BEFORE THE ADJUDICATING OFFICER SECURITIES AND … · KOTAK SECURITIES LTD, BAKHTAWAR 1ST FLOOR,...

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BEFORE THE ADJUDICATING OFFICER

SECURITIES AND EXCHANGE BOARD OF INDIA

(ADJUDICATION ORDER NO.: SD/AO/08/2008) UNDER SECTION 15I OF THE SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992 READ WITH RULE 5 OF THE SEBI (PROCEDURE FOR HOLDING INQUIRY AND IMPOSING PENALTIES BY ADJUDICATING OFFICER) RULES, 1995

Against M/S KOTAK SECURITIES LIMITED

PAN: AAACK3436F BRIEF FACTS OF THE CASE: 1. M/s Kotak Securities Limited (hereinafter referred to as ‘KSL’ or the

‘Noticee’) is registered with Securities and Exchange Board of India (hereinafter referred to as ‘SEBI’) as a Depository Participant (DP) of National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited (CDSL) under the category of stockbroker, vide SEBI registration numbers IN-DP-NSDL-23-97 and IN-DP-CDSL-158-2001. KSL has its registered office address at 1st Floor, Bakhtawar, 229, Nariman Point, Mumbai 400 021. The Depository participant Module (DPM) of KSL is installed at Nirlon House, 2nd Floor, Dr A B Road, Worli, Mumbai- 400 025. The DP has total 41,412 beneficial owner accounts (BO accounts), of which there are 34,300 individual accounts, 7,109 corporate accounts and 3 clearing member accounts.

2. KSL is a subsidiary of Kotak Mahindra Bank Limited and is the entity

entrusted with stock broking activities for the Kotak Mahindra Bank. KSL was incorporated on 20th July, 1994. The Company is registered with SEBI as a participant of NSDL, CDSL, member of BSE, NSE and a dealer with Over the Counter Exchange of India.

3. KSL has 37 branch offices including the registered office at Nariman

point, which have around 402 NSE trading terminals in cash segment and 245 terminals in F & O Segment (including CTCL) and 50 BSE trading terminals spread across 78 centers in the country.

4. KSL as part of its operations extends to their clients a facility, which they

term as “delayed payment facility”, which is similar to Margin Trading facility. In the said scheme, clients of KSL are permitted to trade based on initial margin deposited with them. Any client approaching KSL for

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availing Margin Trading facility has to first enter into an agreement with KSL, which is very crucial. The agreement provides for the percentage margin that the client has to bring in either in the form of cash or securities. The present margin that the client has to bring in is 20%, the rest 80% is funded by KSL (from sample agreement forms it has been observed that, the margin has come down from 30%, 25% to the present 20%). As per the agreement, KSL has a lien over the securities that will be purchased by the client and it can also open a separate beneficial owner account for the client. The beneficiary account for the client is opened in the name of KSL and the first line of the address contains the name of the client, styled as A/c 'clients name' and adjacent to it the client broking code is given in brackets. All the margin trading accounts are opened in the name of KSL and are identified with the help of the short name in the depository system and the name of the client in the first line meant for address. For all such accounts opened by KSL, the address shown is that of their office at Bakhtawar, Nariman Point. Few samples of the pattern described above as per the depository system are as given below, which are taken from the Inspection Report:

Client Id 10265249 Category House Status Active

Name KOTAK SECURITIES LIMITED

Address A/C PARAG MEHTA (PR459)

KOTAK SECURITIES LTD, BAKHTAWAR

1ST FLR 229 NARIMAN POINT

MUMBAI

Pin Code 400021

Client Id 10249022 Category House Status Closed


Address A/C PRUDENT ENTERPRISES (PG930)


1ST FLOOR 229 NARIMAN POINT

MUMBAI

Pin Code 400021

Client Id 10247771 Category House Status Closed


Address A/C MGF SECURITIES (M1662)


