Order against IL&FS Investmart Ltd

ORDER

UNDER RULE 5(1) OF THE SEBI (PROCEDURE FOR HOLDING ENQUIRY AND IMPOSING PENALTY BY THE ADJUDICATING OFFICER) RULES, 1995 READ WITH SECTION 15HB OF THE SEBI ACT, 1992.

AGAINST M/s. IL&FS INVESTSMART LIMITED

BACKGROUND:

1. M/S. IL&FS Investmart Limited (hereinafter referred to as IIL)  is a member of the Stock Exchange, Mumbai and the National Stock Exchange Ltd, Mumbai (for brevity’s sake hereinafter referred to as the BSE & NSE respectively) with registration nos. INB011020832 and INB231020833 respectively and is registered with the Securities and Exchange Board of India, 1992 (hereinafter referred to as the SEBI) as a stock broker.

2.  An inspection of the books of account, documents and other records of IIL was conducted by SEBI during October 2002 under the SEBI (Stockbrokers and Sub-Brokers) Regulations, 1992 (hereinafter referred to as the “Regulations"). During the inspection, certain irregularities and violations of the Regulations were alleged to have been committed by IIL. While communicating the findings of the inspection to IIL vide letter dated March 24, 2003, SEBI also advised them to submit their comments to the same. As the response of IIL made vide letters dated April 16, 2003 and July 1, 2003 was found to be unsatisfactory, Shri S.V.Krishnamohan was appointed as the Adjudicating Officer, vide order dated February 25, 2004 to inquire into and adjudge the following violations by IIL:

• Failure to exercise due diligence in allowing exposure to clients in violation of Section 15HB of the SEBI Act, 1992 (hereinafter referred to as the Act) read with Regulation 26(xvi) of the Regulations.

• Granting trading terminals at places other than those specified in SEBI Circular no: SMDRP/POLICY/CIR-49/2001 dated October 22, 2001 and also to franchisees without any agreement specifying the scope/ responsibilities of franchisees in this regard, in violation of Section 15HB of the Act read with Section 26(xix) of the Regulations.

• Committing irregularities in maintaining client database in violation of Section 15HB of the SEBI Act, 1992 (hereinafter referred to as the Act) read with Regulation 26(xii) of the Regulations.

 SHOW CAUSE NOTICE/ REPLY/ PERSONAL HEARING:

3. The then adjudicating officer issued a show cause notice dated June 23, 2004 to IIL calling upon them to show cause as to why enquiry proceedings should not be initiated against them in terms of Rule 4 of the SEBI (Procedure for holding Enquiry and Imposing Penalty by the Adjudicating Officer) Rules, 1995 and penalty should not be imposed upon them under Section 15HB of the Act. IIL was advised to make their submissions, if any, along with supporting documents that they wished to rely upon, within 14 days from the date of the receipt of the notice, and were also advised that in case they failed to reply within the stipulated period, it would be presumed that they have no adequate explanations to offer.

4. IIL replied to the said notice vide letters dated July 6, 2004 and July 15, 2004. In the interim period, I was appointed as the Adjudicating Officer by the Chairman, SEBI; vide order dated September 30, 2004 to enquire into the above mentioned acts of omission and commission by IIL.

5. Thereafter in terms of rule 5(1) of the SEBI (Procedure for Holding Enquiry and Imposing Penalty by the Adjudicating Officer) Rules, 1995, a notice of hearing dated October 12, 2004 was sent to IIL advising them to attend the hearing proceedings to be held on November 1, 2004.

6. On the said date, Smt K Kamala, Vice President, Operations & Risk Management, IIL and Shri Sachin Joshi, Chief Financial Officer, IIL appeared before me and reiterated their contentions made earlier. They contended that during the year 2000, NSE had released the computer to computer link (CTCL) which enabled all broking houses to expand their operations but that the rules at that point in time were not really clear regarding the operations of the terminal and that the NSE had clarified the roles on the terminal expansion only towards the fag end of 2002 and added clarity to the sub broker module. They emphasized that thereafter, all their documentation on various terminals had been completed as was brought out in their replies to the show cause notice. They emphasized that in three particular cases where the documentation was not completed, they had terminated their business relationships and taken out the terminals provided to the franchises as on the dates mentioned in their replies. It was further submitted that irrespective of the location of the terminal, IIL had the practice of registering the clients centrally and also settling all the transactions directly with the customer without involving any intermediary. It was further stated that no investor grievance was registered against them even from the locations where the trades had taken place and on the basis of the above, requested that a lenient view be taken of their procedural lapses as a bonafide mistake.  They further stated that the NSE registration was valid up to September 30, 2005.

 CONSIDERATION OF ISSUES:

7. I have taken into consideration the facts and circumstances of the case as well as the submissions made on behalf of IIL and the material available on record including the findings of the inspection report.

8. The charges leveled against IIL for which the present proceedings were initiated, the submissions, if any, made by them in this regard and my findings on the same, are elaborated herein below: -

 9. Irregularities in the maintenance of the complete data base of the client agreement and client registration form:

 In the case of the clients listed below, the details regarding annual income, photograph, PAN No. of the clients were not found.

1.                 Bhanu N Mehta

2.                 Mehta Lakshmi Bhanu

3.                 Sheth Mukesh Mahindra Bhai

4.                 Mohanan Nair

5.                 Neerja Chawla

The Memorandum and Articles of Association was not available in the case of Canbank Financial Services Ltd, which was a corporate client, while in the case of the clients listed below, the client agreement forms were found to be undated and not stamped and the SEBI Registration No. was not mentioned.

