Case Study - Karvy Stock Broking Limited (Part III/IV - The Lender Banks' Case)


Click to read Part I (Facts), Part II (SEBI) and Part IV (Policy Developments).

In pursuance of the November 22 Order, NSE passed an order temporarily suspending KSBL from using its platform. The four lenders Bajaj Finance Limited, ICICI Bank Limited, HDFC Bank Limited and IndusInd Bank Limited had issued various loans against shares facilities in favour of KSBL whereby loan amounts were secured against certain shares held in KSBL’s account. The outstanding exposure of Bajaj Finance Limited, ICICI Bank Limited, HDFC Bank Limited and IndusInd Bank was Rs. 344 Crore, Rs. 642.25 Crore, Rs. 350 Crore and Rs. 159.16 Crore respectively. The lenders appealed to the Securities Appellate Tribunal (“SAT”) seeking setting aside of the interim order to the extent that the shares pledged with the Banks should not be transferred to the BOs. SAT Ordered the banks to file their representations before SEBI.


Each of the said lenders had entered into LAS Agreement or its equivalent whereby KSBL had represented its absolute title over the said securities. On KSBL’s subsequent failure to keep up the margin amount in its account, each of the lenders issued notices to KSBL calling upon it to make payment of outstanding amounts. However, because of the interim order, the lenders were rendered disabled from invoking pledge. Lenders submitted themselves as a bona fide pledgees in law. SEBI’s Order in this matter pertains mainly to the determination of whether the pledges were valid or not. To that tune, it first assessed the regulatory contours of PoAs.


Powers of PoA

SEBI addressed the concerns raised by banks in its Order dated December 13, 2019, where it said:

The PoA can be acted upon by a broker only if there is any order/instruction/transaction for trade on the exchange. After the order is matched or confirmed or executed, the extent of shares to be delivered or extent of amount to be paid is crystalized and then the PoA can be activated/acted upon, for fulfilling delivery or settlement obligation.

Nature and Scope of PoA

On matching/confirmation/execution of a trade, securities move from BO Account of the client to the pool account of the stock broker by way of a PoA, since a stock broker settles the trades on a net basis for purpose of his pay-in obligations. Thereafter, the securities move from pool account of the broker to the settlement account of the CC for the settling of the net pay-in obligations, on behalf of the client.


Even though the securities have moved from the clients’ BO Account to the pool or settlement account, the client continues to be the BO under Section 10(3) of the Depositories Act, 1996 and the securities lying with the stock broker remain in trust for the client. Such client is also entitled to every benefit (dividend/bonus/rights shares, etc) received in respect of shares even though they are lying in pool or settlement account, by virtue of Section 10(3) and the broker is thereunder obligated to remit the same to the clients.


SEBI Circular dated April 23, 2010 – Standardization of PoA

This Circular standardized requirements pertaining to PoA. It provides that PoA is merely an option available to the client for instructing his broker or DP to facilitate the delivery of shares and pay-in/pay-out of funds etc. It further provides that no stock broker or DP shall deny services to the client if he/she refuses to execute PoA in their favour.


Misuse of PoA by KSBL

SEBI, in its Order dated December 13, 2019 observed the following in this regard:

“The said Circular makes it clear that the PoA given by the client to the broker is not general PoA, but is a specific PoA which can be exercised by the broker contingent upon execution of trade on the stock exchange, on instruction of client.”

Accordingly, concluded that KSBL unauthorisedly removed/transferred impugned securities to the said DP Account. The securities belonged to clients who had paid in full against these securities and there was no further instruction to act upon for KSBL.


KSBL was not authorized to pledge securities owned by its fully paid clients and hence, this unauthorized transfer of securities by it, amounts to misappropriation of clients’ securities.


