Case Study - Karvy Stock Boking Limited (Part IV/IV - Policy Developments)
Owing to the seriousness of this case, SEBI has tightened its surveillance over other brokers. It has also attempted to make several policy changes in securities laws governing stock brokers and mutual fund distributor, as an after-thought of Karvy.
Read Parts I (Facts), II (SEBI) and III (Lender Banks' Case) here, here and here respectively.
SEBI Circular on ‘Margin obligations to be given by way of pledge/re-pledge in depository system’
SEBI on February 25, 2020 issued this momentous circular with a view put in place a framework to mitigate the risk of misappropriation or misuse of the client’s securities available with the TM/CM/DP. This Circular envisages curbing misappropriation and misuses such as using client’s securities to meet exposure requirement, margin or settlement obligation of another client or of the TM/CM itself. This is a landmark policy resulting from the impact of KSBL Case.
Primarily, the circular requires all TM/CM to close all existing Demat accounts tagged as ‘Client Margin Collateral’ by June 30, 2020. The TM/CM is required to transfer all the client’s securities lying in such accounts to the respective clients’ Demat accounts. Thereafter TM/CM are prohibited from holding any client securities in any BO Accounts of TM/CM, other than specifically tagged accounts as indicated below, and in pool account(s), unpaid securities account, as provided in the SEBI Circular dated June 20, 2019.
However, clients having arrangements with SEBI registered custodians for clearing and settlement of trades shall continue to operate under the extant guidelines. This Circular notably clarifies that an off-market transfer of securities leads to change in ownership and shall not be treated as a pledge.
Accordingly, with effect from June 01, 2020, TM/CM are barred from accepting collateral from clients in form of securities except by way of margin pledge created in depository system in accordance with Section 12 of the Depositories Act, 1996 read with Regulation 79 of the SEBI (Depositories and Participants) Regulations, 2018 and the relevant Bye-Laws of the Depositories.
The Circular bars transfer of securities to the Demat account of the TM/CM for margin purposes (i.e. title transfer collateral arrangements). In case a client gives PoA in favour of TM/CM, such holding of PoA shall not be considered equivalent to a collection of margin by TM/CM in respect of securities held in the Demat account of the client.
Client Securities Margin Pledge Account
A separate pledge type, viz. Margin pledge is drawn out for pledging client’s securities as margin to the TM/CM. The TM/CM shall open a separate Demat account for accepting such margin pledge, to be tagged as ‘Client Securities Margin Pledge Account’. Basically, a client shall initiate the margin pledge only in favour of the said separate account through physical instruction or electronic instruction mechanism provided by the Depositories. Such instruction shall have the details of client, TM, CM and default segment. In case the client has given a PoA to the TM/CM, such TM/CM may be allowed to execute the margin pledge on behalf of such client to the Demat account of the TM/CM tagged as ‘Client Securities Margin Pledge Account’.
The pledge request form shall disclose express consent by a client for re-pledging of the securities by the TM to CM and further by the CM to CC. On receipt of the margin pledge instruction either from the client or by TM/CM as per the PoA, DP of a client shall initiate a margin pledge in the client’s account. The client will submit acceptance by way of One Time Password (“OTP”) confirmation on the mobile number or other verifiable mechanisms. Such confirmation shall also be required if securities of such client are being re-pledged.
For providing collateral in form of securities as margin, the client shall pledge the securities with TM and TM shall re-pledge the same only with the CM and only from the TM’s ‘Client Securities Margin Pledge Account’. The CM shall create a re-pledge of securities on the approved listonly to the CC only out of the said account. While re-pledging the securities to the CC, CM/TM shall fully disclose the details of the client wise pledge to the CC/CM.
Thus per the context, re-pledge means an endorsement of pledge by TM/CM in favour of CM/CC as per procedure laid down by the Depositories. The TM and CM are obligated to ensure that the client’s securities re-pledged to the CC are available to give exposure limit to that client only.
Funded stocks held by the TM/CM under the margin trading facility shall be held by the TM/CM only by way of pledge. For this purpose, the TM/CM shall be required to open a separate Demat account tagged ‘Client Securities under Margin Funding Account’ in which only funded stocks in respect of margin funding shall be kept/transferred, and no other transaction shall be permitted. The securities lying in this account shall not be available for pledge with any other bank/NBFC.
Release of Margin Pledge
In case of a client creating pledge of securities in favour of the TM/CM against the margin, the TM/CM may release the ‘margin pledge’ after internal exposure and risk management checks. The request for release of the pledge can be made by the client to its DP or to the TM/CM who shall release the pledge in the depository system.
For release, if client securities are given to TM/CM as margin pledge and which are re-pledged in favour of the CC, the CM shall make a request to the CC. The client through TM, or the TM on his own, may request the CM to make an application to the CC for the release of margin pledge. CC shall do margin utilization check at the CM level before releasing the re-pledge of securities to the CM. the CC will release the re-pledged client securities to CM after blocking other available free collateral of CM. The CM/TM in turn, after doing their risk management shall release the securities to TM/Client, as the case may be.