1. Honda Ashok Prakash Rao

2. Kishore Ramchand Bhatia

3. Poonawala Shares and Securities Pvt Ltd

4. Vinay kumar Jain

5. Mehta Lakshmi Bhanu

6. Jayaram Nandakumar

7.     Kapil Kakkar

Furthermore, the client registration forms were not serially numbered.

10. These deficiencies found in the client constituent agreement amounted to a violation of the SEBI Circular no: SMDRP/POLICY/IECG/1-97 dated February 11, 1997

11. In their defense, IIL admitted that most of the above referred to deficiencies had been rectified by them. As regards failure to maintain serially numbered registration forms, it was contended that each branch was identified based on a specific code and that the client code at each branch was auto generated series of codes from the system which were serially numbered and provided a better operational control and adequate audit trail. In view of the same, it was requested that they may be permitted to continue with the existing practice.

12. Subsequently however, it was stated that although on the date of the inspection they had around 1,200 registered clients and had taken utmost care while registering the clients, at times if not readily provided, the documents were sent by the client in due course of time. As regards the five reported instances wherein the details of the annual income, photograph, PAN No. etc of the clients were not found, it was submitted that the formalities of obtaining the required documents from the clients had been completed within a short span of time. These documents were enclosed as proof of their submission. In the case of the corporate clients, it was submitted that as the documentation was voluminous, certain documents viz, the Memorandum and Articles of Association had been kept separately as in the instant case of M/s.Canbank Financial Services Ltd and hence was not provided at the time of inspection. However upon being traced, the said documents were placed alongwith the client registration form and member client agreement. In support of the said contention, IIL enclosed a copy of the said documents in their reply. On the said basis, IIL stated that there were no violations on their side.

13. As regards, the issues of documentation, IIL submitted that the client registration process had been centralized at the head office. It was stated that the registration forms were received at the branches spread through out the country and later forwarded to the head office which then validated all the clients’ registration forms and agreements. Referring to the seven cases reported in the inspection report, IIL submitted that as per the existing practice, the process of rectification was completed in the head office in due course but the same being a continuous process, the said client agreement were duly amended and rectified and there were no deficiencies. It was stated that in any case, the deficiencies noticed in the above cited 13 instances were unintentional, technical lapses and purely procedural in nature. Keeping in mind the overall registration of around 12,000 clients, the instances pointed out by SEBI were quite insignificant in as much as there was a substantial compliance by them of the requirement of the proper   maintenance of the client database and hence as such, there was no violation by them of Regulation 26(xii) of the Regulations read with Section 15HB of the Act.  

 14.  From the facts abovementioned, it is clear that there were admitted instances of failure on the part of IIL in the maintenance of the client registration and agreement forms from some of the clients.

 

15. SEBI vide its Circular no. SMD/POLICY/IECG/1-97 dated February 11, 1997 had advised all the stock exchanges to introduce the concept of “know your client” and asked the member-brokers to maintain the data base of their clients. In continuation with the same, vide Circular No.SMD/POLICY/CIR /5-1997 dated April 11,1997, SEBI forwarded the clients’ registration form and broker-client agreement form to the stock exchange. In terms of the said circular, it was the responsibility of the broker to provide for the clients’ details as and when the need arose. Further all the stock exchanges were advised to implement the above with immediate effect and complete the client-registration before May 31, 1997.

 16. However as brought out earlier, in the instant case, there have been admitted lapses, though subsequently rectified at times, wherein the client database was not maintained properly by IIL.  Although IIL has provided an acceptable explanation as regards their lapses in the instances brought out above, due note has to be made as regards the very purpose of issuing the relevant circulars of SEBI as well as the rationale behind their issuance. The essence of these client broker agreements is that they provide for provisions relating to keeping the money of the clients separately to protect the interest of the investors. The investors in turn come to know of such rights, inter alia, by executing such agreements. In terms of the circular, it is thus the responsibility of the broker to provide for the clients’ details as and when the need arises. However by admittedly failing to comply with the scheme as formulated by SEBI, it is clear that there has been a certain amount of failure to exercise due diligence by IIL, while carrying out its functions resulting in the violations of the provisions of the above mentioned circulars.

17. Violation of the code of conduct regarding exercise of due diligence, skill and care:

During the course of the inspection, IIL was found to have extended the margin trading facility to select clients where a margin of 25% was collected from the client while the balance was funded by them.  The source of funding the above facility was through a line of credit from IIL and / or internal surpluses. The exposure was also allowed in select scripts. It was however noted that IIL had applied 15% hair cut on securities brought by the clients for dealing in the margin trading account (the margin security) but provided certain relaxations in cases of select clients as in the case of M/s. Poonawala Shares and Securities Ltd, who besides being the top most client of IIL in terms of turnover, was also a member of the Pune Stock Exchange. It was also further found that IIL did not strictly collect the required margin and also did not provide any hair-cut on the securities placed by this client and instead offered them a great exposure and several relaxations thereby exposing itself, to a greater risk. The details relevant to this client as on October 17, 2002 are as brought out in the table below.

