2023 (7) TMI 1615 - Board - SEBI

SEBI clears depository of violations under DP Regulations, Section 19G Depositories Act and Section 15HB SEBI Act

The SEBI Board held that the depository (Noticee) had not violated Regulation 79(5) read with Regulation 79(3) of the DP Regulations, Regulation 17 read ... Depository's duty - Manner of creating pledge or hypothecation - Noticee failed to monitor pledge of securities by BRH from ineligible demat account - failed to assign appropriate nomenclature to the demat account maintained by BRH - failure to freeze the demat accounts of BRH - Violation of the provisions of Regulation 79(5) read with Regulation 79(3) and Regulation 17 read with Clause 2, 5 and 10 of Code of Conduct for Depositories - applicability of the monetary penalty under the provisions of Section 19G of the Depositories Act, 1996 and Section 15HB of the SEBI Act, 1992 - HELD THAT:- The restrictions on trades in the demat account of BRH were imposed only vide Interim Order dated October 07, 2019, while the pledges had been created by BRH at different times starting from June 2007 to September 2019. Therefore, the time of pledge creation by BRH, no 'freezing order' was operational with respect to the demat account pertaining to the pledged securities. The capability of determining debit balances of clients, or obtaining the authorization of the clients before creation of the pledge etc, lies within the purview of Stock Exchanges, and not the Depositories. The extant provisions do not mandate submission of details of clients' funds and securities balance with the depository by the broker. Therefore, the Noticees in its capacity as the depository, could not be expected to have visibility in the operation of BRH to the extent of inferring the illegality of the hypothecation of the shares based on the debit balance of the clients. Thus, Noticee, by allowing creation of pledge by BRH from demat accounts of its clients, had not violated the provisions of Regulation 79(5) read with Regulation 79(3) of DP Regulations, Clause 14.2 and 14.4 of Bye Laws of CDSL and Regulation 17 read with Clause 2, 5 and 10 of Code of Conduct for Depositories as specified in Part D of the Third Schedule of DP Regulations. Appropriate nomenclature - Noticee served the purpose and spirit of the provisions pertaining to nomenclature provided in the Circular dated September 26, 2016, by providing for the tagging of demat accounts in sub-status categories, even though it did not ensure strict compliance with letter of the provisions by changing the name of account itself. Upon consideration of the facts pertaining to the method of nomenclature adopted by the Noticee in toto, therefore, Noticee had not violated the provisions of Clause 2.3.1 read with Clause 1.2 of Annexure of SEBI Circular dated September 26, 2016. Freeze on the demat accounts - Noticee, vide letter dated April 18, 2019, had sought SEBI's approval for the amendment of its Bye Laws to the effect that where a pledge or hypothecation had already been created on securities prior to the date on which the operations in respect of such securities had been frozen, the pledgee could invoke the pledge/hypothecation through the Depository Participant and the Noticee should register the pledgee as the Beneficial Owner of such securities. Further correspondences dated October 09, 2019, October 11, 2019 and January 10, 2020 were exchanged between the Noticee and SEBI, that is, after the passing of Interim Order dated October 07, 2019. However, SEBI had not raised any objection to the aforesaid practice of CDSL or prohibited the same either, in the aforesaid correspondences. From the material on record, including the extant provisions and the correspondence exchanged between SEBI and the Noticee since 2014, that it could not be construed that the Noticee was mandated to ensure prohibition on invocation on securities pertaining to which freezing order had been issued. Therefore, the Noticee, by allowing HDFC to invoke the pledge over securities as detailed in foregoing paragraphs, had not violated the directions contained in SEBI Interim Order dated October 07, 2019 read with CDSL Bye Law 13.4.2. Noticee has not violated the provisions as alleged in the SCN. The Show Cause Notice issued against the Noticee is accordingly disposed of. 1. ISSUES PRESENTED AND CONSIDERED 1.1 Whether a depository is under a legal obligation, while processing a request for creation of pledge over securities in a stock broker's client account, to verify client-wise debit balances/authorisations and refuse creation of pledge of securities of ineligible clients, and whether allowing such pledges violated Regulation 79(3) & 79(5), Regulation 17 read with Clauses 2, 5 and 10 of the Code of Conduct for Depositories under the DP Regulations, and Clauses 14.2 and 14.4 of the depository's Bye Laws. 1.2 Whether assignment of 'sub-status codes' to stock broker demat accounts, without changing the account name itself, constituted compliance with Clause 2.3.1 read with Clause 1.2 of the Annexure to SEBI Circular dated September 26, 2016 prescribing uniform nomenclature for demat accounts. 