1ST FLOOR, 229 NARIMAN POINT

MUMBAI

Pin Code 400021

5. Further it has been ascertained from the Inspection Report that the funds

for margin trading have been borrowed from their group concerns (such

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as Kotak Mahindra Capital, Kotak Mahindra Investments etc) and other Institutions (such as ING Savings, Deutsche Mutual Fund, LIC Mutual Fund, SBI Mutual Fund, HDFC etc). It was also observed that the majority of the borrowings is from the Kotak Mahindra Investments Ltd, to the tune of approximately 45%. Registered clients who are willing to avail margin trading facility, have to deposit margin either in the form of cash or securities. In case of securities, margin money is calculated after the haircut and it is determined in terms of shares classified/grouped by KSL. The shares were classified as A, B and C categories based on its risk perception. KSL has provided that for shares categorized as B there is 10% haircut, shares categorized as C there is 20% haircut and there is no haircut on shares categorized as “A” by them. Here the expression ‘haircut’ means the value calculated, say, for B category shares, 10% of the total value of shares is deducted from such total value, considering the market variations and the prices of the shares changing due to T+2 system. For e.g., if company A’s shares cost Rs.2000/- each and there are 100 shares of the client given as margin, then the margin money realizable is calculated as follows, the total value being Rs.2, 00,000/-, based on the liquidity if they are categorized as B category shares then after 10% haircut, the value will be Rs.1, 80,000/- with Rs.20, 000/- being considered as the haircut amount considering the price fluctuations and market variations. KSL presently under their accepted category of shares have 337 scrips, of which 85 are under category A, 46 are under category B and the rest 206 scrips under category C. Generally for any trading day (only intra-day), KSL extends an exposure of seven times to the client, for the margin collected by them, which is presently 20% margin. For instance, the client can take exposure upto Rupees seven lakhs worth securities, on a margin of Rupees one lakh. However, the clients are expected to reduce the exposure to five times the margin by the end of the day.

6. The most peculiar feature that was noticed in the beneficiary account

opening procedure for these margin trading clients is that none of the clients have entered into an agreement with KSL, as required under Regulation 41 of SEBI (Depositories and Participants) Regulations, 1996 (hereinafter referred to as the ‘said regulations’). The process is such that the client need not know that a beneficial owner account has been opened on his behalf and there is no control of the investor over the account regarding debit or credit of securities into the account. To evidence the same, sample copies of the account opening applications have been made available in the record. On perusing these sample account opening applications the following have appeared, the details of which will be discussed in the later paragraphs:

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i. The beneficiary accounts have been opened without entering into agreements with the clients, without taking signatures of the client on the beneficiary account opening application.

ii. The beneficial account opening application does not contain certified copies of the identity and address proof of the clients and photographs are usually pasted on the applications.

7. Furthermore, it is alleged that KSL has violated Regulation 42 (1) of the

said Regulations, by co-mingling, mixing each of the beneficial owners securities with the securities of the other beneficial owners.

8. KSL has also allegedly violated Regulation 54 (4) of said Regulations, by

delaying the dispatch of the Demat Request Forms (DRF) received by them, by more than seven days.

9. As KSL has allegedly violated Regulations 41, 42 and 54 of the said

Regulations and the SEBI Circular No. SMDRP/POLICY/CIR-36/2000 dated August 4, 2000 (hereinafter referred to as the ‘said circular’), KSL is allegedly liable for monetary penalty under Section 15HB of the Securities and Exchange Board of India Act, 1992 (hereinafter referred to as the ‘SEBI Act’).

APPOINTMENT OF THE ADJUDICATING OFFICER

5. Mr. S V Krishna Mohan has been appointed as the Adjudicating Officer

vide order of SEBI dated April 8, 2004 under Section 15I of the SEBI Act read with Rule 3 of the SEBI (Procedure for holding inquiry and imposing penalties by Adjudicating Officer) Rules, 1995 (hereinafter referred to as the ‘Adjudication Rules’) to inquire into and adjudge Section 15HB of the SEBI Act the violation of the provisions of the SEBI (Depositories and Participants) Regulations, 1996. However, vide SEBI order dated September 30, 2004, the present case has been transferred to Mr. S. Biju for adjudication proceedings and thereafter, Ms. Babita Rayudu was appointed as the Adjudicating Officer vide order of SEBI dated April 8, 2005.