Client Code	Client Name	Security	Quantity	Rate	Hair Cut	Amount
M0500001	Poonawalla Shares and Securities	ALFALAVAL	2300	256.00	0	588,800.00
M0500001	-do-	COATESIND	2000	87.15	0	174,300.00
M0500001	-do-	HCL-INSYS	2000	86.20	0	174,200.00
M0500001	-do-	INFOTECENT	1000	142.45	0	142,450.00
M0500001	-do-	L&T	6000	182.45	0	1,094,700.00
M0500001	-do-	MORGANSTAN	164000	8.35	0	1,369,400.00
M0500001	-do-	MRPL	100000	7.15	0	715,000.00
M0500001	-do-	NIRLON	100000	0.00	0	0.00
M0500001	-do-	PENTACOMMU	100000	9.25	0	925,000.00
M0500001	-do-	STROPTICAL	20000	61.70	0	1,234,000.00
Sub Total						6,416,050.00

18.  On this count, IIL was charged with violating clause A(2) of the code of conduct prescribed under Regulation 7 of the Regulations and the conditions for grant of registration.

19. In their defense, IIL admitted that this was a one off case where waiver of margin requirement had been considered, albeit after detailed evaluation of risk with proper checks and balances. They submitted that the company had a long standing relationship with the client and adequate care had been exercised before extending such a relaxation. Subsequently vide their reply dated July 1, 2003, IIL contended that keeping in mind the concern shown by SEBI, all the amount due from the client had since been received and accounts had been fully settled.

20. Thereafter vide their letter dated July 15, 2004, IIL contended that the policy of providing hair cut was an internal guideline of the company. Referring to the case of M/s Poonawala Shares and Securities Pvt Ltd, it was contended that at the time of taking the decision in the said case, IFLS had evaluated the client on various crucial parameters like financial soundness, creditworthiness and its track record, and that they had in their custody, certain deposits and securities which had not been taken into consideration by the inspection team. While reiterating that the margins had been collected and that there were no defaults in margin collection, IIL enclosed an annexure detailing the exposure given to the client  vis-à-vis the cover that IIL had in the form of cash and security with the hair cut of 25%, which is reproduced hereunder.

