Order in the matter of Karvy Stock Broking Limited – Representations by Axis Bank Ltd.

Order in the matter of Karvy Stock Broking Limited- Representations by Axis Bank Ltd.

WTM/AB/SEBI/MIRSD/HO/42/2019-20

SECURITIES AND EXCHANGE BOARD OF INDIA CORAM: ANANTA BARUA, WHOLE TIME MEMBER ORDER

UNDER SECTIONS 11(1), 11(4) AND 11B OF THE SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992 - IN THE MATTER OF KARVY STOCK BROKING LIMITED In respect of representation made pursuant to order of Hon’ble SAT, by Axis Bank Limited

1. A communication dated November 23, 2019 was received by Axis Bank Limited (hereinafter referred to as “the Representor”) from National Securities Depository Limited (NSDL), a depository registered with SEBI, which inter alia stated as under:

“Please refer to SEBI Ex Parte–Ad Interim Order bearing ref. no. WTM/AB/SEBI/MIRSD/HO/35/2019 dated November 22, 2019, wherein it appears that Karvy Stock Broking Ltd. (KSBL) misused client securities, pledged the same and generated funds, though it did not have a legal right to do so and in violation of various SEBI circulars and guidelines referred to therein.

SEBI advised Depositories, as a proactive and interim measure, to take all immediate necessary actions to protect the interest of investors, whose shares have been pledged. Accordingly, based on the information provided by NSE, such client securities that appear to be pledged are therefore under a state of abeyance. You may intimate your pledgee client (DP ID: IN300484/Client ID: 10392275) suitably.”

2. Aggrieved by the aforesaid communication, the Representor filed an Appeal (L) No. 597 of 2019 – Axis Bank Limited Vs. SEBI & Ors. Before Hon’ble Securities Appellate Tribunal, Mumbai (hereinafter referred to as “Hon’ble SAT”) whereby Hon’ble SAT has directed as under:

“…………………. 11. Having heard the learned counsel for the parties, and having perused the documents, we are of the view that the preliminary objection regarding maintainability of the appeal is not sustainable since the appellant is an affected party impacted by all the impugned communications/ orders together which the appeal is also challenging. It is a fact that the appellant as a bank has lent funds to Karvy under a permitted Loan against Shares arrangement and under the Depositories Act, rights and sanctity are provided to such pledged accounts. Therefore, the appellant is an affected party is clearly undisputed. It is also a fact that the appellant was not heard either by SEBI or by the Exchanges or Depositories before passing the impugned directions. Though, the account frozen explicitly by the WTM of SEBI by order dated November 22, 2019 is not the same account as that of the appellant implicitly the order has got extended to such accounts because of the sweeping nature of the WTM’s directions to protect the interest of the investors. Hence the action by Respondent No. 3 NSDL is also a consequential one as clearly stated in their communication.

12. Though the learned Senior Counsel for the appellant seeks to suggest a solution stating that some of the investors in fact owe dues to Karvy and hence securities to the extent of such dues rightly belonging to Karvy at least could be used by the appellant to invoke the pledge so that at least part of the funds would be available to the appellant. We are not in a position to ascertain the veracity of the information as provided by Karvy to the appellant. Therefore, in view of the facts and circumstances of the case we direct the appellant to file an appropriate representation before SEBI. If such an application is filed SEBI will hear the appellant and other relevant entities and pass appropriate directions within 15 days from the date of this order. In the interim status quo shall be maintained in respect of the securities in Account No. 19502787 named “Karvy Stock Broking Limited- Client Account-NSE CM…………...”

3. In view of the aforesaid order dated December 17, 2019 passed by the Hon’ble SAT in Appeal (L) No. 597 of 2019, an opportunity of hearing was provided to the Representor alongwith other concerned entities like National Stock Exchange of India Limited (NSEIL) (Respondent No. 5 in the Appeal), Karvy Stock Broking Ltd. (KSBL)

(Respondent No. 2 in the Appeal), NSDL (Respondent No. 3 in the Appeal) and Central Depositories Services Limited (CDSL) (Respondent NO. 4 in the Appeal), on December 19, 2019. During the hearing, the Representor made the representation dated December 19, 2019. During the said hearing, the representatives of NSDL and NSEIL were present. However, KSBL was not present on the said date of hearing. In view of this, the hearing was adjourned to the next day i.e. December 20, 2019. During the hearing held on December 20, 2019, the advocates/representatives of NSDL, NSEIL, KSBL and the Representor were present. During the said hearing, the advocate for KSBL undertook that any money that would be received from the clients whose securities were pledged under the demat account no. 19502787 named as “Karvy Stock Broking Ltd. – Client Account NSE-CM” (hereinafter referred to as “impugned demat account”), would be deposited into a no lien escrow bank account to be opened by NSEIL. Further, in the said hearing, NSEIL agreed to share the data in respect of KSBL's clients as on November 22, 2019, whose securities are pledged through the impugned demat account, with the Representor. On the said date, matter was adjourned for further hearing to be held on January 08, 2020.