6. Consequently, the then Adjudication Officer Ms. Babita Rayudu was

sent on deputation and thereafter, the undersigned was appointed as the Adjudicating Officer in the instant matter vide SEBI order dated November 23, 2007.

NOTICE, REPLY AND PERSONAL HEARING

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7. A Notice dated November 21, 2003 was issued to KSL (hereinafter

referred to as ‘Noticee’) subsequent to the inspection conducted by the SEBI team during the month of September, 2003 communicating the findings observed by SEBI, asking the Noticee to provide their comments within 14 days from the date of receipt of the notice. A reply dated December 6, 2003 was filed by the Noticee and they requested for a personal hearing as well.

8. A Show Cause Notice dated July 5, 2005 under Rule 4 of the

Adjudication Rules was issued to the Noticee to show cause as to why an inquiry should not be held against them and penalty imposed under Section 15HB of the SEBI Act for their failure to enter into agreement as mandated under Regulation 41 of the said Regulations and the violation of Regulations 42 and 54 of the said Regulations and the said SEBI Circular. The Noticee has filed a detailed reply vide letter dated August 19, 2005.

9. Subsequently, the then Adjudicating Officer had given an opportunity of

personal hearing on September 13, 2005 and September 26, 2005, which could not be held due to non-attendance of the Noticee. However, the personal hearing scheduled on October 10, 2005 had happened. Noticee filed the written submissions vide reply dated October 17, 2005. However, on the appointment of the undersigned as Adjudicating Officer, the undersigned by considering the principles of natural justice, issued separate notices of hearing to be scheduled on October 13, 2008, which did not take place as the Noticee sought extension of time and thus the hearing was re-scheduled on November 18, 2008. On the scheduled date of hearing i.e. on November 18, 2008, Advocate Kevic A Setalvad and Advocate Manvendra Kane, appeared on behalf of the Noticee and made detailed submissions and produced some documents in support of the same.

WRITTEN SUBMISSIONS/ CONTENTIONS RAISED BY THE NOTICEE: 10. The Noticee, vide its replies dated December 6, 2003 and August 19,

2005 had made submissions. Further submissions were made during the personal hearing held on October 10, 2005, subsequent to which detailed written submissions have been submitted vide letter dated October 17, 2005. In addition, a fresh hearing was granted by the undersigned on November 18, 2008. The extracts of submissions made by the Noticee along with the contentions so raised, inter alia are stated below:

• KSL is a public company registered under the Companies Act, 1956. It is registered with SEBI as a Depository participant (hereinafter

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referred to as KSL-DP). It is also member broker (KSL-Broker) of the Stock Exchange, Mumbai (BSE) and the National Stock Exchange of India Limited (NSE) in both the capital market and Futures & Options segment.

• The process by which the client securities are deposited with KSL is given below: (a) KSL- Broker is required to collect margins from its clients before allowing them to have exposure in the stock market. The margin could be in the form of cash and/or securities etc. Where the client wishes to provide securities as margin, the client is required to deposit the same with KSL in a depository participant account in the name of KSL. (b) In few cases, clients of KSL opt for a delayed payment facility option whereby the client carries forward his dues on the basis of a minimum margin based on the valuation of the securities of the client placed in the control of KSL and the cash margin transferred by the client to KSL. In such case also the securities of the client are deposited with KSL in a depository participant account in the name of KSL.

• KSL has drawn attention to SEBI Circular no. SMDRP/POLICY/CIR-33/2000 dated July 27, 2000 which read thus:

“……All the client excluding FIs/FIIs/MFs shall maintain a deposit of minimum margin with a broker in the form of cash, bank guarantees, FDRs or approved securities………”

• It was stated that as per the procedure followed by KSL, the Member Client Agreement signed between the client and KSL provides that the Client may place margin with the member in form of securities as approved by the member and that such securities may be placed in a separate depository account titled ‘Kotak Securities Limited’ to be earmarked as margin from the Client.