POONAWALLA'S GROSS EXPOSURE VIS-A-VIS DEPOSITS FOR THE YEAR 2002-2003
Date	Gross Exposure	Cash Deposit	Securities margin after 25% haircut	Total margin	Margin/ exposure ratio
5-Apr-02	11478269	(129885.95)	4716985	4846871	42.23
8-Apr-02	10823775	(4430642.08)	4716985	9147627	84.51
10-Apr-02	19902547	(5573135.57)	4716985	10290120	51.70
11-Apr-02	58803222	(5573135.57)	4716985	10290120	17.50
12-Apr-02	61768472	(5285132.10)	4716985	10002117	16.19
15-Apr-02	166810419	(5285132.10)	4716985	10002117	6.00
16-Apr-02	178370559	(7822252.10)	4716985	12539237	7.03
17-Apr-02	205417539	(7949651.10)	4716985	12666636	6.17
18-Apr-02	135345752	(10479625.42)	4716985	15196610	11.23
19-Apr-02	156869922	(11073312.92)	4716985	15790298	10.07
22-Apr-02	152681052	(10778900.92)	4716985	15495886	10.15
23-Apr-02	178398322	(10778900.92)	4716985	15495886	8.69
25-Apr-02	139237111	(11201564.42)	4716985	15918549	11.43
26-Apr-02	103615791	(12733699.63)	4716985	17450684	16.84
29-Apr-02	106525562	(11494319.63)	4716985	16211304	15.22
30-Apr-02	192522070	(21993274.63)	4716985	26710259	13.87
2-May-02	228251486	(26881254.63)	4716985	31598239	13.84
7-May-02	223540176	(26918249.99)	10491985	37410235	16.74
8-May-02	181616060	(26815489.99)	10491985	37307475	20.54
13-May-02	194884710	(27032771.44)	10491985	37524756	19.25
14-May-02	171313071	(31487808.66)	10491985	41979793	24.50
15-May-02	187148895	(30945058.72)	10491985	41437043	22.14
17-May-02	199720978	(30945058.72)	10491985	41437043	20.75
20-May-02	115102474	(30177261.88)	10491985	40669246	35.33
21-May-02	195667778	(30177261.88)	10491985	40669246	20.78
22-May-02	201029286	(29713693.36)	10491985	40205678	20.00
23-May-02	192252714	(29605484.36)	10491985	40097469	20.86
24-May-02	139891447	(29605484.36)	10491985	40097469	28.66
27-May-02	120748102	(29385334.36)	10491985	39877319	33.03
28-May-02	163167874	(29385334.36)	10491985	39877319	24.44
29-May-02	181362192	(29393688.09)	10491985	39885673	21.99
30-May-02	192591425	(29209093.09)	10491985	39701078	20.61
31-May-02	54104044	(36989176.68)	10491985	47481161	87.76
1-Jun-02	32455437	(36714376.68)	10491985	47206361	145.45
3-Jun-02	50097341	(38349107.25)	10491985	48841092	97.49
4-Jun-02	59589366	(38168357.25)	10491985	48660342	81.66
6-Jun-02	58139399	(39649808.42)	1667569	41317377	71.07
7-Jun-02	83675148	(39649808.42)	1667569	41317377	49.38
10-Jun-02	84593159	(41300325.92)	1667569	42967895	50.79
11-Jun-02	76885962	(41322503.92)	1667569	42990073	55.91
12-Jun-02	83038042	(40961707.44)	1667569	42629276	51.34
13-Jun-02	90544875	(41024002.44)	1667569	42691571	47.15
14-Jun-02	131584332	(41019013.69)	1667569	42686582	32.44
17-Jun-02	129532802	(41019013.69)	1667569	42686582	32.95
18-Jun-02	93427458	(41045495.97)	1667569	42713065	45.72
20-Jun-02	96145058	(30841495.97)	1667569	32509065	33.81
21-Jun-02	96882978	(27451495.97)	1667569	29119065	30.06
30-Jun-02	97373161	(27480742.53)	1667569	29148311	29.93
2-Jul-02	115392221	(27480742.53)	1667569	29148311	25.26
3-Jul-02	141812930	(27480742.53)	1667569	29148311	20.55
4-Jul-02	75230521	(27491402.93)	1667569	29158972	38.76
5-Jul-02	141462359	(27491402.93)	1667569	29158972	20.61
8-Jul-02	153827018	(27573437.67)	1667569	29241006	19.01
9-Jul-02	152550006	(27548837.67)	1667569	29216406	19.15
11-Jul-02	156489466	(27550301.71)	1667569	29217870	18.67
12-Jul-02	145820670	(27429581.71)	1667569	29097150	19.95
16-Jul-02	131821411	(27429581.71)	1667569	29097150	22.07
17-Jul-02	141270942	(27429581.71)	1667569	29097150	20.60
19-Jul-02	145749702	(27429581.71)	1667569	29097150	19.96
23-Jul-02	107797409	(27911350.56)	1667569	29578919	27.44
24-Jul-02	103475541	(27838811.56)	1667569	29506380	28.52
25-Jul-02	60894993	(32600853.41)	1667569	34268422	56.27
26-Jul-02	99378539	(32603911.47)	1667569	34271480	34.49
31-Jul-02	66607605	(30766823.97)	1667569	32434393	48.69
2-Aug-02	72838465	(30475843.97)	1667569	32143413	44.13
5-Aug-02	72519283	(30559273.05)	1667569	32226842	44.44
6-Aug-02	66475433	(30393218.05)	1667569	32060787	48.23
7-Aug-02	161364961	(30393218.05)	1667569	32060787	19.87
8-Aug-02	103040886	(30393218.05)	1667569	32060787	31.11
9-Aug-02	146009085	(30393218.05)	1667569	32060787	21.96
12-Aug-02	149882401	(30393218.05)	1667569	32060787	21.39
13-Aug-02	151323581	(30393218.05)	1667569	32060787	21.19
14-Aug-02	156631153	(30393218.05)	1667569	32060787	20.47
16-Aug-02	176908961	(30393218.05)	1667569	32060787	18.12
19-Aug-02	181533596	(30506368.05)	1667569	32173937	17.72
20-Aug-02	172179368	(30687240.21)	1667569	32354809	18.79
21-Aug-02	170787043	(30687240.21)	1667569	32354809	18.94
22-Aug-02	135890699	(30872117.68)	1667569	32539686	23.95
23-Aug-02	154699522	(30204498.93)	1667569	31872068	20.60
26-Aug-02	174777048	(30204498.93)	1667569	31872068	18.24
27-Aug-02	164311695	(30348086.00)	1667569	32015655	19.48
28-Aug-02	162803783	(30392612.00)	1667569	32060181	19.69
30-Aug-02	158458975	(30392612.00)	1667569	32060181	20.23
31-Aug-02	103653170	(30392612.00)	1667569	32060181	30.93
2-Sep-02	153476545	(30640705.77)	1667569	32308275	21.05
3-Sep-02	189843896	(30640705.77)	1667569	32308275	17.02
4-Sep-02	194946151	(30716619.54)	4167569	34884189	17.89
5-Sep-02	192556235	(30716619.54)	4167569	34884189	18.12
6-Sep-02	197861390	(30742480.44)	4167569	34910049	17.64
16-Sep-02	182778337	(31489824.60)	4167569	35657394	19.51
17-Sep-02	164591946	(1828702.85)	4167569	5996272	3.64
19-Sep-02	158848309	(2278294.35)	4167569	6445863	4.06
20-Sep-02	138902135	(2479128.36)	4167569	6646697	4.79
23-Sep-02	139611930	(7828438.36)	4167569	11996007	8.59
24-Sep-02	139937355	(10661929.79)	4167569	14829499	10.60
25-Sep-02	138841909	(10441872.03)	4167569	14609441	10.52
26-Sep-02	156243113	(10443522.03)	4167569	14611091	9.35
27-Sep-02	94729847	(10443522.03)	4167569	14611091	15.42
30-Sep-02	125735202	(10519492.29)	4167569	14687061	11.68
1-Oct-02	125438160	(11097751.29)	4167569	15265320	12.17
3-Oct-02	141291825	(11061891.79)	4167569	15229461	10.78
4-Oct-02	145212883	(11183840.71)	4167569	15351410	10.57
7-Oct-02	184207588	(11148871.71)	4167569	15316441	8.31
8-Oct-02	178880694	(11176491.71)	4167569	15344061	8.58
9-Oct-02	176312259	(11176491.71)	4167569	15344061	8.70
10-Oct-02	122776549	(13170054.14)	4167569	17337623	14.12
17-Oct-02	121034949	(13170054.14)	4167569	17337623	14.32
23-Oct-02	127803869	(13587768.64)	4167569	17755338	13.89
24-Oct-02	163090387	(13595393.76)	4167569	17762963	10.89
25-Oct-02	162816085	(13595393.76)	4167569	17762963	10.91
31-Oct-02	149456254	(13595393.76)	4167569	17762963	11.89
13-Nov-02	102404442	(13595393.76)	4167569	17762963	17.35
20-Nov-02	136680418	(1595393.76)	4167569	5762963	4.22
30-Nov-02	100833240	(1595393.76)	4167569	5762963	5.72
10-Dec-02	98040330	(1595393.76)	4167569	5762963	5.88
31-Dec-02	99166222	(34492737.68)	4167569	38660307	38.99
1-Jan-03	134839723	(22618510.81)	4167569	26786080	19.87
14-Jan-03	97412034	(14992519.27)	4134944	19127463	19.64
31-Jan-03	98499368	(10403643.78)	4134944	14538588	14.76
4-Mar-03	133949869	(10403643.78)	4134944	14538588	10.85
11-Mar-03	133885389	(17709297.47)	4134944	21844241	16.32
24-Mar-03	97492370	(19897852.13)	4134944	24032796	24.65
31-Mar-03	101196405	(19897852.13)	4134944	24032796	23.75