Invocation of Margin Pledge
The manner of invocation has been prescribed depending on the entity that defaults. To that tune, in case of default by TM’s client where securities are re-pledged with CM/CC, the TM must request the CM, who must, in turn, make a request to the CC per the procedure laid down by the Depositories. If a TM’s Client whose securities are pledged with such TM defaults, the TM can invoke the pledge.
In case of default by TM’s client whose securities are re-pledged with the CC, the TM must request the CM, who shall in-turn request the CC to release the re-pledged securities. Here, the CC shall after blocking equivalent available free collateral provided by the CM, release the re-pledged securities to CM’s CSMP Account for TM, who shall, in turn, invoke the pledge in Client’s Demat Account. Similarly, in case of default by client/ TM of CM where securities are re-pledged with CC, CM can file a request with the CC. CC shall after blocking collateral as in the above case, release the pledged securities in CM’s CSMP Account. CM shall, in turn, invoke pledge in Client’s Demat Account with the TM.
The CM can directly invoke re-pledged securities of TM having open positions with CM to close out such position if the TM/Client of TM default. Likewise, in case the CM defaults, CC can (after exhaustion of collateral held with it) invoke re-pledge of such client who has open position and their re-pledge are blocked by the CC to close out their open positions. The re-pledged securities of other clients not having an open position with CC are naturally not available for the invocation to meet settlement default of the CM.
Framework for utilization of client’s pledged securities for exposure and margin.
Presently, the margin requirement is computed on a real-time basis at client level by the CC. It is aggregated at the level of CMs to arrive at the total margin requirement. The CC maintains and monitors the collateral at the CM level. CM is required to provide collateral in various acceptable forms such as Cash, Bank Guarantee, pledge of acceptable shares, etc. The day to day real-time risk management with respect to the client/TM exposure and the margin requirement shall continue to be the responsibility of the CM, and CC shall not monitor the client level exposure against the available client level collateral in real-time.
In order to provide exposure to CM and/or to the client/TM of a CM, CC shall aggregate margin requirement at the CM level. The Circular prescribes a precise methodology for calculation of the same.
The Circular also provides that in case of a trade by a client/TM whose securities are re-pledged with CC shall first block the available collateral provided by CM is mentioned in the point above. However, at a periodical interval (latest by end of day), CC shall release the blocked securities collateral of CM to the extent of re-pledged securities collateral of that client/TM available with the CC.
It provides that in the event of default by a client of TM, the TM shall make good the default to CM. In the event of default by a client or TM on its proprietary position, the CM shall make good the default to CC. Further, it prescribes a precise process to be applied by the TM/CM/CC for invocation pledged and re-pledged securities of the client/TM/CM. This involves encashment, followed by direct invocation of re-pledged securities of clients having an open position to meet settlement obligation of the defaulting CM.
It also prescribes that in case of default by a client of TM or of TM itself, CM shall be entitled to liquidate and encash the available collateral, followed by direct invocation of re-pledged securities of the client of defaulting TM who has open position through CM
Other Policy Changes
Discussion paper on ‘Usage of pool accounts in Mutual Fund Transactions’
On December 23, 2019, SEBI published its Discussion Paper on ‘Usage of pool accounts in Mutual Fund Transactions’ whereby proposal was made to discontinue pooling of funds/units by stock brokers, Mutual Fund Distributors (“MFD”), Investment Advisers (“IA”) and other platforms for Mutual Fund transactions. For the implementation of the same, certain measures prescribed therein may be ensured in case of transactions on Exchange platforms through stock broker(s).
All intermediaries involved in the process are proposed to be required to put a necessary system in place to ensure both subscription and redemption (funds transferred and units transacted between the investor and AMC) take place without the use of pooling through escrow/nodal account etc.
Said discussion paper which came to be published shortly after the unravelling of Karvy Scam expresses concerns stemming seemingly from its aftermath. The Discussion paper noted the following:
“In the recent past, instances have come to light where client’s funds/securities were diverted or mis-utilized by trading member/clearing member toward margin obligations or settlement obligations of itself or for some third party or for raising loan against shares on its own account, etc.”
Circular on ease of process for transmission of units dated December 24, 2019
This Circular simplifies the process for transmission of units. It provides that Asset Management Companies (“AMCs”) must implement image-based processing wherever the claimant is a nominee or a joint holder in the investor folio. AMC must have a dedicated Central Help Desk to provide assistance on the transmission process. Further AMCs must adopt a common transmission request form and No-Objection Certificate forms to be made available on the website of AMCs, Registrar and Transfer Agents (RTAs) and Association of Mutual Funds in India (AMFI). AMCs shall also implement a common set of document requirements for transmission of units to claimants being nominees or joint holders in the investors account. AMCs shall implement a uniform process for treatment of unclaimed funds to be transferred to the claimant including the unclaimed dividends, the uniform process for treatment of unclaimed funds is mandated to be published by the AMFI within 30 days from the date of issuance of the Circular, will be binding on all mutual funds/AMCs.
Potential proposal for unique-ids for shares
Times of India recently published that in order to prevent frauds like in this case, SEBI is considering a unique identity number for dematerialized shares that will establish a trail of ownership. In dematerialized shares, transfers are documented, but the absence of a unique identity made it possible for Karvy to pledge clients’ shares, held in its account as if they were it's own.
 Acceptable securities that may be accepted as collateral from the client.