Broker default – Only a strong deterrent can plug the gap

The recent episode of mis-utilisation of client assets at a broking firm has drawn a lot of market attention. In reality, there have been several such instances, especially in North India, of brokers misusing client assets for other businesses. There were 20 such instances between September 13, 2013 and November 30, 2019. There were 5 in 2015, 7 in 2018, and 3 instances in 2019.

Whenever a broker ‘defaults’, such a broker is ‘expelled’ from the membership of the stock exchange. Reasons leading to ‘broker default’ have undergone a change in the recent past.  Prior to 2013, instances of default were an offshoot of the broker’s failure to honour settlement obligations with clearing corporations.

However, broker defaults now come by when they are unable to repay client assets -- shares or money – as and when required. Default of settlement obligations is almost non-existent nowadays because stock exchanges are very strict on margin collection and have a monitoring system. If a broker fails to honour settlement obligations, such a broker is disabled from trading after issuing a suitable notice. This system is working effectively and perhaps that’s the reason why broker defaults of settlement obligations are becoming a thing of the past.

Broker default in refunding client assets is primarily due to diversion of client funds/securities towards businesses other than those of securities – most of the time real estate or financing for speculative trades. When real estate business does not take off or one client assets are applied for margins of other clients who end up in speculative losses, the broker fails to repay.

When Power of Attorney (POA) is questioned, it may not be the only misuse of the POA that is the cause of default. The running account system operated by brokers, where a client’s account is settled once a month/quarter as may have been opted by the client, leaves such assets in the control of brokers till settlement. Some investors, intentionally or negligently or due to blind faith in the broker, leave their financial assets with him for long, which emboldens him to use these for other businesses.

At the time of using such funds, the broker may not have the intention of duping the client, but other businesses may not simply work out, hence the default. Brokers with other business interests may divert these funds, which end up in liquidity issues/losses. In one instance, the broker diverted client funds for building a hotel and restaurant which could not be completed on time, which delayed cash flows resulting in default. In another instance, the broker used clients’ assets towards setting up a chain of ‘beauty parlours’ that failed to click and gifted expensive cars to his son.

The regulatory framework is strong enough in terms of communication to clients on outstanding amount/securities lying with brokers, guidelines on purposes for which the POA can be used and cannot be used and so on. The Securities and Exchange Board of India (SEBI) has also implemented the Risk Based Supervision System under which brokers who have a number of clients and may have a huge impact on investor confidence are inspected regularly -- once a year -- by stock exchanges.

Internal audit guidelines issued by the exchanges for the conduct of internal audit also focus on use/misuse of client assets. When stock exchange inspections unravel misapplication of client funds/securities, they do take severe action which includes ‘expelling’ the broker from membership.

When the broker is expelled from membership, clients of such brokers are compensated out of the Investor Protection Fund for the amount/value of securities not refunded by the broker for trades on the exchange.

On expulsion, the broker may not be able to continue doing business on the bourse, but there is no bar on the ‘other’ business. He will have other non-financial assets on its balance sheets like ‘amounts receivable’, ‘real estate’ etc. He will be able to realise value out of such assets even after being expelled, but stock exchanges and SEBI do not have any view on what the broker does post expulsion. He continues to benefit from those assets whereas clients queue up before the exchanges for compensation.

In the current regulatory regime, non-financial assets of the broker or other firms controlled by him remain untouched. If those assets, including dwelling units of defaulting brokers, are attached and sold to recover amounts payable to clients, this type of events will not continue. The broker should know that consequences of default will be far reaching and seizure of his personal assets can only be a deterrent.

Another area of focus is that margins collected by the broker do not get into his financial accounts, because of which the value of client assets being controlled is not known to the broker himself and regulators. There is no relationship between the broker’s volume of business and the net worth. If a thinly funded broker has access to financial assets that run into multiples of his own funds, he can be tempted to misuse the money leading to failures.

Broker failure is simply not a matter of commercial loss; it is a fraud on investors and impacts investor confidence in capital markets. The punitive action should be like the one taken on ‘fugitives’ to deter recurrence.