4. The Representor filed a Miscellaneous Application No. 650 of 2019 in disposed of Appeal (L) No. 597 of 2019 wherein Hon’ble SAT vide its order dated December 20, 2019 while disposing of the miscellaneous application passed the following order:

“…..2. On the application of the appellant, and after considering submissions of the parties, we modify our order dated December 17, 2019 to the extent that SEBI will pass appropriate orders on the representation of the appellant on or before January 15, 2020. Misc. Application No. 650 of 2019 is accordingly disposed off……..”

5. On January 08, 2020, the Representor was heard when the representatives of NSEIL, NSDL and KSBL were also present. The Representor sought three days’ time to file written submissions which was granted to it. The Representor has filed its written submission dated January 14, 2020 on the same date.

6. I have considered the representation dated December 19, 2019, submissions made during the hearings held on December 19, 2019, December 20, 2019 and January 08, 2020 and the written submission dated January 14, 2020 and my finding thereon are given in the following paras.

7. During the hearing held on January 08, 2019, the Representor produced a copy of the order dated December 31, 2019 passed by Hon’ble Debts Recovery Tribunal-II (hereinafter referred to as “DRT”), Hyderabad in O.A. No. 883/2019 – Axis Bank Ltd. Vs. M/s. Karvy Stock Broking Ltd. stating that the DRT by the said order has granted a stay in respect of transfer of pledged shares. I have perused the said order and on perusal it is noted that in the said order the respondents-defendants, their agents and/or servants have been restrained from any manner whatsoever dealing with, disposing of, transferring, alienating, encumbering or otherwise charging movable/immovable properties described in petition schedules A to E, till the date of next hearing and the matter has been directed to be called on February 04, 2020. Hon’ble DRT has also directed the Respondents/Defendants to deposit sufficient security before DRT within 15 days from the date of the receipt of the order failing which the properties in Schedules shall stand attached. The Representor who is petitioner in the said O.A., subsequent to the above order dated December 31, 2019 of Hon’ble DRT, attended the hearing on January 08, 2020 and made submissions for disposal of its representation dated December 19, 2019 and also filed its written submissions on January 14, 2020 seeking passing of appropriate order by SEBI. The order dated December 31, 2010 passed by Hon’ble DRT does not in any way affect the order of status quo directed by the Hon’ble SAT and disposal of the representation dated December 19, 2019 made by the Representor as directed in the orders dated December 17, 2019 and December 20, 2019, passed by Hon’ble SAT. Moreover, the Representor itself has requested for passing of appropriate order in its written submissions dated January 14, 2020.

8. The Representor has submitted that the impugned demat account is different from the demat account in respect of which SEBI has issued directions in the interim order, therefore, by issuing communication dated November 23, 2019, NSDL has acted beyond the scope of the order. The Representor has also submitted that unlike the demat account referred to in the interim order dated November 22, 2019 passed by SEBI, the impugned demat account was disclosed to the stock exchanges by KSBL. To deal with this contention of the Representor, it would be appropriate to understand the background in which the letter dated November 23, 2019 appears to have been issued by NSDL. On November 22, 2019, Securities and Exchange Board of India (hereinafter referred to as “SEBI”) passed an ex parte ad interim order cum show cause notice dated (hereinafter referred to as “interim order”) against KSBL as in the interim report given by NSE in the matter, revealed that in one demat account no. 11458979, named KARVY STOCK BROKING LTD (BSE) which was not disclosed by KSBL in its filings with stock exchanges, the securities worth Rs. 2300 crore (approx.) of more than 95,000 clients, were unauthorizedly transferred into the account by KSBL to generate funds for its own/group entities use. In the interim order, inter alia, depositories were directed to ensure that transfer of securities from DP account no. 11458979 is permitted only to the respective beneficial owner who has paid in full against the securities, under supervision of NSEIL. I find that as KSBL was found to be involved in unauthorized pledging of the securities belonging to its clients, NSDL as a proactive measure, to protect the interest of the investors, has kept in abeyance the securities lying in the impugned demat account as it was expected to act on the similar lines.

