Karvy’s clients have a legitimate right to their shares

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The Karvy saga demonstrates how a disingenuous custodian can, by deceitful means, expose thousands of hapless and unsuspecting investors to the imminent loss of their hard-earned savings. Thanks to the timely intervention and effective interim directions of the Securities and Exchange Board of India (Sebi), though, such an undesirable event was averted, and the securities wrongly assigned were transferred back to their rightful owners.

Karvy, as a Sebi-registered broker to thousands of active stock market investors, pledged securities worth more than 2,300 crore belonging to over 95,000 clients with four lenders as collateral in lieu of loans worth hundreds of crore. The Sebi Act, read with several circulars and guidelines issued by it, clearly require a broker to keep the fully-paid-for securities of its clients in separate beneficiary accounts, specifically to guard against any such misdemeanour by brokers. Instead—according to Sebi’s interim order of 22 November issued on the basis of a preliminary report by the National Stock Exchange (NSE) red-flagging several non-compliances by Karvy—the broker, misusing the powers of attorney furnished by its clients for the efficient and seamless disposal of their securities upon their oral instructions, allegedly first got them transferred to its own account, and then pledged them to various lenders, making them out to be its own securities. The loans received from those bankers were credited to six different accounts of Karvy. Sensing the potential for irreversible damage to thousands of mostly small investors, Sebi ordered depositories not to allow the transfer of these securities from Karvy’s own account, except to the beneficial owners of these fully-paid-for securities under the supervision of the NSE.

The Securities Appellate Tribunal (SAT), upon appeals by the lenders, heard them on 3 and 4 December. In two separate orders, the tribunal did not reflect upon the merits of the Sebi order and only directed it to give an audience to lenders. In fact, in the order of 4 December, it noted that pursuant to Sebi’s order, the securities legitimately belonging to over 80,000 Karvy investors had already been transferred to their respective accounts, and refused to freeze those accounts or reverse such transfers, and rightly so.

Deciding this matter on merit is going to be an arduous task for any adjudicator. Karvy’s actions are prima facie illegal, in violation of the Sebi Act, as well as the rules and instructions issued thereunder. They seem to have the odour of fraudulent transactions, and will probably merit criminal investigation and prosecution under the Indian Penal Code for dishonest misappropriation of property and criminal breach of trust.

Not just that. The securities’ regulator may take additional action as per the statute that it is a child of. A more detailed and thoughtful examination will be required to weigh the legitimacy of the ownership rights of investors who were clients of Karvy, against those of the pledgees of these securities, who lent money to Karvy by accepting its professed ownership of these, as appears to have happened.

It is a well-known fact and matter of practice that retail investors, who generally have a regular but minor interest in the securities market, hand their brokers blank powers of attorney to be used upon their oral/telephonic instructions for the sale of shares and suchlike. This has been in vogue despite Sebi’s Master Circular on Delivery Instruction Slip providing other more secure modes of instruction for the delivery of securities, such as delivery instruction slips or the Speed-e facility. This is well known to mostly everyone associated with stock markets, including banks. On this fact alone, Karvy’s lenders should have acted more cautiously and conducted appropriate due diligence on the ownership of the pledged securities. In the usual course of events, it seldom happens that a bank lends a large amount of money without adequately checking the collateral offered by the borrower as a guarantee of loan repayment. Thus, the maxim “caveat emptor” should squarely be applicable in this case. Let the buyer beware. Before lending money to an entity whose primary business is to deal in securities on behalf of scores of retail investors, banks ought to take all possible care to ensure that the collateral they are accepting is actually owned by the pledgor. Banks, in contradistinction with small retail investors, are far better placed—given their corporate clout, access and wherewithal—to exercise such caution. After purchasing the securities and having handed the customary powers of attorney to their “trusted” brokers, retail investors have no occasion to block any illegitimate or uninstructed conveyance of their assets.

In any case, in such circumstances, one set of stakeholders will have to bear the brunt. If investors have got the securities safely in their own accounts, the only recourse available to lenders against a borrower who may have flouted the law is civil and criminal action, including perhaps the initiation of insolvency proceedings. These banks have the means to adopt this course of action.

Had the reverse happened and banks got the pledged shares, thousands of small investors would have been left high and dry in their effort to repossess the securities. From this perspective as well, it is only fair that retail investors of relatively modest means are not deprived of their lawfully acquired assets.

Jagvir Singh is founding partner, Jupiter Law Partners, Delhi



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