  

21.  IIL contended that most of the times, they had margin cover of more than 10% which was in line with the SEBI guidelines and that even when they closed the accounts, full dues were recovered from the client and there were no pending dues. On the basis of the above, it was contended that there was no violation of clause A(2) of the code of conduct prescribed under Regulation 7 of the Regulations as regards the condition for grant of registration and Regulation 26(xvi) of the Regulations read with Section 15HB of the Act.

 

22. I have carefully examined the submissions made by IIL in their defense and noted their contention of having in their custody, certain deposits and securities of the clients who were offered this margin trading facility. However this issue was never brought to the notice of the inspecting team to enable them to get a proper perspective in the matter. In fact the information given in the tabular column was never submitted to SEBI even in their replies made thereafter. Almost 2 years after the inspection, IIL has taken this plea of having always given due attention to the financial status of the client.  

 

23. Be that as it may, I have perused the SEBI Circulars relevant to the issue of collection of margin money. In terms of the Circular no SMDRP/POLICY/CIR-33/2000 dated July 27, 2000, all the clients excluding FIs/FIIs/MFs were directed to maintain a deposit of minimum margin with a broker in the form of cash, bank guarantees, FDRs or approved securities, not less than 10% of the net open position of a client at any point of time. The actual delivery of shares sold or actual payment made for shares bought was to be excluded from the net position. Subsequently vide circular no SMDRPD/Policy/Cir-6/2001 dated February 1, 2001, in order to ensure compliance with this requirement, SEBI had stipulated that the stock exchanges obtain an auditors' certificate to this effect from all brokers on a quarterly basis and the brokers in turn, were directed to obtain a similar certificate from their sub-brokers. Thereafter vide SMD/Policy/Cir-12/2002 dated May 17, 2002, it was decided that for the collection of 10% upfront margin from clients, only trades which would result in a margin of Rs.50,000 or more should be considered. In other words, if client’s position exceeded Rs. 5 lacs, the broker would necessarily be required to collect 10% margin from the client. It was also decided that the certification of the collection of this upfront margin would be done by the compliance officer as appointed in terms of regulation 18A of the Securities and Exchange Board of India, (Stock Brokers and Sub-Brokers) Regulations, 1992.

 

24.  I have also examined the contents of the tabular column brought out earlier, in the context of the charges leveled against IIL. From the show cause notice served on IIL, I have noted that the collateral maintained by IIL for its client; M/s Poonawala Shares and Securities Pvt Ltd as on October 17, 2002 was shown as amounting to Rs. 64,160,50/-. It has been further shown that IIL has not applied any haircut for various securities as collateral. However, IIL in their defense have enclosed the annexure showing gross exposure vis-à-vis the deposits of M/s. Poonawala Shares and Securities Pvt Ltd lying with them. From the same, it is noted that although as on October 17, 2002, M/s. Poonawala Shares and Securities Pvt Ltd had a gross exposure of Rs.12,10,34,949.00, the cash amount and securities margin lying with IIL after 25% hair cut, amounted to Rs.1,31,70,054.00 and Rs.41,67,569.00 respectively, totaling an amount of Rs.1,73,37,623.00 lying with IIL. Thus, the ratio of margin cover to the total exposure was found to be 14.32%.

 

25. These figures clearly indicate that while there was a deviation by IIL from their internal guidelines as regards collection of 25% of the margin from their clients in the form of cash or securities, the principle laid down in the SEBI Circular No SMDRP/POLICY/CIR-33/2000 July 27, 2000 in terms of maintaining a margin cover of more than 10%, appears to have been adhered to.

 

26. However, there was a lack of adherence by IIL on a few occasions to the principles laid down in the SEBI circular no SMD/Policy/Cir-12/2002 dated May 17, 2002, which had mandated the collection of 10% upfront margin from clients in respect of trades which would result in a margin of Rs. 50,000/- or more. From the tabular column brought out earlier, I have noted that in a few instances, IIL failed to collect the 10% margin from M/s Poonawala Shares and Securities Pvt Ltd despite the client’s position exceeding Rs 5 lacs in such cases. No justification has been provided for these aberrations. On the contrary, IIL has admitted waiving the margin requirement on certain occasions albeit after checking the financial soundness of the clients. However the fact that IIL had waived the margin requirement in certain instances after detailed evaluation of risk with proper checks and balances could perhaps be a mitigating factor while evaluating this case in its entire perspective especially when one takes into consideration the fact that no investor grievance is pending against IIL.

 

27. Unauthorized grant of trading terminals

 

SEBI vide its circular no: SMDRP/POLICY/CIR-49/2001 dated October 25, 2001 directed all exchanges to grant trading terminals only to the members registered office, branch offices and their registered sub-brokers’ offices and to withdraw the trading terminal granted earlier in places other than those mentioned above. However it was observed that IIL had maintained its trading terminals at the clients end as well, as brought out in the table below.