1.3 Whether, upon a SEBI interim order directing that no debits be made in the demat accounts of a stock broker, a depository was legally required (i) to mark a freeze that also prevented invocation of pre-existing pledges, and (ii) to refuse invocation of such pledges by a lender, and whether permitting such invocation violated Clause 13.4.2 of the depository's Bye Laws and the SEBI Interim Order. 2. ISSUE-WISE DETAILED ANALYSIS 2.1 Scope of depository's duty when creating pledge over securities in stock broker's client accounts Legal framework (as discussed) 2.1.1 Regulation 79(3) of the DP Regulations requires the depository, within fifteen days of receipt of an application and after concurrence of the pledgee through its participant, to create and record the pledge and intimate the participants of the pledger and pledgee. 2.1.2 Regulation 79(5) requires the depository, if it does not create the pledge, to intimate the participants of the pledger and pledgee along with reasons. 2.1.3 Under Bye Law 14.2 of the depository, on an application by a Beneficial Owner, the depository/participant issues a certificate of holdings certifying that the Beneficial Owner is entitled in its name to the securities proposed to be pledged. 2.1.4 Bye Law 14.4 provides that the depository/participant shall not refuse permission to create a pledge in respect of securities available for pledge unless operations in respect of those securities are restrained or frozen by order of a court, tribunal, SEBI, government, RBI, other competent authority or the depository itself; if it refuses, it must intimate reasons to pledgor and pledgee. Interpretation and reasoning 2.1.5 The Court found that pledges in favour of lenders were created between June 2007 and September 2019, a period during which no freezing or restraint order operated on the demat accounts from which the securities were pledged. 2.1.6 The Court held that the statutory and bye-law obligations at the pledge-creation stage are limited to (a) verifying availability of the securities in the Beneficial Owner's demat account, and (b) obtaining concurrence of the pledgee through its participant, and, where pledge is refused, recording and communicating reasons. 2.1.7 Bye Law 14.4 confines the depository's power to refuse creation of pledge to cases where 'operations in respect of those securities are restrained or frozen' by a competent order. No such restraint existed at the time of creation of the impugned pledges; hence, on the text of the Bye Law, the depository was not empowered to refuse. 2.1.8 The Court rejected the contention that the depository was obliged to ascertain client-wise debit balances in the stock broker's books or to verify client authorisations prior to creation of pledge, noting that: (a) extant provisions do not mandate brokers to submit client funds and securities balances to the depository; (b) supervision of stock brokers' operations, including monitoring misuse of client securities and debit balances, lies primarily with stock exchanges, not depositories; and (c) imposing such verification obligations on the depository would be 'farfetched' and beyond the scheme of the DP Regulations and Bye Laws. 2.1.9 In light of this limited statutory role, the Court held that allowing creation of pledge on the securities in the concerned client accounts did not amount to a failure to 'monitor' pledging from ineligible accounts in the manner alleged, nor a breach of the Code of Conduct obligations to safeguard investors and the depository system. Conclusions 2.1.10 The depository, by permitting creation of pledges on securities in the broker's client accounts in the absence of any subsisting restraint/freezing order at the time of pledge creation, did not violate Regulation 79(3) or 79(5) of the DP Regulations, Clauses 14.2 and 14.4 of its Bye Laws, or Regulation 17 read with Clauses 2, 5 and 10 of the Code of Conduct for Depositories. 2.2 Compliance with SEBI circular on nomenclature/tagging of stock broker demat accounts Legal framework (as discussed) 2.2.1 Clause 1.2 of the Annexure to SEBI Circular dated September 26, 2016 prescribes specific nomenclatures for stock broker demat accounts, including 'Name of Stock Broker - Client Account', '- Collateral Account', and '- Pool account'. 2.2.2 Clause 2.3.1 requires stock exchanges and/or depositories to ensure that all existing demat accounts maintained by stock brokers are assigned appropriate nomenclature within three months from the circular; this timeline was later extended to July 1, 2017 by a subsequent SEBI circular. Interpretation and reasoning 2.2.3 The account from which securities were pledged had 'BRH Wealth Kreators Ltd' as first holder and was tagged in the depository system with the sub-status 'Corporate CM/TM - Client account', indicating it was used for safekeeping of client securities. 