SEBI, in its Interim Order dated November 22, 2019, observed that the securities lying in the aforesaid KSBL DP Account actually belonged to clients who are the legitimate owners of the securities. KSBL thus did not have any legal right to create any kind of pledge on these securities. SEBI noted that the pledging was only permissible for meeting the obligations of the respective clients. This was not the case. Considering the misuse of clients’ securities by KSBL in an unauthorized manner for its own use, and purposely failing to disclose the DP Account to exchanges created serious doubt on its conduct and integrity.
SEBI thus found KSBL’s acts to be prima facie in violation of Stock Broker Regulations, SEBI circulars dated November 18, 1993; April 17, 2008; September 26, 2016; December 16, 2016; June 13, 2017; June 22, 2017, and Circular No. CIR/HO/MIRSD/DOP/CIR/P/2019 dated June 20, 2019.
SEBI prohibited KSBL from taking on any new clients. It Ordered the Depositories to not act upon any instructions given by KSBL in pursuance of PoA, given to KSBL by its clients. This was done in order to prevent further misuse of clients’ securities by KSBL.
The Depositories were ordered to monitor the movement of securities to and fro the DP Account, of clients of KSBL, in order to ensure that client operations are not affected. Further, the Depositories were ordered not to allow the transfer of securities from aforesaid KSBL except to respective BOs who have paid in full against these securities under NSE supervision. Finally, the Depositories and Stock Exchanges were directed to initiate appropriate disciplinary proceedings against KSBL for misuse of clients’ funds and securities per their respective bye-laws, rules and regulations.
SEBI’s law on misuse of clients’ securities by brokers
SEBI has, in this Order, traced the law on segregation of client funds and securities from that of the broker as well as the pledging and exposure norms.
In order to protect clients’ funds and securities, the Securities Contracts (Regulation) Act, 1956 and SEBI (Stock-Broker) Regulations, 1992 require the stock brokers to segregate securities or moneys of clients’ and requires brokers to not use these for self or for any other client.
As early as in 1993, SEBI Circular No. SMD/SED/CIR/93/23321 dated November 18 made it compulsory for all member brokers to keep the money of clients in a separate account and their own money in a separate account. It prohibited any payment for transactions in which the member broker is taking a position as principal to be made from the client’s account.
Accordingly, it obligated brokers to keep such moneys in a separate account in name of the member with the word “client” was required to appear in the title. Such accounts for client’s securities inter alia provide for firstly, fully paid securities, pending delivery to clients and secondly, fully paid client’s securities registered in the name of the member, if any towards margin requirements.
Thereafter, SEBI Circular No. MRD/DOP/SE/Cir – 11/2008 dated April 17, 2008 reiterated the need for brokers to maintain proper records of client collateral and to prevent misuse of client collateral. This Circular required brokers to maintain records to ensure a proper audit trail of use of client collateral, which should include details of receipt of collateral from client and acknowledgement issued to the client on receipt of collateral; client authorization for the deposit of collateral with the exchange/clearing corporation (“CC”)/clearing house towards margin; record of deposit of collateral with exchange/CC/clearing house; a record of return of collateral to client and credit of corporate action benefits to clients.
This was done to ensure that client collateral is not used for any purpose other than meeting the respective client’s margin requirement/pay-ins.
Further, SEBI Circular No. SEBI/HO/MIRSD/MIRSD2/CIR/P/2016/95 dated September 26, 2016 on enhanced supervision of Stock Brokers and DPs provides that brokers must upload clients’ fund balance and securities balance by the Stock Brokers on Stock Exchange system, specifically providing among other things, ISIN wise number of securities pledged, if any, and the funds raised from pledging such securities.
This Circular also provides that transfer of securities between the Broker’s Client Account to its Proprietary Account is permitted only for legitimate purposes such as the implementation of any Government/Regulatory directions or orders, in case of erroneous transfers pertaining to client's securities, for meeting legitimate dues of the stock broker, etc. For such transfer of securities, stock broker is required to maintain a stock transfer register clearly indicating the day-wise details of securities transferred.
Further, a lien on or pledge of client’s securities to the extent of the client’s indebtedness is permitted only if the same is done through Depository system and in compliance with Regulation 58 of the SEBI (Depositories and Participants) Regulations, 1996 (since repealed).
SEBI Circular No. CIR/MRD/DP/54/2017 dated June 13, 2017, prohibits a broker from granting further exposure to clients when debit balance arise out of client’s failure to pay the required amount and such debit balance continues beyond the fifth trading day, as reckoned from date of pay-in, except in accordance with the margin trading facility provided under this Circular.
SEBI Circular No. SEBI/HO/MRD/DP/CIR/P/2016/136 dated December 16, 2016, specified that “the member shall transfer securities from pool account to the respective beneficiary account of their client within 1 working day after the pay-out day. The securities lying in the pool account beyond the stipulated 1 working day shall attract a penalty at the rate of 6 basis point per week on the value of securities.”
This Circular references the prevalent practice of Trading Member (“TM”) and Clearing Member (“CM”) of transferring clients’ securities into their own account by title transfer and then placing such securities as collateral to Banks/NBFCs and/or fulfilling securities shortage of other clients/proprietary trades.
The Circular then goes on to state that this is not contemplated in the provisions of the abovementioned SEBI Circulars. It came into force on October 01, 2019 and sought to clarify the underlying norm that, under no circumstance shall the TM/CM retain securities received in pay-in beyond five trading days and be used for any other purposes. It provides that the TM/CM shall transfer the securities received in pay-out within one trading day. In case the client fails to meet the pay-in obligation, the TM/CM is entitled to retain the securities for five trading days from the day of pay-out, following which TM/CM is under obligation to liquidate the securities to recover the dues.
It also explicitly provided that w.e.f. September 01, 2019, clients’ securities lying with the TM/CM in “client collateral account” , “Client Margin Trading Securities account” and “client unpaid securities account” cannot be pledged to the Banks/NBFCs for raising funds, even with authorization by the client as the same would amount to fund based activity by TM/CM which is in contravention of Rule 8(1)(f) & 8(3)(f) of Securities Contracts (Regulation) Rules, 1957.