Is your broker misleading you?

NSEL is not the only one to be blamed for the Rs 5,600-crore payments scam. Brokers did no favours to their clients, whose gullibility or carelessness was also at fault

An investment analyst who lost his own money, albeit a small amount, in the National Spot Exchange (NSEL) scam confesses the pitch was too lucrative. "The presentations and mails from brokers were too convincing. So, I decided to try it before recommending it to my clients. He thanks his stars that the scam happened and he lost his own money instead of clients'. "It would have caused irreparable damage to my reputation," he says.

There are some gems in the presentation made by brokers to their clients, around 13,000 of them, to convince them to invest in NSEL products. Here are some of these:

• 100 per cent safe and secure investment model

• Regulated by various government authorities namely, state APMC, Forward Markets Commission (FMC), Warehousing Development and Regulatory Authority

• Backed by 100 per cent physical commodities

• Exchange maintains Settlement Guarantee Fund. Notwithstanding default of any member, payment is honoured according to the exchange schedule

• Pre-tax annualised returns in the range of 12-16 per cent per annum (some even claimed 18 per cent or more)

With several officials of leading brokerage houses Anand Rathi, Geofin Commtrade and India Infoline getting arrested last week, the heat is now on brokers for misleading customers. Look at these pointers one by one and see how both brokers and NSEL misled the investor.

Fully safe and secure

Says Arun Kejriwal, investment analyst: "NSEL was a multi-layer marketing scheme. From Jignesh Shah (chairman) to the exchange to brokers, everyone barraged the investor with the promise of great returns." Some brokers told investors they needed to put only five per cent; the rest was paid-up by the broker. Some sold it as safer than gold.

The question to ask was what qualifies for '100 per cent safe and secure'? From an Indian investor's perspective, the closest instrument to this is bank fixed deposits. Let's look at some interesting numbers here.

In the past 20 years, the country's largest bank, State Bank of India's highest rate of return for its one-year fixed deposit has been 12.79 per cent, in 1995. Since then, its one-year FD rates have seldom crossed even 10 per cent.

However, NSEL investors were offered in excess of 12-18 per cent. Even the more aggressive option, the Sensex, has returned above 12 per cent on an annualised basis only 10 times (half the time) since 1995. At other times, it has fallen. Clearly, there isn't a safe and secure model consistently offering such high rates. Debt returns will be conservative and Sensex returns will be unpredictable.

Says a financial planner: "Investors need to know where the returns are coming from. If there are no duration and interest rate/inflation risks, the returns will come from taking higher credit risks. If a sovereign bond is paying you seven per cent per annum, an AAA-rated paper might pay you eight per cent, an AA-rated paper nine per cent and so on. As you go down the credit scale, the returns might increase.

Lesson

Anything that looks too good must have a catch. There are no free lunches in life. If the Sensex, which is volatile, can give over 15 per cent returns only half the time in 20 years, and safe and secure debt FDs can never do so, how does one expect such returns without any risk?

Regulated by?

It seems even many brokers were completely unaware that NSEL's spot trading was not regulated by any agency. Says a broker: "We were under the impression that NSEL was being regulated by the FMC." And, as the presentations from brokers show, they thought the exchange was regulated by not one but three government agencies. According to market experts, brokers did not do their own due-diligence, thereby exposing the investors to an unregulated product.

It appears NSEL was set up by a simple exemption granted by the Union ministry of consumer affairs, allowing it to function outside the supervision of FMC. After the scam was discovered, FMC took harsh action against the exchange but investors are still fighting in the courts.

Lesson

Investors need to find if a product is regulated or not. "There is no difference between putting money in a chit fund and in NSEL schemes, as both are not regulated. Investors don't know what is being done with their money," said a senior broker, on condition of anonymity. According to Securities and Exchange Board of India guidelines, any activity that is unregulated and not covered by a regulator is banned.

Commodity backing

Did any broker check whether the backing by physical commodities actually existed? Says a broker: "When an exchange is regulated by so many bodies, why should one bother with checking the goods? It should have been done by the exchange."

Interestingly, when the scam was discovered, NSEL initially claimed Rs 6,200 crore of commodities in warehouses. These would have more than covered for the Rs 5,600 crore of losses to investors. Alas, it wasn't true. Soon, reports emerged that the warehouses either did not have the adequate amount of goods or the quality wasn't good enough to get the right value.

Says a compliance officer with one of the leading brokerages: "Many brokerages were also introducing this product in their wealth management business from their commodity business. However, given the perishable nature of commodities, there wasn't much due-diligence. Many followed a wait and watch policy, which saved them."

Lesson

Ask yourself this question: Do I understand this product? Many investors who did not understand the spot market put in money for assured returns. Importantly, one wonders how many of them really knew or bothered about whether the exchange or broker had the physical commodities. Those in the sector say many did not bother going through the warehouse receipts which were supposed to give specifications about the product quality, settlement cycle and physical delivery conditions.

Settlement guarantee fund

Investors were assured by brokers that even if any member defaulted, NSEL had a settlement guarantee fund(SGF) to ensure repayment. Again, this number was completely hazy. But against varying claims that its SGF ranged from Rs 839 crore to Rs 62 crore, between July 29 and August 14, the bourse had Rs 84.66 lakh in the actual SGF.

In its annual report, the exchange termed it 'security guarantee fund', and it appeared under the head 'reserves and surplus'. From NSEL's annual report, it is clear the exchange first tried to project the margins it collected from investors as the SGF but later changed the practice and set aside a portion of its reserves.

Lesson

If you invest in a stock and the broker fails to deliver, both the BSE and the National Stock Exchange have a mechanism for redressal. NSEL had none. So, investors had no recourse but to go to court. One needs to find the risk profile of the product, how the returns are calculated and the charges involved. Investors need to ask the sellers of the product about the mechanism available for investor grievance redressal. "Where do I go when something goes wrong? Most people are not aware of this," said the head of a brokerage house.

As Kejriwal says: "Both the exchange (NSEL) and brokers have to be blamed for this mess." But, investors also messed up.