• Further, it was stated that since the client is forwarding these securities to KSL for utilization as margin and the securities need to be under the control of KSL, the securities are maintained in a depository participant account opened in the name of KSL. Also it was said that KSL needs to constantly monitor the margins and the exposure received against the same to ensure that the client is asked to top-up the margins once the same falls below the acceptable limits.

• KSL has also mentioned that the deposit of securities as margin placed with stock brokers is permitted to be registered in the name of the broker in accordance with the conditions set out in the Press Release dated November 18, 1993 issued by SEBI which states thus:

“2. It shall be compulsory for all member brokers to keep separate accounts for client’s securities and to keep such books of accounts, as may be necessary, to distinguish such securities from his/their own

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securities. Such account for client securities shall, inter alia, provide for the following: .................................. (e) Fully paid for client’s securities registered in the name of the member, if any, towards margin requirements, etc.

• Thus KSL has claimed to be in compliance with the aforesaid SEBI Regulation in getting transferred the Clients’ securities provided as margin to a depository account registered in its own name.

• That, if KSL was not registered as a depository participant, KSL-Broker would have opened a depository account in its own name with some other depository participant for complying with the aforesaid regulation. In such a case, KSL would have entered into an agreement with such depository participant.

• That since KSL is also a depository participant in the instant case, KSL-Broker has opened the said accounts in its own name with KSL-DP.

• Furthermore, the definition of “beneficial owner” as defined in the Depositories Act, 1996 has been quoted, which is as follows: ‘beneficial owner’ means a person whose name is recorded as such with a depository.’ In this context it is stated that KSL is a beneficial owner of the said accounts within the limited purview of the Depositories Act, 1996.

• KSL has also drawn attention to Section 10 of the Contract Act, which states thus, ‘All agreements are contracts if they are made by the free consent of the parties competent to contract.’ That a contract implies two parties and can only be bilateral. The same party cannot be a party to a contract on both sides and hence there cannot be a contract between KSL-DP on one side and KSL-Broker on the other side when both are one and the same entity i.e., KSL.

• That opening of the depository participant account by KSL-Broker with KSL-DP is purely an artificial distinction created in order that KSL may clearly identify and set aside the securities of the client as margin securities, which practice would ensure discipline and eradicated chances of misuse of Client’s shares.

• That the signatories of the said depository accounts are authorized to operate the accounts vide a Resolution of the board of directors of KSL (a duly attested copy of which along with the specimen signatures is attached with each such account opening form). Here the signatories are employees of KSL and as such information necessary to establish the signatories’ identity is already available with KSL.

• Thus, KSL has reiterated that the accounts are opened in the name of KSL as the securities are received as margin in compliance of the circulars/press releases issued by SEBI in this regard from time to time. And that since KSL is acting in two capacities i.e., as a broker

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and as a depository participant, distinction drawn in the Inspection report (hereinafter referred to as the ‘said report’), between the two is an artificial distinction. That Section 10 of the Contract Act is against KSL entering into contract with itself.

• Hence, it was stated that KSL has not violated Regulation 41 of the said Regulations and the said Circular as stated in the said Inspection Report.

• As regards the next issue regarding the violation of Regulation 42 of the said Regulations, it was stated that KSL as a share broker is liable to transfer stocks to the clients account within 24 hours of payout. KSL ensures that in all cases where the client has paid up his dues, the transfer happens to the client’s designated account directly within the time frame indicated above. In all cases, the clients directly transfer the shares to the KSL pool account from their respective beneficiary account to meet their pay in obligations.

• Further, it is stated that only in the case of clients not availing delayed payment facility who have bought securities and have not paid up their dues is the share delivered into a KSL house account. In such cases, on receipt of the payment from the client, the respective shares are transferred into the client’s account. However, if the client sells off the said shares before paying up his dues, the shares get transferred to the pool account directly from the house account to meet the pay-in obligation of the client and the sale proceeds of such transaction are adjusted against the pending dues of the client.

• KSL claims that the said Inspection Report incorrectly states that clients of respective branches have to transfer their sale obligations to such designated accounts and that obligations to clients are transferred by KSL first to such respective branch account and therefrom to the respective investor account.