9. The Representor has submitted that the pledge has been created under an Overdraft Against Shares Facility provided by the Representor to KSBL, vide Agreement dated June 10, 2019. It has been further submitted that as on date, the principal amount of about Rs. 80.47 crore and interest, cost charges etc. thereon is outstanding and due to the Representor from KSBL. The overdraft facility is claimed to be secured by KSBL by pledging the securities lying in the impugned demat account. It is the case of the Representor that since the pledge was created under the impugned demat account which was identified as “Karvy Stock Broking Ltd. – Client Account NSE-CM”, hence, the pledge created on the securities lying in such account was in accordance with the provisions of SEBI circular dated September 26, 2016 and was a valid pledge. It has further been argued that such a validly created pledge has not been rendered invalid by SEBI circular dated June 20, 2019 which merely casts obligation on the stock brokers to unpledge all the securities belonging to their client and does not declare pledges so created as invalid. According to the Representor, SEBI circular dated June 20, 2019 did not per se declare the pledge existing on the date of coming into force of the circular, as invalid. More so when the Representor itself brought to the notice of KSBL and SEBI about the compliance with the requirement of circular dated June 20, 2019 regarding unpledging of securities belonging to the clients. It has further been submitted by the Representor that the validity of pledge is not dependent on the subsisting obligation of the client towards the broker. The Representor has also submitted that KSBL had represented to it that the shares pledged with it by KSBL belonged to its client and the amounts availed under the OAS Facility were less than or equal to the amounts owed by such clients to KSBL.

10. As requested by the Representor during the hearing held on December 20, 2019, NSEIL undertook to provide the data pertaining to fully paid and partly/unpaid clients of KSBL whose securities were lying in the impugned demat account. During the course of hearing held on January 08, 2020, the Representor submitted that the NSEIL has provided it data of securities pledged by KSBL with the Representor with bifurcation in to fully paid and partly/unpaid clients and the Representor has also disputed the correctness of such data. I note that the data of pledged securities provided by NSEIL indicates that securities pledged by KSBL in favour of the Representor belonged to its fully paid as well as partly/unpaid clients. As per NSEIL, the value of the securities belonging to fully paid client is Rs. 171.74 crores and value of the securities of other than fully paid clients is Rs. 13.69 crores.

11. Regarding pledging of securities of fully paid clients, a stock broker has no authority to pledge the securities of its fully paid clients. If a stock broker pledges securities of its fully paid clients, it amounts to misappropriation of clients’ securities by the stock broker. Even if securities belonging to fully paid clients are pledged by the stock broker, such pledge does not pass any title to the pledgee, as the stock broker in such case himself/itself does not possess any title/right over such securities. Thus, pledge of securities, belonging to fully paid client, is not treated as valid pledge in law.

12. The Representor has also referred to the judgment of the Hon’ble Supreme Court in Standard Chartered Bank Vs. Custodian (2000) 6 SCC 427 and the order of Hon’ble SAT in the matter of Liquid Holdings Pvt. Ltd. Vs. SEBI and New Delhi Televisions Ltd. Vs. SEBI. I have perused these judgments/orders and find that they have no bearing in the facts and circumstances of the present case as in the first instance the clients did not pledge their securities in the impugned demat account in favour of KSBL and nor did KSBL have right/authorization to pledge the securities of client in the impugned demat account, in favour of the Representor. The consequences of accepting the contention of the Representor regarding pledge has been explained in ABN Amro Bank Vs. Indian Railway Finance 1996 85 Comp Cas 689 CLB, as follows:

“...........52. If wrongful pledging of a third party's securities is recognised as valid for the purpose of conveying title, the investors will be in for a raw deal. The securities market being a wide network, it is essential to rely on the services of intermediaries who take upon themselves the responsibility of delivering the scrips or receiving the price. Every such transaction has to be as per the rules of the stock exchange and should be evidenced bya contract note as the brokers being members of the stock exchange are governed by the rules and regulations of the exchange. If such wrongful pledging is recognised, there will be total chaos in the securities market. As such the stock exchange regulations do not permit this in the ordinary course. Thus, we come to the inevitable conclusion that the delivery of the IRFC bonds does not convey a good title to the petitioner-bank, and they cannot appropriate the same to themselves..............”