 

S.No.	Name of the holder	User ID	Location
1.	K V Parekh	AHMFR1	Ahmedabad
2.	Online Script India Pvt Ltd	BANGFR1	Bangalore
3.	Indian Syntans Investments P Ltd	CHINTRD1	Chennai
4.	Ananth Krishnan	CHENTRD3	Chennai
5.	Meenakshi	COIMBFR1	Coimbatore
6.	Richard Pinto	GOAFR1	Goa
7.	V C Gupta	DELHIFR2	Gurgaon
8.	Tadla Nandagopal	HYDFR1	Hyderabad
9.	Poonawalla Securities P Ltd	PUNETRD2	Pune

28. By maintaining trading terminals at places other than those specified, without any agreement specifying the scope/ responsibilities of franchises in this regard, IIL was found to have violated the provisions of the SEBI Circular referred above.

29. Vide their letter dated April 16, 2003, IIL submitted that they had established proper checks and balances to ensure that all the trades were properly monitored before the same were executed, in compliance with the spirit of the SEBI guidelines and further assured that specific steps would be initiated to either discontinue the trading terminals or insist on sub broker registration from the said clients. It was stated that they were in the process of compliance with the findings as brought out in the inspection report and that the revised independent branch management agreement had been finalized and that they were in the process of executing this revised agreement with all existing franchises to comply with the findings.

30. IIL further submitted that NSE had permitted the computer to computer link (CTCL) facility only during early 2000 which facilitated the expansion of broking houses by having branches/ deemed branches. It was stated that during the initial phase, while the company focused on having its own branches, subsequently especially during the later part of 2001, franchisee/ authorized model of expansion started to gain momentum in the broking industry. It was contended that the model to be adopted for expansion was not very clear due to the confusion that existed in the franchisee/ authorized person model vs. sub-broker model but that considering the risk associated with sub-broker model, the franchisee/ authorized person model concept gained acceptance. It was stated that all the cases of terminals mentioned in the inspection report were the deemed branches of the company operated by their dealers. Hence, once the model was finalized based on the clarity on the subject, the documentation process was initiated which took some time for completion. IIL further submitted that the current rule permitted appointment of authorized person, where such an entity was not already a direct member of NSE and was not associated in any manner with any other NSE member.

31. Elaborating on the said fact, IIL further stated that the concept of the authorized person was permissible under the byelaws of the rules and regulations of NSE of which IIL was a trading member. In this context, IIL referred to Regulation 1.3.3 of the capital market regulations which defined authorized person to mean a person who is authorized by the exchange as an approved user of the trading member or a participant and employed, whether through the contract of employment or otherwise, by a trading member for remuneration (whether by way of salary, commission, allowance or otherwise) expressed in terms of money or capable of being expressed for any kind of work or activity, manual or otherwise and who gets his remuneration directly or indirectly from the trading member or a participant and includes any person employed by it or through a contractor and includes any person acting in any capacity on behalf of the trading member or participant for any activity related to the trades done and executed on the exchange even if such a person is not receiving a consideration or remuneration from the trading member or a participant for services rendered by him.

32. It was contended that the concept of authorized person was prevalent in NSE from its very inception. In terms of the definition brought out earlier, it was contended that an authorized person could be paid commission, salary or in any other form for assisting the broker for bringing the business or doing allied activities.  IIL admitted having appointed the franchisees/ authorized persons by entering into franchisee agreements with them in terms of Regulation 3.3.1 of the NSE bye-laws, rules and regulations for introducing new clients within the norms prescribed by the said bye-laws rules and regulations. It was reiterated that terminals were installed at the franchisees’ place which were deemed branches of the company and hence the terminals given to the franchisee were in terms of the bye laws, rules and regulations of the NSE and no dealings had been carried out with an unregistered intermediary nor were they allocated unauthorized terminals.

33. IIL further submitted that the guidelines for CTCL terminals were introduced vide NSE Circular REF/ NSE/MEM/3574 dated August 29, 2002 and that the requirement of intimating NSE about the terminals had become effective only after August 2002. On the said basis, IIL contended that there was no violation of allocating the unauthorised terminals to the said franchisees.

34. Furthermore, referring to the instances pointed out at the time of inspection as brought out in the tabular column above, IIL submitted that M/s.Online Script India PVt Ltd, Meenakshi (Lakshmi Investments), Richand Pinto (Jose Pinto), VC Gupta and Tadla Nandagopal were authorized persons / franchisees of the company who had entered into franchisees/ branch management agreement with them and were continuing the business relationship with them. It was stated that M/s.Indian Syntans Investments was one of their clients, using their services through their branch located in the premises belonging to M/s P N Investments from whom they had rented the place. As regards, the terminals installed at the premises of K V Parekh, Anantha Krishnan, M/s.Poonawala Securities Pvt Ltd, it was contended that the same were operated by the dealers appointed by the company and as on date, these terminals were deactivated. On the said basis, IIL submitted that all their terminals were authorized terminals, validly installed and operated by the dealers appointed by them.  IIL also enclosed the copies of the agreements stated to have been entered into with the said parties.  

35. IIL further submitted that the charges leveled against them had neither resulted in any unfair advantage nor caused any financial loss to the investor(s). On the said basis and the fact that no investor complaints were pending against them and that there were no lapses that were repetitive in nature, it was requested that the charges leveled against IIL be dropped and no penalty be levied under Section 15HB of the Act.

