Of transgressions and misdemeanours

Jay Bhattacharjee

Broking-firm shenanigans will strike at the very foundations of the capital market

The cat is now out of the bag. Reports about defaults committed by a number of stockbroking firms with their vyaj badla financiers have been circulating in the corridors of the country’s financial sector during the last few weeks, but they have now surfaced in a number of publications. In an article in the third week of March, this analyst had referred to the ominous market feedback about the defaults, but the powers that be hardly reacted. Evidently, it is still the tip of the iceberg that one is now witnessing but the figures being talked about range between Rs 700 crore Rs 800 crore of financiers’ funds that have not been paid back to them by the borrowing entities.

Even if the final figure is a fraction of these mind-boggling amounts, the damage to the financial sector and the bourses can never be underplayed. As it is, the Indian capital market structure is rickety and frayed to the limit; the patchwork quilt cannot possibly withstand another tonne of bricks landing on it. The defaulting broking firms are said to be members of the National Stock Exchange and the Bombay Stock Exchange; at least till now, there are no reports of members of other bourses being involved.

The modus operandi of the errant firms was simple; they borrowed funds and shares from their financier clients for deployment in the automated lending and borrowing mechanism (ALBM) system in the NSE or its equivalent in the BSE. The marketing ploy used a number of newspaper and magazine articles which emphasised how safe the entire process was.

In theory, the mechanism was supposed to be foolproof, since the clients were always supposed to have equivalent amounts of securities and funds in their accounts, matching the moneys and shares that they had lent. The stock exchange settlement structure was the safety net that the financiers relied on. What the poor lenders had not reckoned with is the infinite capacity for duplicity and chicanery of our high-flying business operators. The actual operations were quite different from what was supposed to have been done: the stockbroking firms never utilised their clients’ moneys in the ALBM. They used these funds either for their regular pay-ins at the NSE and the BSE or diverted them to the unofficial badla market in the Calcutta Stock Exchange (CSE).

The deployment in the CSE, in the vast majority of the cases, was in cash, so that there is no legal recourse whatsoever. The plan of action with the shares that were borrowed from their vyaj badla clients ran a parallel track; the securities stayed in the pool accounts of the brokers and were sold off to meet their obligations to the stock exchanges at the end of each settlement. Since the individual stock exchanges got their payments on schedule at the end of each settlement, they did not suspect anything abnormal. It is only now that the extent of the skulduggery is becoming apparent to some of the exchange managements.

The unsuspecting financiers and vyaj badla clients were regularly fobbed off with fraudulent contract notes and other official-looking documentation. This involved doing dummy runs with official stationery in the back-office computers since the trading computers, obviously, could not be used to generate confirmations of non-existent transactions.

One should also point out at this stage that some broking firms, who are also Depository Participants (DPs), found it easier to manipulate the illegitimate movements of the securities that they had borrowed for ALBM transactions. In other words, the National Securities Depository Limited (NSDL) will have to be involved in the investigations that will be launched to unravel the details of this sordid scandal.

At first glance, the defaulting broking firms have committed offences ranging from purely criminal ones, like criminal breach of trust and forgery, to a slew of capital market transgressions and misdemeanours. The consequences of all these events will strike at the very foundations of the capital market. Once it transpires that vyaj badla or badla finance has such high risks (as opposed to the general perception that it is virtually risk-free), then the entire flow of funds to the bourses from financiers will dry up. This will mark the end of badla as it is currently practised; the volume of business and market liquidity will plummet.

It is, therefore, imperative that the two stock exchange managements and the regulatory body, the Securities and Exchange Board of India (Sebi), start swinging into action at the earliest. Observers feel that the NSE, being a totally professional organisation, will not be lagging in its response; there is, of course, the reality that the regional offices of NSE may not be geared to tackle offences and defaults of this magnitude. However, the central office must despatch its inspection and surveillance teams to the offices of the errant brokers to carry out audit and search exercises at the earliest, after it receives the first complaints from investors who have not been paid their dues.

Sebi, too, must pull up its socks. Again, there are disturbing reports that the apex regulatory body has certain turf problems; it appears that complaints against NSE brokers are primarily handled by the Sebi head office at Mumbai, merely because the NSE is also headquartered in the western metropolis. This happens even when the complainant and the NSE firm accused of default are located elsewhere. Surely the regional office of Sebi where both of them are situated should have jurisdiction over such complaints? Cynics will always say that this country will never be the same without these bagatelles.

The NSDL must examine whether these fly-by-night broker DPs who have misappropriated clients’ securities should be allowed to operate. Clearly, these characters do not deserve to be in a vocation where trust and fiduciary accountability are a prerequisite. Finally, North Block and Raisina Hill must act before the effects of this latest scam start snowballing. Our mandarins do not like their slumber to be disrupted; they have often been known to shoot the messenger who brings bad tidings. Currently, they have already been awakened by some other developments and there is, therefore, some hope that they might consider action on this one.

Mr Bhattacharjee is a senior corporate analyst and Member of the Delhi Stock Exchange