Stockbroker defaults are a cause for concern. The main reason for these failures is the misuse of investors’ securities and funds. A sudden increase in the reported number of broker defaults could perhaps be a consequence of the enhanced oversight role of regulators.

Broker failures due to misuse of securities are mainly due to the power of attorney (PoA) given by investors to brokers. The PoA is intended to facilitate the receipt and payment mechanism of a transaction, i.e. the broker can release the sold shares on behalf of the investor without submitting a physical delivery instruction slip ( SAY). However, some brokers abuse this PoA to transfer investors’ shares to their pool account and then engage them to raise funds for their own purposes or to meet the margin requirements of other investors. To address this misuse, the regulator has stipulated that shares offered as collateral must remain in an individual’s demat account and must be marked as “collateralized” in the depository system. The regulator has strictly prohibited brokers from using investors’ securities as collateral.

Additionally, the regulator has now implemented an electronic DIS system that allows investors to sell shares without a PoA with the broker. Investors should understand that the PoA is not a mandatory requirement according to the regulator and exchanges.

Misuse of idle investor funds was another reason for broker failures. To avoid this, the regulator has implemented a current account authorization mechanism whereby unused funds are returned to investors at a predefined frequency. Thus, if investors have opted for a current account, they must consciously monitor that the broker settles the account according to the agreed frequency (30 or 90 day settlement). Also, investors should not keep unused funds with the stockbroker, as claims for such funds in the event of misuse are not accepted by exchanges in the event of a broker’s default. Brokers are now required to report fund allocation at each client level so that one client’s funds cannot be used for another’s margin requirements.

Our analysis of some broker failure cases shows that investors are attracted to fixed/guaranteed/regular returns or capital protection schemes that are not part of the services a broker can offer. Investors should refrain from entering into such loan agreements in which brokers pay interest on the funds offered by the investor. Any such agreement that is not honored does not constitute a claim of the exchanges against the defaults of the brokers.

Sebi has issued several operational guidelines for the management of client funds and securities. The regulator has also designed enhanced surveillance and early warning systems to detect misuse and misuse of funds. These early warning signals are signaled in the event of a deterioration in the financial health of the broker/depository participant; pledge transactions; increasing number of complaints due to unauthorized transactions, unauthorized delivery instructions and non-receipt of funds and securities. Apart from this, internal auditing of brokers is mandated on a semi-annual basis, in which they have to certify compliance/non-compliance in areas such as PoA execution; maintain a registry – client wise-script wise; segregation of client funds/securities from broker funds/securities.

Yet, as broker failures continue in the face of robust regulatory measures, the oversight role of exchanges must be strengthened and exchanges and internal auditors must be held accountable. Part of the solution lies in investors becoming more vigilant. Investors can do this by performing certain checks, such as ensuring their KYC information is up-to-date, ratifying emails/SMS sent by exchanges regarding their trades with contract notes received from the broker, and promptly checking the statement of funds and securities balance sent. by trading on a weekly basis. Apart from this, investors should check and reconcile their Consolidated Account Statement (CAS) with their securities holdings and not give general power of attorney to their brokers.

Thus, it is important that investors follow the principle of “caveat emptor”: that they are aware and become more responsible for their money.

Kuldeep Thareja, Mitu Bhardwaj and Rasmeet Kohli work with the National Securities Markets Institute. Views are personal.

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