Post Karvy, legal shadow cast over collateral business

The Karvy incident may result in the collapse of the loan-against-shares market as it raises questions over the sanctity of pledged securities.

Illustration: Dominic Xavier/Rediff.com

In the aftermath of the Karvy incident, lending against third-party collateral facility raises questions over regulations concerning banks and brokers which are at loggerheads.

While the Securities and Exchange Board of India (Sebi) and National Securities Depositories (NSDL) have ordered the transfer of securities, which were kept as collateral, lenders followed the old business model of sanctioning loan against shares and allegedly overlooked certain parameters.

Legal experts feel that this could lead to a collapse of the loan-against-shares market as it raises questions over the sanctity of the pledged securities.

“Before the pledged shares can be characterised as ‘collateral’, one has to keep in mind that Karvy did not have a right to pledge the shares as collateral.

"So for the lenders to assert a right to enforce the pledge is problematic, considering that all they possess is an invalidly created right, pitted against the valid title of the investors,” said Bharat Chugh, partner, L&L Partners, and former judge.

If Karvy did not possess adequate authorisation, the pledge in favour of lenders may be unenforceable, he said.

It is debatable whether lenders or clients should be left holding the can.

However, lenders have a lien over pledged securities.

However, most of them believe Sebi’s move to transfer securities back to clients is unprecedented.

NSDL has transferred securities from Karvy’s demat account to demat accounts of respective clients (82,559 of 95,000) who have paid in full against these shares.

This is in compliance with Sebi’s November 22 order and done to protect the interest of the investors.

The transfer of securities was supported by adequate legal backing, experts said, and was done only after it was found prima facie that Karvy was not authorised to pledge clients' shares with banks to raise finance for sister entities.

According to Chugh, this was based on various regulations issued by the market regulator over the years which have sought to outlaw this egregious practice.

However, the same appears to have continued unabated.

There are concerns that the lenders' rights have been totally disregarded since they were not heard by Sebi before it passed the order and before NSDL implemented the same.

Karvy lenders moved the Securities Appellate Tribunal (SAT) against NSDL’s action.

The brokerage reportedly has availed of loans against securities from ICICI Bank, IndusInd Bank, and HDFC Bank, and the total exposure is about Rs 3,000 crore.

SAT did not give immediate relief to the lenders but given them a chance to present the case before the market regulator.

During the argument, the lenders had collectively said that the move could put the entire collateral business in a quandary if the underlying security will no longer be available to be invoked.

The lenders had argued on two key points.

One, they had no reason to doubt Karvy’s pledges since everything was done bona fide and according to the standard operating procedure, and the same was duly monitored by the depositories, the exchanges, and Sebi.

Second, lending against securities is a normal and permitted business activity of lenders and if they are not allowed exercising their bona fide rights, this would have a chilling effect on the practice of lending.

Further, once these shares enter the open market, it would be impossible to recoup them and banks would be left with no security.

Senior bankers said lenders have the right to recover from entities like Karvy.

But banks can’t sell shares which were pledged. The rights of actual owners (of shares) remain intact.

Bankers, however, agree in private that it was their responsibility to verify aspects like ownership and charge on collateral.

Experts point out that even though Sebi allowed pledging of shares by brokers earlier, it changed this in its June circular, where it barred pledging of shares for any kind of purpose.

Further, Sebi requires brokers to maintain separate accounts for client securities and its own securities.

However, the bankers would still have to establish bona fides on their part and do proper due diligence.

With inputs from Abhijit Lele.