An unauthorized pledge is invalid in law

In its Order dated December 13, 2019, SEBI assessed whether the pledge created by KSBL on clients’ securities, in favor of the banks was valid or not. SEBI began by noting that by a reading of Section 12(1) of the Depositories Act, 1996, it is clear that a BO can create a pledge on securities “owned” by him. Similar is provided under Regulation 58 of DP Regulations 1996 and Regulation 79 of the DP Regulations, 2018.


SEBI asserted that the securities lying in said DP Account were pledged unauthorizedly by KSBL. These securities belonged to the clients and by virtue of Section 10(3) of the Depositories Act, 1996, the clients were entitled to all benefits attached to such securities. Thus, KSBL did not at all own these securities. Accordingly, SEBI noted that in terms of provisions of the Depositories Act, 1996 and the DP Regulations, KSBL could not have pledged these securities as it was not in accordance with the law. Thus, it noted that the pledge was invalid and did not create any right in favour of the banks.


SEBI proceeded with saying that the ignorance of the June 20, 2019 Circular by Lenders was incomprehensible as they are also registered as DP. It further concluded that the Lenders did not verify the title of KSBL over the pledged securities and merely relied on the representation of KSBL, which reflected a lack of good faith on their part.


The Claim of Axis Bank

Axis Bank separately filed an appeal before the SAT against the Ex-Parte-Ad-Interim Order passed by SEBI in this matter. SAT Ordered SEBI to provide Axis Bank with an opportunity of hearing. Prior to this, Axis Bank had moved the Debts Recovery Tribunal at Hyderabad (“DRT”), which had granted a stay in respect of the transfer of pledged shares.


In its representation before SEBI, Axis Bank had submitted that a pledge was created under an Overdraft against Shares facility provided by Axis Bank to KSBL vide an Agreement dated June 10, 2019, and as on the date of its representation, the principal amount of Rs. 80.47 Crore and interest, cost charges, etc. thereon are outstanding and due to the Axis Bank from KSBL. Axis Bank claimed that the pledge, in its case, was created under the impugned DP Account which was defined as NSE-CM. It prayed that hence, the pledge created on securities in such account was in accordance with the September 26, 2016 Circular and was a valid pledge. It further argued that such validly created pledge has not been rendered invalid by SEBI Circular dated September 26, 2016. It was further submitted that the pledge was not rendered invalid by the June 20, 2019 Circular, as it merely casts an obligation on the stock brokers to unpledged all the securities belonging to their client and does not declare pledges so created as invalid.


SEBI clarified that even prior to coming in force of the June 20, 2019 Circular and in term of SEBI Circular dated September 26, 2016, stock broker was entitled to have a lien on client’s securities limited to the extent of indebtedness of such client and the stock broker could only pledge securities of such indebted clients with their explicit authorization while maintaining records of such authorization. SEBI also clarified that the June 20, 2019 Circular also required stock brokers to unpledged the pledges existing as on the date of coming into force of the said Circular.


The June 20, 2019 Circular makes it clear that the PoA given by the client can be used for the purpose of pledging in favor of stock broker only for the purpose of meeting the margin requirement.


Other legal fora

In the Lender’s case, SEBI had noted that the securities were already transferred to the clients’ accounts and rights already created/restored involving more than 80,000 investors. Accordingly, it found a prayer to recall securities or to retain them as frozen, untenable. SEBI thus asked the banks to approach civil courts for the same.


Appeal to DRT

The DRT, on application by ICICI Bank, asked KSBL to repay dues within 15 days, failing which the firm’s properties will be attached. It also restrained KSBL from any transfer of these assets.


Telangana High Court

KSBL got a relief from the Telangana High Court, which issued an order staying ICICI Bank’s petition moving the DRT to recover dues, to the extent of appointing an advocate commissioner to take possession of properties belonging to KSBL.

SEBI noted that the authorization claimed by Axis Bank under the PoA is not ‘explicit authorization’ of the client, as referred to under SEBI Circular dated September 26, 2016. Accordingly, Axis Bank’s plea also failed.

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