13. As regards pledging of securities belonging to partly paid/unpaid clients, I note that prior to coming into force of SEBI circular dated June 20, 2019, in terms of SEBI circular dated September 26, 2016, stock broker was entitled to have a lien on client’s securities only to the extent of indebtness of the client and the stock broker could pledge securities of indebted clients with the “explicit authorization” of the client and the stock broker was required to maintain records of such authorisation. In this regard, SEBI circular dated September 26, 2016 provides as under:

“2.5. As per existing norms, a stock broker is entitled to have a lien on client's securities to the extent of the client's indebtedness to the stock broker and the stock broker may pledge those securities. This pledge can occur only with the explicit authorization of the client and the stock broker needs to maintain records of such authorisation. Pledge of such securities is permitted, only if, the same is done through Depository system in compliance with Regulation 58 of the SEBI (Depositories and Participants) Regulations,1996. To strengthen the existing mechanism, the stock brokers shall ensure the following:

2.5.1. Securities of only those clients can be pledged who have a debit balance in their ledger. 2.5.2. Funds raised against such pledged securities for a client shall not exceed the debit balance in the ledger of that particular client. 2.5.3. Funds raised against such pledged securities shall be credited only to the bank account named as "Name of the Stock Broker - Client Account". 2.5.4. The securities to be pledged shall be pledged from BO account tagged as "Name of the Stock Broker - Client Account"……………………”

The above circular was modified by June 20, 2019 which prohibited pledging of the securities of the clients by the stock broker and also required stock brokers to unpledged the pledges existing as on the date of coming into force of the circular dated June 20, 2019 i.e. October 01, 2019. The Representor has claimed that vide their letters dated August 20, 2019 and September 18, 2019, has requested KSBL to fund the outstanding amount and unpledge the securities, to ensure compliance with the SEBI circular dated June 20, 2019.

14. From the above, I note that pledging of securities of unpaid clients required taking of “explicit authorization” by the stock broker from each such client and in respect of each such pledging. The Representor has submitted that the PoA given by the client was sufficient authorization to create such a pledge. However, I do not agree with such interpretation given to the scope of PoA. I note that the scope and ambit of the PoA is laid down in the SEBI’s circular dated April 23, 2010 which standardized the requirements pertaining to PoA and inter alia provided as:

Relevant Extract of the SEBI’s Circular dated April 23, 2010:

“PoA favouring Stock Brokers PoA executed in favour of a Stock Broker by the client should be limited to the following: 1. Securities i. Transfer of securities held in the beneficial owner account(s) of the client(s) towards stock exchange related margin / delivery obligations arising out of trades executed by the Client(s) on the stock exchange through the same Stock Broker.

ii. Pledge the securities in favour of Stock Broker for the limited purpose of meeting the margin requirements of the client(s) in connection with the trades executed by the clients on the stock exchange through the same Stock Broker. Necessary audit trail should be available with the Stock Broker for such transactions.

iii. To apply for various products like Mutual Funds, Public Issues (shares as well as debentures), rights, offer of shares, tendering shares in open offers etc. pursuant to the instructions of the Client(s). However, a proper audit trail should be maintained by the Stock Broker to prove that the necessary application/act was made/done pursuant to receipt of instruction from Client.”

15. The said circular, makes it clear that the PoA given by the client to the broker can be used for the purpose of pledging in favour of the stock broker, “only” for the purposes of meeting the margin requirements. The authorization claimed under said PoA by the Representor is not the “explicit authorization” of the client, as referred to under SEBI circular dated September 26, 2016 and of which record is also required to be maintained by the stock broker of all such authorisations.

16. The Representor, in para 18 (e) of its representation dated December 19, 2019 has prayed that in respect of partly/unpaid clients, KSBL be directed to issue five days notice to the clients or the Representor be allowed to issue 5 days notice to clients to enable the clients to redeem the pledged shares by making payment of the corresponding outstanding indebtedness, failing which the Representor be permitted to invoke the pledge on shares. If the Representor is able to show proof of authorization in respect of securities having value of Rs. 13.69 crores belonging to unpaid clients, such securities can be released to the Representor after following the above procedure under supervision of NSEIL.

17. The Representation made by the Representor is disposed of, on the aforesaid lines.

sd/- Place: Mumbai ANANTA BARUA Date: January 14, 2020 WHOLE TIME MEMBER SECURITIES AND EXCHANGE BOARD OF INDIA