In an ex-parte decision, the Securities and Exchange Board of India has disallowed Karvy Stock Broking from opening any new accounts and placed restrictions on its ability to operate demat accounts. The firm has, in Sebi’s view, misused customers’ shares by pledging them and taking loans. “Ex-parte" means Sebi did this, before even giving Karvy a chance of being heard. In fact, the NSE ordered a forensic audit of Karvy, and requested Sebi for quick action. There are two parts to this: what has happened and what you can do to get out of it.

Karvy is a stock broker. When you buy shares, brokers take your money and give it to the exchange. They receive shares in a “pool" account (a Karvy demat account which is a temporary store for customer shares). From this, they are required to transfer the shares to your own demat account.

When you sell shares, Karvy must transfer your shares from your demat to their pool account, deliver the shares to the exchange, receive the money and transfer it to you. How can they transfer shares from your demat account? You give them a power of attorney (PoA) that allows them to do so. Karvy has, it appears, misused this PoA to take some customers’ shares out. They took a loan on these shares and gave the money to sister company Karvy Realty.

Effectively, they’ve borrowed money using customer shares to fund themselves. This isn’t new, of course. Brokers often take customer shares as collateral and lend them money as “margin". Some brokers, including Karvy, offered this as a carrot—buy on Monday, and close the trade on Friday. The Monday trade was financed by pledging those shares to a lender, who would then get repaid when you reversed the trade on Friday, allowing you a leverage of as much as 10 times your capital.

This was prone to abuse, so in October 2019, Sebi said brokers had to segregate all such activity in different accounts, unpaid securities were to be held in an unpledgeable account, client margin funding was to be done through a separate account, and so on. This brought down the house at Karvy, as they couldn’t unwind all the loans and trades fast enough. In the melee, it turns out that Karvy took a loan against one such account, where they had transferred customer shares, and then gave their related company the borrowed money.

Sebi has now clamped down on the ability of Karvy to debit any customer’s demat accounts, even for a legitimate purpose, and stopped it from opening new accounts.

Customers of Karvy Broking may not be impacted at all, but they need to know if they are. First, determine if your shares are in the Karvy pool or in your demat account. Your shares are actually held in NSDL or CDSL (whichever your broker is with), which are the depositories. Both provide online “view only" access to your demat account holdings. Check if what Karvy says you own actually exists in your demat account. If it does, you are relatively safe. You must then create a new demat account at a broker you trust more, and transfer the shares “off-market" from the Karvy account, using a signed instruction slip. You may not be allowed to sell any more shares from Karvy (since they can’t touch your demat account anymore to deliver those shares).

What if the shares aren’t in the demat account? Then Karvy may be holding them in a pool account. You need to follow up with it to get the shares transferred immediately to your demat account. (It can transfer shares into your demat account, but can’t take any from you). If that doesn’t happen, you should take the legal route. Note that an ex-parte order is only given when Sebi thinks more damage could be done if there was a delay, so you should expect bad news as it investigates further.

It’s indeed unfortunate that a large broker like Karvy has set the cat among the pigeons, and indeed, even the largest bank-run brokers have margin-funding operations, which makes trusting anyone very difficult. Recent Sebi regulation ensures that brokers can no longer do this, but for those who’ve done this already, it spells trouble.

As an investor with any broker, verifying your demat account periodically is a must. But we should have harsh penalties on PoA abuse to deter rogue brokers. Such transgressions should be detected electronically now, and surveillance against abuse is necessary.

Deepak Shenoy is CEO at Capitalmind Wealth, a Sebi-registered portfolio manager

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