36. Relying upon the order passed by SEBI vide order June 2, 2004 in the matter of JM Morgan Stanly Retail Services Pvt Ltd, wherein SEBI had inter-alia held that imposing any penalty without any loss caused to any investor would not be furtherance to the objects of the SEBI Act, 1992, IIL submitted that as in the case above mentioned, no loss was caused to any investor due to the administrative and technical lapses and hence, the same principles should be applied in their case.

37. I have examined all the contentions raised by IIL in support of this charge as well as the contents of the SEBI circular no.SMDRP/Policy/Cir-49/2001 dated October 22, 2001. This circular issued by SEBI to all Executive Directors/Managing Directors of all Stock Exchanges, inter alia deals with the issue of grant of trading terminals and clearly states that “exchanges are advised to grant trading terminals only at the members’ registered office, branch offices and their registered sub-broker’s offices”. Thus it is clear that the exchanges have been mandated to ensure due implementation of the said circular as regards grant of terminals only at the members’ registered office, branch offices and their registered sub-broker’s office.    

38. However I have noted that NSE had subsequently come out with guidelines regarding the location of CTCL terminals and grant of permission to a member to extend the terminals to approved /authorized persons. The circular of NSE no.282 dated August 29, 2002 inter-alia states as follows:-

• The persons who handle each CTCL terminal of the trading member are known as approved persons. Necessary prior approval of the exchange is required to be obtained before any CTCL terminal is entrusted to an approved person, failing which it shall be treated as a violation.

• CTCL terminals need to be located only in the office of the trading member or in the office of their registered sub-brokers.

• If it is found that the CTCL terminal is at a place which is not the office of their registered sub-brokers, such a place shall be deemed to be the office of the trading member.

• Trading members shall not entrust the CTCL terminals to their clients or to any unregistered intermediary other than approved persons. Approved person may be an employee of the trading member, a registered sub-broker, an approved user or an authorized person who has been approved by the exchange.

39. Thus in terms of the circular issued by NSE, although a restriction has been provided as regards appointment of an approved person in terms of seeking the prior approval of the exchange, an approved person is shown as a person approved by the member, to be authorized to operate the terminals.

40. Upon analyzing this concept, it would seem that any person can be authorized by the broker to operate the terminals. Moreover an authorized person could also mean a person who introduces clients to the trading member, for which he would receive some commission/remuneration from the said member and not from the clients. In other words, the person handling the terminal would mainly have to introduce clients only.  This would leave the issue of onus wide open. Furthermore it appears that although the CTCL terminals should be located only in the office of the trading member or in the office of their registered sub-brokers, a place which is not the office of their registered sub-brokers, could also be treated as the office of the trading member.

41. The essence of SEBI insisting upon maintenance of trading terminals at the specified locations is to ensure that there are no unauthorized terminals which are prone to misuse for unregistered sub-broking and illegal trading activities. Maintenance of trading terminals at the specified locations also ensures that data required for the purposes of finding out illegal trading/ unregistered sub-broking activities etc., through analysis of data is obtained from the exchange, itself. However, this is not possible without getting back to the brokers for details where the trades are executed through CTCL terminals. Thus such mode of operation would defeat the very purpose of confidentiality required in such matters and consequently create difficulties in the task of unearthing of such activities. Another issue would be the lack of direct control over these terminals by the Exchanges.

42. However, from the facts above mentioned, it appears that the provisions of the NSE Circular are not in line with that contained in the circular of SEBI issued in order to obviate the possibility of unregistered sub-broking and illegal trading activities.

It is for SEBI to examine this issue.

43. In the instant case, faced with two conflicting circulars, IIL appears to have taken the defense of having acted along the lines of the circular issued by NSE. While this could be on account of the fact that the circular issued by SEBI is directed to the exchanges for implementation of the same, the fact cannot be discounted that as a registered entity of SEBI, the onus lies on IIL to ensure due adherence to the directions contained therein.

44. Notwithstanding the above, it is clear that IIL has also acted contrary to the NSE circular, and granted trading terminals to clients, obviously without due intimation to the exchange.

45. The act of IIL being aware of having granted unauthorized trading terminals is apparent from their contention that “the terminals installed at the premises of K V Parekh, Anantha Krishnan, M/s.Poonawala Securities Pvt Ltd were operated by the dealers appointed by the company but that as on date, these terminals were deactivated’. It is clear that being aware of the maintenance of these terminals at a place which was not their office, IIL decided to discontinue the trading terminals or insist on sub broker registration from the said clients.

46. It is also clear that IIL designated the persons/ entities who were essentially their clients and running their trading terminals as their branches or franchisees, without entering into any agreements with them specifying the scope of the responsibilities / obligations of the respective parties. The fact is that no such agreement had been entered into with the parties at the time of the inspection. In the absence of the same, the possibility of such parties having acted in the capacity of un-registered sub-brokers could not be ruled out. It is noted that the agreements annexed to their reply dated July 15, 2003 were entered into subsequently, with all the parties, in as much as these agreements are all dated subsequent to the date of the inspection conducted during September 2002.

47. It could be relevant to state the fact that the irregularities as regards the grant of unauthorized trading terminals were not rectified even at the time of the inspection conducted by SEBI in the subsequent year i.e. October 2003 in as much as 5 clients at whose ends the trading terminals were maintained, were seen to continue running these trading terminals at the time of inspection.

48. In fact their act of executing revised agreements with all existing franchisees is indicative of their non compliance earlier. The agreement entered into with Online Scripts India Pvt Ltd is dated January 5, 2004 although the agreement is stated to have commenced from September 1, 2003.

