to fixed compensation limits determined by the stock exchanges (minimum limit being INR 1 lakh and maximum being INR 25 lakhs). For example, if an investor loses his fund which is worth INR 1 crore and, after realisation of stockbroker’s assets, gets INR 50 lakhs as recovery for the loss and another INR 25 lakhs from the IPF, he will still suffer a loss worth INR 25 lakhs owing to the act of stockbrokers.
Arbitration: IPF guidelines also provide for an arbitration mechanism pursuant to which investors can make a claim for the balance amount, if the claim amount is more than INR 25 lakhs.
Consumer Protection Act 1986: There was lot of ambiguity with respect to whether the investors can move the relevant consumer court against the stockbrokers for redressal of their grievances. The SEBI vide letter dated 9 July 2015 to the stock exchanges responded in the negative as regular purchase and sale of shares is in the nature of ‘commercial purpose’ and any dispute arising solely out of such commercial transactions does not fall under the purview of the Consumer Protection Act 1986.
What is there in the investor’s basket?
Investors seem to be the biggest losers in this game as they have limited recourse available in respect of their grievances against defaulting stockbrokers. In all matters related to stockbroker’s default, the SEBI has made sure that the securities which were traded or pledged illegally are restored to almost all the rightful investors. But the problem arises where the stockbroker’s funds are inadequate to make good the loss of the investors.
The maximum number of investments in India are done through stockbrokers with the objective of getting favourable returns, but if the investment itself is at the stockbroker’s peril, it will be extremely challenging for the market to find investors. Moreover, investments through intermediaries are based on the notion that their protection is well regulated through the EBI and other regulatory mechanisms and, therefore, fewer chances exist of investors getting bamboozled by the stockbrokers. However, recent instances of default by stockbrokers has led to a serious apprehension that the money might go down the drain. This has shaken the basic foundation on which a ‘client-broker’ relationship is based. Furthermore, investors do not have any remedy against the brokers under the Consumer Protection Act 1986; perhaps, availability of the said remedy would have enabled an effective and efficient redressal mechanism.
Mandatory corporate governance reforms: Similar to public listed companies meeting a certain threshold, there should be a mandatory provision for an independent audit and appointment of at least one independent director on the board of stockbroker corporations in order to maintain transparency and accountability. For example, Section 143(12) and Schedule IV of the Companies Act 2013 requires the auditor and the independent director of a company to report any fraud which they believe is being or has been committed. Moreover, presence of an independent director on the board may forestall any law-defying action intended to be taken by other board members.
Increase in base minimum capital (BMC) requirements for stockbrokers: BMC is the deposit given by a member of the exchange against which no exposure for trades is allowed. These margins are required to be furnished by the members under the bye-laws, rules and regulations of the stock exchanges and are meant for any contingencies in the future or any other claims of the trading member for the due fulfilment of engagements, obligations and liabilities arising out of or incidental to any bargains, dealings or transactions.
Since the market structure has undergone significant structural changes over the years, it is high time to revise the BMC requirement for stockbrokers as BMC was last revised almost 7 years ago in 2012 with the limit increasing from INR 10 lakhs to INR 50 lakhs. This will provide an additional recourse to the suffering investors in order to claim compensation from the margin deposit.
Increasing the liability of the bourses: Several circulars issued by the SEBI in order to protect the interests of the investors also put an obligation on the stock exchanges to ensure better compliance of all the law. The SEBI has, on multiple occasions, directed the stock exchanges to make necessary provisions in their bye-laws and regulations for the purpose of regulating transactions and handling of securities between clients and brokers, specifically under the 2019 Circular. There lies a responsibility on stock exchanges to keep checking the compliance of these rules and regulations by the stockbrokers, and if the latter fails to fulfil such responsibilities, stringent liability must be fixed on them.
Remedies available to the investors should be commensurate with the loss suffered by them, or else, they will be dissuaded and left with no option other than pulling back from making investments. Mere tightening of existing rules and regulations will not provide a conclusive solution to the investors; the regulator must focus on proper implementation of the existing laws and ensure better coordination between market players especially stock exchanges and clearing corporations as they play a key role in monitoring brokerages.