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SEBI Imposes Stringent Norms to Prevent Misuse of Clients’ Securities

Finsec Law Advisors

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In the aftermath of the Karvy Stock Broking Limited (“KSBL”) incident, SEBI issued a circular on February 25, 2020 imposing stringent restrictions on transfer of clients’ securities to the demat account of trading members (TM) / clearing members (CM). In November 2019, SEBI found that KSBL had allegedly misappropriated client’s securities and funds to the tune of Rs. 1096 Crore, by misusing the powers of attorney (“PoA”) issued by such clients. As per SEBI’s order dated November 22, 2019, KSBL had violated SEBI’s circular dated June 20, 2019 which explicitly prohibited stock brokers from pledging clients’ securities except for meeting pay-in obligations of the clients. Some of the major changes introduced through the circular are discussed below.

With effect from June 01, 2020, for providing collateral of securities as margin, a client is now required to pledge the securities with the TM as “margin pledge”, which is to be created in accordance with the provisions of the Depositories Act, 1996, the SEBI (Depositories and Participants) Regulations, 2018 and the relevant bye-laws of the depositories. According to the circular, in case of a “margin pledge”, the TMs will, in turn, repledge such securities with the CM, which will in turn repledge such securities to the clearing corporations. In this regard, TMs / CMs are required to open and maintain separate demat accounts tagged as “Client Securities Margin Pledge Account” and the complete trail of such re-pledge, as stated above, should be reflected in the demat account of the pledgor.

While re-pledge has been defined as endorsement of pledge by the TM / CM in favour of the CM or clearing corporation, as the case may be, it has been clarified that any off-market transfer of securities shall not be treated as pledge as it leads to a change in ownership.

The circular lays down a detailed and comprehensive framework for operating such “margin pledge” which provides for initiation of such pledge, release and invocation of pledge, etc. It is stated that a “margin pledge” can be initiated by clients in favour of the TM / CM through physical or electronic instruction mechanism of the depositories only, and express consent of such clients is required on a ‘pledge request form’. The circular also inter alia states that in case of any default by the client, the TMs can invoke such pledge by making a request to the CM, who will in turn make a similar request to the clearing corporation, in accordance with the bye-laws of the depositories.

Additionally, the TMs and CMs are required to ensure that any client’s securities pledged to the clearing corporations shall be used for providing exposure limits to such client only.

Further, the circular expressly prohibits TMs / CMs from transferring clients’ securities to their own demat accounts for the purpose of meeting margin obligations. In case any PoA is executed by the clients in favour of the TM / CM, mere holding of such PoA shall not be construed as collection of margin by the TM / CM in respect of such clients’ securities.

As per the circular, all existing demat accounts tagged as ‘Client Margin Collateral’ are required to be closed by TMs / CMs by June 30, 2020 and all client securities lying in such accounts are required to be transferred to the respective clients’ demat accounts.

The above restrictions have been imposed in order to prevent stock brokers from misusing clients’ securities, by merely relying on the PoA executed by such clients.