49. The agreement with the Meenakshi ( Lakshmi Investments) is dated October 1,2002 with the same date shown as date of commencement. This agreement is shown to be in force for one year i.e, till October 1, 2003. The franchisee agreement with Mr.Jose Savio Pinto is dated November 28, 2001 and is shown to have commenced on the same date but is due to expire on November 28, 2004, while the franchisee agreement with V C Gupta entered into on December 7, 2001 is shown to commence from December 2001 and expires on December 7, 2004. The agreement with Dadla Nandagopal is dated October 7, 2003 but shown to commence from September 1, 2003. The agreement with P N Investments dated June 30, 03 is shown to commence on July 1, 2003 but expired on June 30, 2004.

 50. Having regard to the above, and the fact that no satisfactory explanation has been given by IIL for their earlier non-compliances so as to condone these irregularities, I am inclined to hold that there was a failure on the part of IIL to maintain authorized trading terminals which fact has been admitted to by IIL.  Persons, who operate in the market, are required to maintain high standards of integrity, promptitude and fairness in the conduct of the business dealings. People, who operate in a manner otherwise, are not fit or proper persons to operate in the market.

 51. In view of the above as well as the admitted instances of lapses on the part of IIL in the maintenance of the complete data base of the client agreement and client registration forms as brought out in the earlier part of the order,  I am inclined to hold that no case has been made out by IIL for dropping the present proceedings altogether.

 52. I have examined the contention of IIL of having acted in a bonafide manner and their contention that the unintentional, technical lapses committed by them are procedural in nature. While the said lapses may be technical and few in number, in so far as the bonafides of IIL is concerned, from the facts detailed above, an inference can easily be drawn that they  were not unaware of the compliance requirements and yet disregarded the legal obligations cast upon them. Any evasion of the compliance requirements issued by the regulator is bound to affect the interest of the investors. Although such a loss cannot be specifically computed in monetary terms, the fact remains that all regulatory provisions have a specific purpose behind their enactment. The very purpose of enacting any legislation is due adherence to the procedures laid down there under to ensure the sound and smooth functioning of the capital market. If no cognizance were to be taken of any breach of these provisions and no liability fixed there upon, the entire purpose of incorporating the provisions in the said enactments would become redundant.

53. I have examined the order passed by SEBI in the matter of JM Morgan Stanly Retail Services Pvt Ltd, that is sought to be relied upon by IIL. In the said case, there were a few instances of failure to obtain client registration forms and agreements by  JMM which were viewed as technical lapses. However, upon examining the issue as to whether contract notes were issued by JMM for the vyaj badla transactions and whether the said member had failed to maintain a record of duplicate vyaj badla bills,  SEBI opined that as there was no statutory requirement in the  maintenance of duplicate bills in physical form only, and that as the maintenance of bills in electronic form would constitute adequate compliance with the said  requirement and that as the issues relating to vyaj badla were entirely academic in as much as vyaj badla was abolished as far back as in the year 2001, the recommended penalty of suspension of certificate of registration for a period of three months was reduced to that of a warning.

54. In the instant case, I am congnisant of IIL being a corporate member with branches all over India and operating since a considerable period of time with several leading institutional players as their clients. Besides as brought out earlier, IIL has the membership of both BSE & NSE and is also operating on the Wholesale Debt Market Segment (WDMS) of the NSE. Taking the same into consideration as well as the fact that some of the lapses committed by IIL are not substantial when compared to the number of clients being serviced by them, the present matter certainly calls for the imposition of a penalty.

55. Section 15HB of the SEBI Act, 1992, reads as follows:

“Whoever fails to comply with any provisions of the Act, the  rules or Regulations made  or directions issued by the Board thereunder for which no separate penalty has been provided shall be liable to a penalty which may extent to Rs.1 crore”

56. However, while adjudging the quantum of penalty, the adjudicating officer is required to have due regard to the factors laid down in Section 15 J of the Act which are as under:-

a)  the amount of disproportionate gain or unfair advantage, wherever quantifiable, made as a result of the default;

b)  the amount of loss caused to an investor or group of investors as a result of the default;

c)  the repetitive nature of the default

57. These provisions also find mention in Rule 5(2) of the SEBI (Procedure for holding enquiry and imposing penalty by the Adjudicating Officer) Rules, 1995.

58. Some of these pre-requisites are in the negative and are in favour of IL. However on a judicious exercise of the discretion conferred upon me, bearing in mind the facts and circumstances of this case as well as after analysing all the material available on record as well as the mitigating factors, if any, I am inclined to hold that although the penalty need not be imposed in terms of the provision provided in Section 15HB of the Act, the imposition of penalty is very much necessitated.

ORDER:

59. In view of the foregoing, in exercise of the powers conferred upon me under Rule 5 of the SEBI (Procedure for Holding Enquiry and Imposing Penalty by the Adjudicating Officer) Rules, 1995, and in the interest of justice, equity and good conscience I think it appropriate to levy a penalty of Rs. 2,00,000/- .

60. The penalty amount shall be paid through a cross demand draft drawn in favour of “SEBI- Penalties remittable to the Government of India’ and payable at Mumbai which may be sent to Smt. Usha Narayanan, Chief General Manager, Securities and Exchange Board of India, Mittal Court, B Wing, 224 Nariman Point, Mumbai – 400021.

 

Date:  NOVEMBER 18, 2004	G. BABITA RAYUDU
Place: Mumbai	ADJUDICATING & ENQUIRY OFFICER