MC Investigates| Beware of unlicensed financial advisors who use your account for stock manipulation

People approach unlicensed entities like their friendly, neighbourhood broker because of reasons such as prospects of better returns and a lower threshold of entry. (Photo by Tima Miroshnichenko/Pexels)

A few days ago, the Securities and Exchange Board of India (Sebi) fined an eminent doctor Rs 5 lakh.

The doctor had been charged with participating in a pump-and-dump scam, where a stock’s value is artificially inflated through circular trading and paid promotions.

Also read: Unlicensed entities manage hundreds of crores for investors

Circular trading is when a group of people buy and sell a scrip among themselves to create the false impression of increased volumes in a stock.

The doctor, who was part of the team that created the leprosy vaccine, submitted to the regulator that he was not into trading shares and had not placed these trades. He said his broker and financial advisor had fraudulently placed the trades, using his personal details.

The defence may sound unbelievable. But to anyone familiar with the world of illegal money management, it is highly likely that a person who does not know investing or trading allows his/her broker to trade on their behalf. It is most often an informal (illegal) arrangement because the broker or advisor isn’t licensed to manage another’s money.

“Many small brokerages have been known to take trades to create volumes in illiquid stocks using client accounts,” said an insider.

Misled clients

It leaves clients helpless when trades placed in their name turn out to be loss-making or even illegal, as may have happened with the doctor.

The Sebi order noted a contradiction. While the doctor said the financial advisor had taken the trades, there was a mail in which the doctor said the trades were part of his routine trading and were based on his own research and analysis. Besides this, the Sebi investigator said the doctor did not take any “meaningful legal recourse” to stop the trades.

While the reason for the doctor’s action are not known, a market insider said clients who don’t know trading can be misled by brokers with the promise of higher returns. The client may never know that the broker is doing this as part of a pump-and-dump scam.

“Dealers need a recorded conversation that confirms that the client has asked them to place the trade. In the doctor’s case, the email may have served as the confirmation. But brokers can also call the client and tell them that they are sending details of a good trade, please confirm (call or email) and the client may follow that instruction, but the recording of their communication won’t reflect the earlier conversation that briefed the client,” said the insider.

“There have also been cases when smaller brokers do the call recording with the client later, when an investigation has started. The clients may be friends and family who have allowed the broker to trade for them,” he added.

So, why can’t clients go for a legal arrangement to get higher returns?

In India, if a person wants a third party to manage their money, he/she can approach a mutual fund house, a portfolio management service (PMS) or an alternative investment fund (AIF). These are the licensed fund managers.

But clients approach unlicensed entities like their friendly, neighbourhood broker because of reasons such as prospects of better returns and a lower threshold of entry. While the best mutual funds offer 15 percent pre-tax returns, unlicensed entities offer 20-30 percent returns.

An investor may approach a PMS or an AIF, but to invest through a PMS, a person must have a minimum of Rs 25 lakh, while an AIF demands at least Rs 1 crore.

Also read: Illegal money managers| Fraudsters exploit rules meant to protect small investors

Not so ‘sweet’ deal

Sometimes people are approached by employees of brokerages with a ‘sweet’ deal. They are told their money can be made to work “more efficiently” in return for a cut of the profit. Smaller brokerages may shut their eyes to this because it helps them generate volumes, which mean revenue.

Take, for example, what happened to Mathew (name changed on request) from Pathanamthitta district in Kerala. He had been investing in stocks using a demat account in a reputed brokerage. Mathew had never tried his hand at trading.

In 2017, when he needed an added source of income, he approached a brokerage to see if there was a way to generate regular income through options trading. He knew it was risky and therefore went to seek some advice on this.

According to Mathew, he was introduced to a dealer who offered to trade on his behalf. For the trading capital, the dealer advised Mathew to pledge his shares and get margin money. Thus, the nightmare started, he said.

The first one or two trades were profitable. Then they started running into losses. When the dealer asked Mathew for the cash margin, Mathew paid up but did not understand what it was. Later, he realised the dealer had taken a highly risky, unhedged futures position.

Meanwhile, Mathew had to pay penalties for margin shortfalls and brokerage interest of up to 18 percent for margin loans. He ended with Rs 8 lakh in losses.

To meet this, he had to sell the stocks he had accumulated previously. This was before the Covid rally. If he hadn’t pledged the stocks, they would have multiplied in value in the post-pandemic rally. For him, the losses were greater than the Rs 8 lakh he had to pay to cover the bad trades.

In December 2018, the market regulator made it mandatory for stock brokers to implement two-factor authentication on their trading apps. The brokers are expected to take the biometric data and one more data point from the customer (something that only the customer knows or something that only the customer has access to like a one-time passcode) to log in to the trading account.

This was done to stop unauthorised third parties from trading through a client’s account. But dealers can place trades through client accounts without having to log in to each account individually.

Mathew has paid off all his obligations and now does his own trading.