Introduction

Since November 2019, Karvy Stock Broking, located in Hyderabad, India, has been making news for various wrong reasons.

It is estimated that the scam runs into 2500 crores of rupees and affects more than 2 lakh investors. As per reports till 23rd Nov 2020 NSE/BSE have declared Karvy Stock Broking as a defaulter and KSBL has been expelled from their membership.  

Before we understand the scam

We need to understand how the trading system works in India:

• Investors can not buy directly at the exchanges, they have to approach the exchange through brokers
• Brokers have a pool account where they hold the securities of the clients and they can have the following criteria in that 
• On the day of the settlement the securities first come to the pool account of the broker and are then transferred to the respective clients of the broker
• At the time of account opening the brokers take power of attorney from you so that they can move your securities from your demat account when you sell and can credit the security in your account when you buy. 
• If PoA is not given most of the online brokers will not allow you to sell. However if you do not give PoA then every time you need to give the signed instruction slip (DIS) within a day to move the securities. 
• Essentially the trading and clearing members are two different entities but most of the brokers perform the dual function of broker as well as the clearing member. KSBL was one such entity. 
• Once you buy or sell the security the settlement will happen on t+2 day i.e you will receive funds in your bank account or receive securities automatically in your demat account.  
• This process of receipt of funds/shares in your account is done by the depository participants based on the instruction given by the broker.

How did they pull off the scam?

Let’s understand that despite such tight regulations of SEBI and so much of digital footprints how this scam was pulled off.

There were complaints from the clients of KSBL for not receiving the timely payout. Initially they tried to get away by calling it a technical issue but then when the complaints kept on mounting SEBI issued a  warning and asked KSBL to comply with the regulations and clean up their pool account. The scam was uncovered during an audit conducted by NSE in earlier part of 2019.

A detailed report submitted by NSE to SEBI found out that on doing the client level audit it was found that one of the client accounts with DP account No 11458979 (quasi pool account)  was not being reported.

On further probe it was found that it contained the fully paid up shares of other clients and the best part was yet to come, it was found that the shares were mostly pledged and the money raised was was partly used to fund the Real Estate business of Karvy.

The report was filed by NSE to SEBI as SEBI is responsible for the check on brokers. So the scam had two parts to it

• Accounts that were not reported
• Pledging the client’s shares without clients being aware of the same.

Now the question arises that if the entire process is so transparent then how did this heist was pulled off?

Well KSBL found a loophole and targeted the accounts that were not very active.Sometimes you hold the shares in your Demat account and do no further activity. So Karvy transferred the shares from such dormant accounts to their pool account and with the help of the PoA.

They then approached the banks (ICICI , HDFC, Indusind, Kotak, Bajaj finance and Axis bank) and raised funds by pledging these securities. What KSBL did was akin to mortgaging your home as you were not living there for past 2 -3 years to take loan. They transferred the funds to their Real Estate arm. Funds raised were to the tune of 2300 Crores. 

SEBI Stepped In…

SEBI (Securities and Exchange Commission of India) passed an order dated Nov 29, 2019 prohibiting Karvy to take anymore fresh clients for the broking activity . 

The order made the following points

• Karvy can not take fresh clients meaning they can not have new clients
• NSDL/CDSL will monitor the movement of securities to and from the DP account of clients of Karvy Stock Broking Limited to ensure that client transaction are not affected.
• The transfer of securities from KSBL account (BSE )was not allowed with immediate effect from the date of the order and will only be permitted to transfer the securities to the beneficial owners accounts who have paid for the shares in full.

After the scam SEBI has tightened the norms for the brokers and few of the changes that have been implemented since September 2020 are the following

Delivery of Shares

In this case the trading will not be affected. However in case of the buy transaction where only the amount was being blocked by the broker an amount of 20% of the traded amount will be debited.This will move the trade from the postpaid basis to the prepaid basis. This will only affect the broker who are heavily dependent on personal relations and take the shares /money one day after placing the order.

Intraday trading :

Profit from intraday trades now can not be used for trading further on the same day. Now you will have to wait for t+2  days and once funds are reflected in your account only then you can trade further using that money. This will increase the fund requirement for the traders who want to trade more as they will not be able to use the profits from the intraday trade.

Pledging of Shares :

In case the shares are being pledged for the margin purpose the shares will remain in the investors account instead of moving to the account of the broker  and a lien will be created in favour of the broker. Once the lien is created the broker will have to further pledge the shares in favour of clearing corporation for the margin purpose.For doing so broker will have to take the permission of the investor through OTP. This will benefit the investor as the corporate actions will get directly credited to the account of the investor instead of broker account.

While the agencies are doing their work in making the regulations tighter we as investor also have some responsibilities.

• Check your account periodically
• Do not keep excess of funds/securities with broker
• As per SEBI PoA is not mandatory but if you are signing one then clearly mention the rights of the broker and for how long the PoA will be valid
• Sign any document after understanding it

Be smart, choose your broker carefully and do not blindly trust the broker.