2.2.4 Following the circular, the depository, with effect from December 5, 2016, introduced/modified sub-status codes (e.g., Pool Account, Client Account, Proprietary/Deemed Proprietary, Collateral Account) and implemented a system of 'tagging' broker demat accounts through such sub-status codes rather than changing the registered account name. 2.2.5 The depository issued Communiques (including one dated November 22, 2016) to its participants stating that, since appropriate nomenclature could be reflected through separate sub-status tagging, 'DPs are not required to do any change in name of the demat account to give effect to the aforementioned SEBI circular.' It also ensured that older accounts were ultimately categorised into the four specified sub-statuses where brokers did not effect changes themselves. 2.2.6 The Court noted that this implementation methodology (using sub-status tagging to reflect the purpose of the account, without altering the name line) was publicly communicated and that SEBI did not contradict or object to this approach. 2.2.7 On the facts, the concerned account had been duly tagged as a client account via sub-status code, thereby achieving the regulatory objective of clearly identifying the nature and purpose of the demat account, even though the literal account name did not follow the exact nomenclature string prescribed in the circular. Conclusions 2.2.8 The depository's use of sub-status tagging to denote 'Client Account', 'Proprietary Account', 'Collateral Account' and 'Pool Account', without changing the account names, satisfied the substance and purpose of Clause 1.2 and Clause 2.3.1 of the SEBI Circular dated September 26, 2016. 2.2.9 The depository did not violate Clause 2.3.1 read with Clause 1.2 of the Annexure to the SEBI Circular by maintaining the broker's account name while appropriately classifying it via sub-status as a client account. 2.3 Effect of SEBI Interim Order and Bye Law 13.4.2 on invocation of pre-existing pledges Legal framework (as discussed) 2.3.1 The SEBI Interim Order dated October 7, 2019 directed, inter alia, that: (a) the assets of the noticees shall be utilised only for payment/delivery to clients under supervision of exchanges/depositories; (b) depositories shall ensure that no debits are made in the demat accounts of the noticees except for that limited purpose after exchange confirmation. 2.3.2 Bye Law 13.4.2 of the depository provides that the depository or participant 'shall freeze the account of a Beneficial Owner ... in the manner specified in the orders or directions' of SEBI or other competent authority. Interpretation and reasoning 2.3.3 The allegation was that the depository failed to mark a freeze on the broker's demat accounts as required by the Interim Order and Bye Law 13.4.2 and further allowed invocation of pledges by the bank on October 14, 2019 and December 5, 2019, allegedly contrary to the Interim Order. 2.3.4 The Court recorded that, as a longstanding practice, the depository's system allowed invocation of pledges created prior to the freezing of a demat account, while disallowing creation of fresh pledges post-freeze. This position had been communicated to SEBI as early as March 21, 2014 and on multiple subsequent occasions, including immediately after the Interim Order in October 2019. 2.3.5 Despite being informed of this practice and having ample opportunity, SEBI did not, in contemporaneous correspondence, direct the depository to alter its system or proscribe invocation of pre-existing pledges following a freeze. SEBI's later letter of December 20, 2021 declined to approve an explicit bye-law amendment but only stated that invocation in restrained/frozen cases depends on contractual terms and the specific restraining order, and did not mandate discontinuing the existing practice. 2.3.6 The Court noted that Bye Law 13.4.2 merely requires freezing 'in the manner specified' in the relevant order. The text does not expressly state that a freeze must extend to securities already pledged prior to the order or that invocation of such pledges is prohibited. 2.3.7 Further, the Court took note of the decision of the Securities Appellate Tribunal holding that the bank's invocation of pledge over securities in the broker's demat accounts after the Interim Order was valid and that the 'assets' referred to in the Interim Order did not include securities already pledged to the bank. 2.3.8 In light of the statutory wording, the depository's long-standing disclosed practice, SEBI's acquiescence in that practice at the relevant time, and the SAT's interpretation of the Interim Order, the Court held that it could not be inferred that the depository was legally required to prevent invocation of pre-existing pledges following the Interim Order. Conclusions 2.3.9 The requirement under Bye Law 13.4.2 to freeze accounts 'in the manner specified' in the SEBI Interim Order did not, on its terms, oblige the depository to bar invocation of pledges created prior to the order. 2.3.10 By allowing the lender to invoke pre-existing pledges over the broker's demat accounts post-Interim Order, the depository did not act in violation of the SEBI Interim Order or Clause 13.4.2 of its Bye Laws. 2.3.11 Consequently, no contravention of the SEBI Act, the Depositories Act, the DP Regulations or the relevant Bye Laws was established, and no monetary penalty was attracted.