A scam that was just waiting to happen

A scam that was just waiting to happen

The Karvy stock broking scandal appears to have been almost too easy to pull off. The regulator must make sure that this is the last time this happens...

Equity investing in India is mostly about cutting through layers of fiction that companies surround themselves with. Now, as the Karvy scandal shows, what your broker tells you about your stock holdings could also be fictional. To all their other worries, you must also worry that the broker is going to take possession of your stocks, sell them off and appropriate the proceeds. According to the conclusion that a SEBI investigation has come to, that is exactly what Karvy Stock Broking did with several hundred crore rupees worth of shares that belonged to its clients. The shares were transferred from the clients' depository accounts, sold off and the proceeds transferred to Karvy's real estate business.

SEBI has found a particularly brazen and large-scale heist, in all likelihood the largest ever malfeasance of this kind in the Indian equity markets. However, what is truly problematic about this scandal is that it is composed of individual actions that the perpetrators had the right to commit. Only when the end-results were detected by the victims did the fog started to clear and that took a long time. The strange thing is that everyone in this industry as well as the regulator seems to have accepted a strange state of affairs: it is impossible, in practice, to get a demat account and invest in equities without signing over an expansive power of attorney to the broker.

I've had personal experience of this just a couple of years ago when I started looking for a brokerage account where I did not have to sign over such a power to the broker. After wasting a lot of time skimming over literally hundreds of pages of legalese in tiny font sizes, I realised that realistically, it was impossible to have such an account and use it in a practical sense. That's the root cause of the problem: to invest in stocks, you are forced to sign over control of your investments to the brokers.

Such an arrangement may be necessary if you are a short-term punter and are trading on margin because then the broker needs to be able to sell off your investments without your consent if necessary. However, that is not the universal case. A lot of investors, like me, are just interested in buying stocks against full payment and holding them for months and years. I can't understand why such investors have to sign over power of attorney rights to their investments to brokers. Personally, most investors I know and who use Value Research Stock Advisor are exactly this category. SEBI should seriously think of ensuring that such investors are able to retain the rights over their investments. For brokers, such investors are useless businesswise because they hardly ever trade. It's up to the regulator to take care of them.

Interestingly, after an earlier version of this column was published in The Economic Times, I got emails from some people saying that I was mistaken. They explained how, with deep enough knowledge of how the system works, I could set up things in such a way that I might be able to trade in equities without giving the broker the power of attorney. This actually proves my point. What should be the default offered to new investors is actually secret knowledge that is carefully obscured and is only discoverable with some effort!

The most worrying implication of the Karvy scandal is that there is never just one cockroach in any kitchen. Since such a thing is possible, it must be happening at some scale elsewhere too. Certainly, from anecdotal evidence, it would appear that 'temporary' use of clients' holdings is quite common. Obviously, being able to use other people's money is a great temptation and quite hard to resist!

The most important thing at this point would be to resolve this issue rapidly and ensure that investors get their money back quickly. Investors participate in the equity market with the assurance that no matter what happens to the value, equities is the most liquid of all asset classes, and that there is an elaborate regulatory structure to ensure that. However, what we are seeing is a tough test for that regulatory structure.

As much as recovering the money, equally important is the setting of an example. A crisis is always a great opportunity. Unless this issue is closed with punitive measures that are truly strong enough to put the fear of god into anyone else who might be tempted to do the same, this crisis will be wasted.