What can avert broker defaults: Jimeet Modi, Samco Securities

Jimeet Modi, founder & CEO of Samco Securities, on the reasons for broker defaults and how this can be averted through tighter governance and regulations

Jimeet Modi Nov 28, 2019


This is a guest column by Jimeet Modi (above), Founder & CEO, Samco Securities.

In the past few years, defaults by brokers such as Fairwealth, BRH Wealth Kreators, Guiness, Kassa Finvest, Ficus Securities and now Karvy Stock Broking Limited have led to heavy losses for investors and customers. We have therefore performed root cause analysis as to what is regularly causing such defaults and why innocent investors lose their hard money for no faults of theirs. It is important to address these issues through course correction so as to prevent any more broker defaults in the future.

Root causes of broker defaults

1) Related party transactions

Currently, brokers are required to disclose their proprietary trading status to the exchanges and SEBI, however, transactions with related parties are nowhere captured in the scheme of things except at Ministry of Corporate Affairs (MCA). In any case, regulators, clients, customers and investors have no access to actual related party and counter party transactions carried out by the broker. Also, there is no framework for approval or processing of related party transactions like that is required in the Companies Act 2013.

Had these brokers disclosed that they had dealings with related parties, exchanges and auditors would have taken note of such dealings to investigate further and could have identified defaults much earlier. This issue definitely needs to be addressed as such cases of intentional fraud go unnoticed by the clients and also possibly to some extent by regulators and exchanges.

2) Losses due to debt or leveraged proprietary trading

Clients lose money not because of their recklessness, but because brokers take excessive or inappropriate leverage while doing trading in their proprietary accounts, and in order to recoup such losses, brokers sell investor’s shares without their consent thus causing them losses for no fault of theirs. However, prop desks are now well regulated by the authorities after circulars on Enhanced Supervision dated September 26, 2016 and on Handling of Clients Securities by Trading Members dated June 20, 2019. But inspite of all these, in several cases, brokers may do trading through related party transactions but this doesn’t come under proprietary trading. Therefore, this is a misrepresentation of actual proprietary trading under the garb of related parties.

Broker defaults have huge consequences for the investor community at large, hence a few possible reforms to address the loopholes are elaborated into three broad categories namely Governance Reforms, Financial Reforms and Disclosure Reforms.

Suggestions to avoid/prevent broker defaults

1) Governance Reforms

A) Appointment of at least One Independent Director – There should be at least one mandatory independent director on the board of a broker entity. This will bring about transparency and accountability which will improve internal corporate governance of companies. Presence of an independent director on the board will at least prevent the company from taking any law defying steps. Currently SEBI has framed such rules for Listed companies, Mutual funds etc., but they can also be implemented for the brokers as well.

2) Financial Reforms

A) Mandatory Capital Adequacy Ratio – Financial industry becomes robust when participants work with capital adequacy ratios, just like banks. However, currently the capital requirements are static and not dynamic with regards to the size of the business of a broking company. For e.g. currently if the net worth of a Depository Participant (DP) is less than Rs 10 crore then the total value of securities held by the Depository Participant can’t exceed 90 times the net worth in their custody. In case a DP crossed this 90x threshold, they would go into freeze mode and would not be permitted to accept fresh accounts. While, this has been a very healthy practice, the same is not applicable to entities that have a net worth of more than Rs 10 crore and in that case DPs can be custodians of securities disproportionate to their own skin in the game and this ratio could even be 1000x or 1500x. There need to be active reforms to ensure that such capital adequacy norms are introduced and monitored and these shall be a key lead indicator of the financial strength of an entity.

B) Net worth Criteria – Net worth criteria of several SEBI registered intermediaries have gone up over the years. Mutual Funds’ net worth has increased from Rs 10 to Rs 50 crore. PMS’ net worth has also increased from Rs 2 crore to 5 crore last week. However, there has been no change in the net worth requirement of brokers since the past 20 years and therefore this calls upon a relook.

3) Disclosure Reforms

A) Disclosures to clients on related party transactions – Brokers should actively disclose any related party transactions done by them with any associates/subsidies/others. This should be a mandatory disclosure not only to the regulatory authorities but also to the clients so that they are aware of the way their broker is functioning and any red flags can give them an insight to re-evaluate the current relationship with their broker if any. The regulators may define a specific format by way of which brokers can disclose this on their websites, annual statements, etc.

B) Disclosures to clients on proprietary trading – Brokers should disclose proprietary turnover and proprietary gains or losses at regular intervals not only to regulatory authorities alone but also to clients. Informing clients with proprietary trading related details will help them understand the risks and focus of their brokers in servicing them. The disclosure could also include prop trading even in related party entities which are hitherto going unnoticed.

C) Mandatory requirement to send P&L and balance sheet – Brokers can mandatorily disclose annual statements at least on their company website for clients to know about their financial position. At present, AMCs are compulsorily required to disclose their P&L and balance sheet on their company website, however, there is no such rule for brokers. This should change as details about brokers’ loans, debt, concentration of clients (without disclosing names) are necessary to judge the risks involved in dealing with brokers. In case the broker is experiencing losses or has insufficient cashflows, the broker might turn towards sketchy behaviour, but if financials are known to the client, they may themselves take an informed decision whether to continue or to switch, thereby taking an informed decision without blaming anyone.

Generally, for a public company, the annual report contains all of the above disclosures to evaluate the risks of investing in such companies but currently clients of brokers have nothing to evaluate/measure the risks of dealing with their broker. Times are now changing, clients of a broker should be empowered so that they can take well-informed decisions. But for that they need to be provided with relevant information where the regulator will have to play an important role.

Regulations in India have evolved fast and with every crisis, markets have become more robust and transparent. The current cause of broker debacles will be averted in future if and only if related party transactions are adequately disclosed and ring-fenced. More importantly disclosures should also be to the clients so that they become aware and can make an informed decision in their own interests. Tables have now turned as just like KYC (Know Your Customer), investors should do a KYB (Know Your Broker) to empower themselves.

Jimeet Modi is Founder & CEO, Samco Securities

Jimeet Modi

Jimeet Modi is Founder & CEO, Samco Securities, a leading online stock broking firm.

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