The increasing competition in the broking business has led brokerages to come up with novel ideas to expand their business. One such market practise is providing margin trading facility (“MTF”). Under MTF, brokerages offer to their investor an opportunity to buy a security by paying a fractional amount of the total transaction value. The brokerage funds the purchase by borrowing from lenders and pledging the securities bought with such borrowed funds. To avail this facility, the investors enter into an agreement with their stockbroker and issues a power of attorney (“POA”) in favour of the stockbroker.

A brief overview of the current market practices:

While MTF was introduced to provide flexibility to investors to access the capital markets thereby providing stockbrokers a unique business opportunity, some stockbrokers took this as an opportunity to swindle their clients. They grossly misused the POA’s to transfer shares from the clients account to a pool account or the brokers own account and thereafter create pledge over such transferred securities. POA’s were also used to create pledge over one client shares to meet the margin requirements of another client. Does this not imply breach of trust of investors and even the lenders who have lent money to the brokerages? Experiencing such things is beyond comprehension while dealing with regulated entities. It seems that this needs to change.

In one of the recent orders issued by the Securities and Exchange Board of India (“SEBI”), a stockbroker had misused the POA to transfer the investor’s securities to its dematerialised account and raised funds against these securities to meet the funding requirements of its group company. In view of such abusive actions, the capital markets regulator, SEBI passed an ex-parte ad-interim order inter alia directing depositories to not act upon any instruction given by the stockbroker pursuant to any POA granted in its favour. SEBI further directed depositories to not permit any transfer from the dematerialised account of the stockbroker save in case of transfer to the beneficial owner against payment made in full. This cajoled opposition from the lenders of the stockbroker who appealed to the Securities Appellate Tribunal (“SAT”) as the lenders had granted loans against shares pledged by the stockbrokers and SEBI’s order restricted the lenders from invoking the pledge. SAT remanded the matter back to SEBI and SEBI subsequently inter alia held that the stockbroker was not the beneficial owner of the shares and hence not entitled to create the pledge in the first place itself.

The conflation of the practical issues and the law:

In view of the above and to cease and desist such malpractices, SEBI introduced a new framework vide a circular dated 25^th February 2020 that shall be effective from 01^st August 2020 (“New Margin Framework”). Under the New Margin Framework transfer of securities in favour of the stockbroker / Trading Member (“TM”) (i.e. title transfer collateral arrangement) shall not be permitted. The securities lying in the investor’s dematerialised account will specifically have to be marked as pledged for the purpose of margin. The New Margin Framework also modifies the scope of the POA by which there shall be a need for explicit authorisation from the investor for executing a pledge and a mere POA granted in favour of the stockbroker shall not amount to a margin obligation.

Under the New Margin Framework:

1)Depositories shall provide a separate pledge type viz. ‘margin pledge’, for pledging client’s securities as margin to the TM / Clearing Member (“CM”). The TM / CM shall open a separate dematerialised account for accepting such margin pledge i.e. Client Securities Margin Pledge Account (“Pledge Account”).

2) In cases where a POA is given in favour of the TM / CM, the TM / CM shall continue to be empowered by the POA to execute the pledge on behalf of the investors subject to the investor’s authorisation by means of one time password or such other verifiable methods. Until the investor authorises the same, the status of the pledge will be reflected as “pending”.

3) After receiving the authorisation to pledge from the investor, the investor’s acceptable securities shall be pledged in favour of the TM in TM’s Pledge Account and these securities in the TM’s Pledge Account shall further be re-pledged in favour of the CM in CM’s Pledge Account. Further the securities in the CM’s Pledge Account shall be re-pledged in favour of the Clearing Corporation (“CC”). This pledging trail shall always be adhered to for accepting pledge in order to provide the margin.

Furthermore, to have an efficacious system of MTF and not let the investors interests be jeopardised SEBI inter alia laid down the following:

1) TM’s will be required to open a separate demat account i.e. “Client Securities under Margin Funding Account” for maintaining the securities purchased by the clients via margin obligation and these securities shall not be allowed to be pledged.

2) TM / CM’s will be required to close all existing client margin / collateral account by 30^th August 2020 and transfer all securities lying with TM / CM to the respective beneficial owner’s demat account and it shall in no situation hold investors securities other than in the permitted accounts.

Conclusion:

SEBI has in the past issued several circulars to curb the menace of dealings in client securities. As recent as June 2019, SEBI had issued circular barring stockbrokers from creating pledges on client securities to the banks or non-banking financial companies for raising funds even with clients’ authorisation. It further stated that all securities already pledged must be unpledged before 30^th September, 2019 and returned to the clients upon fulfilment of pay-in obligation or disposed off after giving notice of 5 days to the client. Despite the above there have been misuses of client securities being witnessed and pledges have not been released.

The New Margin Framework has set out a detailed process for margin pledge. It should be effective in curbing the malpractices of misappropriation of client securities. However, one will only have to wait and watch if the market does not use any other cheap tactics to misuse or circumvent this law.