Sebi puts Karvy-HNIs nexus under scanner, EY conducts forensic audit

The Securities and Exchange Board of India (Sebi) and exchanges are probing alleged connivance between Karvy Stock Broking (KSBL) and some of its wealthy clients. Sources say the possibility of high net-worth individuals (HNIs) giving consent to the Hyderabad-based brokerage to pledge their shares to earn additional income on their idle portfolio can’t be ruled out.

While there is a formal system, known as securities lending and borrowing (SLB) mechanism, to loan shares to other market participants — typically short-sellers — it is yet to gain traction in a big way, prompting some investors to enter into informal arrangements with their brokers. A week ago, Sebi issued strictures against KSBL for misusing client securities. The brokerage is alleged to have raised Rs 600 crore by pledging client securities worth over Rs 2,000 crore with banks and non-banking financial companies (NBFCs).

“Whenever securities move from one depository participant (DP) account to other, alerts are set out by the system. Some clients could have been in the dark because of issues such as contact details not being updated. However, it is highly unlikely an investor sitting on a large portfolio could have been completely unaware of securities moving in and out of the account,” said a regulatory source.

Following the Sebi order, the National Stock Exchange (NSE) has appointed EY to conduct a forensic audit to examine the exact misuse of client funds and securities by KSBL. Sources say the findings of the audit are expected soon.

According to preliminary findings, KSBL is alleged to have transferred Rs 1,096 crore to its group firm Karvy Realty between April 2016 and October 2019.

Regulatory sources say their prime objective is to ensure that innocent clients whose funds and securities are stuck with the brokerage are returned safely.

“While investors protection is our main objective, it needs to be probed if some clients had any arrangement with the brokerage for pledging of shares for a fee,” said the source.

Industry players say side deals between clients and brokerages are common in the industry. “It is often seen that a client gives complete access to the broker to trade on their behalf. However, when a trade or the arrangement incurs a loss, the investor typically cries foul,” said a broking official asking not to be named.

In the past few years, Sebi and exchanges have made several regulatory changes to avoid such instances. Some of these include maintaining an electronic or paper trail of instructions given by the client to execute a trade. Also, through a circular in June, Sebi had reiterated that one client’s securities shouldn’t be used for proprietary trades or to meet the shortfall of other clients.

Last week’s Sebi order against Karvy talks about how the brokerage indulged in this practice.

“The securities lying in the DP account of KSBL, actually belong to the clients who are legitimate owners of the pledged securities. Therefore, KSBL did not have any legal right to create a pledge on these securities and generate funds. Even if, the client securities were pledged, it should be only for meeting the obligation of the respective clients only, which was not observed in this case,” the order states.

The order also mentions how Karvy transferred the funds raised by pledging client securities to six of its bank accounts instead of a broker-client pooled account.