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Stockbroker defaults are a cause of concern. The predominant reason for such defaults is the misutilization of investors’ securities and funds. A sudden spurt in the reported number of broker defaults could perhaps be a consequence of the enhanced supervisory role of the regulators.

Broker defaults on account of misuse of securities has been mainly due to the power of attorney (PoA) given by investors to the brokers. The PoA is intended to facilitate easier receipt and payment mechanism for a trade, i.e. the broker can release the sold shares on behalf of the investor without submitting a physical delivery instruction slip (DIS). However, some brokers misuse this PoA to transfer shares of investors into their pool account and then pledge them to raise funds for their own purposes or for meeting margin requirements of other investors. To address this misuse, the regulator has stipulated that shares being offered as collateral must remain in the demat account of an individual and should be marked as ‘pledged’ in the depository system. The regulator has strictly prohibited brokers to use investor’s securities as collateral.

Further, the regulator has now put in place a system of electronic DIS which allows investors to sell shares without a PoA with the broker. Investors should understand that PoA is not a mandatory requirement as per the regulator and exchanges.

Misuse of idle funds of investors has been another reason for broker defaults. To avoid this, the regulator implemented a running account authorization mechanism under which idle funds are returned back to the investors at a pre-defined frequency. Thus, if investors have opted for a running account, they should consciously monitor that the broker settles the account as per the agreed frequency (30 or 90 days’ settlement). Also, investors should not keep idle funds with the stock broker as claims for these funds in the event of misuse are not accepted by the stock exchanges in case of a broker default. Brokers are now required to report individual client-level allocation of funds so that one customer’s funds cannot be used for another’s margin requirements.

Our analysis of certain broker default cases shows that the investors are attracted by fixed/guaranteed/regular returns or capital protections schemes which are not within the scope of services that a broker can offer. Investors should refrain from entering into such loan agreements wherein brokers pay interest on the funds offered by the investor. Any such agreement that is dishonoured does not qualify as a claim by exchanges against broker defaults.

Sebi has issued several operational guidelines for handling of client’s funds and securities. The regulator has also devised systems for enhanced supervision and early warning to detect any misutilization and diversion of funds. These early warning signals are flagged in the event of deterioration in financial health of the stock broker/ depository participant; pledge transactions; increasing number of complaints due to unauthorized trading, unauthorized delivery instructions and non-receipt of funds and securities. Other than this, internal audit for brokers is mandated on half-yearly basis, wherein they have to certify compliance/non-compliance on areas such as execution of PoA; maintaining a register—client wise-scrip wise; segregation of clients’ funds/securities from broker’s funds /securities.

Yet, as broker defaults continue in the face of robust regulatory measures, the supervisory role of exchanges needs to be enhanced and they, along with internal auditors, need to be made accountable. A part of the solution lies with investors becoming more vigilant. Investors can do this by following certain checks such as ensuring their KYC details are up to date, ratifying the emails/SMSs sent by exchanges pertaining to their trades with the contract notes received from the broker, and promptly checking the funds and securities balance statement sent by the exchanges on a weekly basis. Apart from this, investors must verify and reconcile their Consolidated Accounts Statement (CAS) with thier holdings of securities and also not give a blanket PoA to their brokers.

Thus, it is important that investors follow the principle of ‘Caveat emptor’—Let them be aware and become more responsible for their money.

Kuldeep Thareja, Mitu Bhardwaj & Rasmeet Kohli are working with National Institute of Securities Markets. Views are personal.

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