Karvy Crisis: Should Lenders Have Known Better?
Customers wait at a HDFC Bank Ltd. bank branch in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

Karvy Crisis: Should Lenders Have Known Better?

In the latest Karvy Stock Broking Ltd. crisis, the Securities Appellate Tribunal has told four lenders to make their case before the market regulator in order to retrieve their funds.

On Nov. 22, via an interim order, the Securities and Exchange Board of India had barred Karvy from taking on any new clients after investigations indicated the brokerage had unauthorisedly pledged client securities to raise funds that it put to private use. But that’s left the lenders in a fix.

Six lenders, including Bajaj Finance Ltd., HDFC Bank Ltd., ICICI Bank Ltd. and IndusInd Bank Ltd. are seeking transfer of shares that Karvy had pledged with them. Except that as per SEBI’s order these shares have been returned to the more than 83,000 client beneficiary accounts.

As lenders make their case for relief before the market regulator, there are three questions that this case raises:

  • Do brokers need client consent for every transaction under the power of attorney?
  • Do lenders do any due diligence to ensure that the shares being pledged belong to the brokerage?
  • And, finally what relief can lenders now hope for?

Pratibha Jain, head of regulatory practice at Nishith Desai Associates, and Sanjay Asher, senior partner at Crawford Bayley, shared their views on The Fineprint— BloombergQuint’s weekly show on law and policy.

PoA: What Can A Broker Do?

Investors or clients execute a power of attorney in favour of the stockbroker and depository participant to authorise the broker to operate their demat and bank accounts to facilitate delivery of shares and pay-in, pay-out of funds. SEBI has laid down specific guidelines on what a broker can and cannot do using a client’s PoA.

Permitted transactions include meeting client’s settlement obligations and margin requirements, recovering any outstanding amount as a result of a client’s trading activities, etc. A broker isn’t allowed to transfer client securities for off-market trades, execute trade in clients’ name without consent, etc.

What is the market practice around power of attorney? Do clients need to authorise every transaction before a broker undertakes it?

Jain: There are enough and many regulations that clearly state that brokers cannot use clients’ money or clients’ security for its own beneficial purposes, and it can only be either pledged or used for fulfilling a client’s margin or other payout requirements. Given that brokers act as trusted advisers to clients, as far as we know, this is very strictly adhered to in the market. So, the Karvy case really came as a surprise to all of us.

Asher: The law on client-broker power of attorney is very clear and there are enough number of judgments, not only today but even if you go back 50 years when market was still developing, on this. These judgments have clearly laid down that a stockbroker has to work in a very limited and strict framework. And therefore, clearly, Karvy has abused the power of attorney for its benefit, which isn’t permitted.

Should Lenders Have Known Better?

In its interim order, SEBI had noted that Karvy credited the funds — raised by pledging of client securities — to six of its own bank stockbroker-client accounts and didn’t report any of its six bank accounts. Karvy did not have a legal right to create a pledge on these client securities and generate funds. Even if client securities were pledged, it should have been only for meeting the obligation of the respective clients only, which was not observed in this case, SEBI’s order said.

The money, that Karvy allegedly diverted to its group company Karvy Realty, was raised from six lenders — Bajaj Finance, HDFC Bank, ICICI Bank, IndusInd Bank, Axis Bank and Kotak Mahindra Bank.

When lenders had given money to Karvy Broking, should they not have done their due diligence to ensure that the securities being pledged belonged to the brokers and not its clients?

Jain: This is not like some bespoke M&A transaction. These are standard transactions that happen in regular course of business between brokers and lenders, specifically for undertaking their broker business.

Before the June 2019 circular that prohibited brokers from pledging partly-paid securities and had directed them to unwind any loans, brokerages could pledge securities lying in the pool account. Possibly, here, what happened was that the securities were pledged from the pool account which means the lender wouldn’t know that they didn’t belong to Karvy. And then, the money that was raised was used for the purposes of not meeting any requirement the clients had for their transaction. That money which came from the pledge of the securities was transferred by Karvy to their own account which was not disclosed to SEBI.

In that scenario there is no way for the lender to know that the money is being siphoned off for use by Karvy for its own purposes rather than for client purposes. If that is the situation, then according to the law and procedures in the market, there is no wrongdoing on behalf of the lenders. What remains to be seen is whether all transactions of pledging of securities were done in this manner or if there were any pledges that happened from Karvy’s own account.

Asher: The lenders have clearly not carried out proper due diligence because if you go to the depository participant and you get a transaction statement, you will know where the shares have come from and who owns them.

Now, take an immovable property. If you are raising money against an immovable property, you do a title search. Why then a similar title search wasn’t done when money was lent on the basis of securities. Whether it’s an M&A transaction or lending transaction, at the end of the day, one has to check that the person pledging the shares owns them legitimately or not or the shares have been stolen or owned in a manner which is illegitimate.

And so, in my view, clearly the lenders should have done proper or detailed due diligence at the time of lending the money or taking the pledge.

Jain: What Sanjay is saying is right but it’s applicable if Karvy used its own accounts but they were using what is called the pool account, which is where the securities are pooled in by the brokers legitimately under SEBI’s regulations and then used for meeting clients margin requirements or other requirements.

In that scenario, lenders — even if they look where these securities are coming from — they will see them as securities held by Karvy on behalf of the clients and hence you assume that they are following the regulations and using the money for client proposes.

Before lenders enter into such pledge transactions, do they require the brokerage to present board resolutions, or audit committee approvals?

Asher: Absolutely, given the large amounts involved, the lenders should’ve seen whether the brokerage has passed a board resolution under Section 179 of the Companies Act, authorising the officers to pledge shares in the pool account.

Two, they would have taken a certificate from a chartered accountant or from a statutory auditor specifying where the money would be used, where the shares are coming from, whether it’s being raised to meet clients’ margin requirements or any other purpose.

So, surely the lenders should’ve asked for the audit committee and board resolutions, as also a certificate from the statutory auditor of Karvy. Whether the lenders did all this or not will become clear once SEBI concludes its investigation.

What Relief Can Lenders Hope For?

Most of the securities that Karvy had pledged with the six lenders have been transferred to around 83,000 beneficiary accounts as per SEBI’s interim order. Bajaj Finance was the first to move the appellate tribunal against this direction of the market regulator. It had extended loans to Karvy for various working capital requirements, against which the brokerage had pledged shares with an undertaking that it owned the securities, Bajaj Finance argued before the SAT.

But the non-bank lender and other banks were directed to approach SEBI’s whole-time member for any relief.

Can the regulator say that this a contractual dispute between Karvy and the lenders, and what SEBI should’ve done to protect the interests of the investors, it already has?

Asher: The banks can only hope to get their money back and to my mind, lenders may not get any practical relief from SEBI. They will have to take Karvy to court for breach of contract to recover the amounts. SEBI cannot settle the dispute between the lenders and Karvy.

Jain: That’s correct. Though, there is a recent notification under IBC (Insolvency and Bankruptcy Code) that allows financial companies to be taken to insolvency. But that has to be done under the directions of the regulator. Here, SEBI’s primary goal is to protect the retail investors who had given the brokerage mandate to Karvy.

SEBI will first see that how their interest is protected and perhaps lenders could ask the regulator to allow them to recover money via insolvency proceedings. Otherwise, they will have to follow the normal course before courts to recover the money.

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