• KSL reiterated that the shares are transferred to the Client’s beneficiary accounts directly and are not transferred to the KSL pool account unless the client is unable to meet his pay in obligation. In the case of clients who are unable to meet the pay in obligation, KSL cannot take the risk of first transferring the shares to the client’s account and then having the client re-deliver the shares into the pool account as there is already an outstanding due from the client.

• Further, the SEBI press release dated January 23, 2001 states that ‘in order to ensure that securities are moved quickly to beneficiary accounts of investor, it has been decided that Clearing member shall be required to transfer the securities from their respective CM Pool account to the respective beneficiary account of their clients within 4 calendar days or 2 working days after the pay out day.’ Accordingly, separate KSL House accounts were opened for each branch of KSL with the intention of simplifying the process of identification of the respective shares of clients who have been unable to meet their pay

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in obligation. KSL has software in use whereby all shares lying in the House account at any point of time can be identified to a specific client. And that at all points in time the clients’ shares are appropriately segregated and there is no intermingling of client shares.

• At the outset, KSL claims that they have not violated Regulation 42 (1) of the said Regulations as stated in the said Report because, firstly, KSL fulfills the obligation of transferring shares to the client within 24 hours of payout, the Clients transfer the shares directly from their beneficiary account to the KSL Pool account for meeting their pay in obligation and not to any House account of KSL, that it is only in the case of such clients who are unable to meet their timely pay in obligation, that the shares are transferred to the branch wise KSL house accounts, that shares are transferred to the clients’ account from such House accounts on settlement of dues, that only in cases where the client sells the shares before paying up his dues are the shares transferred to the pool account from such House Accounts. This is required to meet respective clients’ pay-in obligation, KSL has a system in place to identify at all points in time the client wise stocks lying in the House accounts. Hence the client securities are appropriately segregated, and finally, that the said Inspection report incorrectly states that clients of respective branches have to transfer their sale obligations to such designated accounts and that obligations to clients are transferred by KSL first to such respective branch account and therefrom to the respective investor account. Thus KSL claims to have not violated Regulation 42 of the said Regulations.

• Furthermore, there were 3 cases where the identity proof of the applicant was not obtained, for which it was submitted that in general as a rule no account is opened without obtaining one of the recommended supporting proofs. And that it is possible that the proofs obtained in the said cases may have got dislodged during handling over the years as the accounts are not current but pertain to the year 2000.

• That in few cases, it was found that photographs were stapled to the forms and were not pasted. In this regard, it was submitted that in general, photographs are pasted on the form. More so currently since there is a requirement of signature on the face of the photograph. However, it was admitted that the photographs were stapled to the form in the cases pointed out. It was further submitted that there is no legal ban on stapling of photographs on account opening forms.

• Further, the said Inspection Report talks about unstamped agreements attached in the instances of BO ID 10175311 and 10269896. However, during the personal hearing conducted, the stamped agreements were produced in both the above instances.

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• In the cases of BO Ids 10114075, 10114067 and 10114680, while there are copies of other proofs of address attached which do not bear a verification signature, there is also a banker’s verification available in original which carries a photograph of the account holder along with the address under the stamp of the bank and the signature of the bank official.

• As regards the violation of Regulation 54 of the said Regulations, the Inspection Report has stated instances of delays in dispatch of Demat Request Forms (DRF) by KSL to the issuer company or their RTA. It has been submitted by KSL in their reply that it is unclear as to what yardstick has been used to determine delays as the number of days of delay needs to exclude the statutorily allowed seven working days. However, it was admitted that there have been some delays in certain cases, wherein the delays range from 1 to 2 days in 8 cases as against the delays of 10 to 12 days in 17 cases as reported in the inspection report.

• As regards the reasons for rejections of DRNs, which was analyzed by the said Inspection Report, to be on the basis of the improper scrutiny on the part of KSL and that the percentage of such rejections being very high, KSL has submitted that, their officials exercise the utmost care to ensure that DRFs are thoroughly checked and then processed to ensure that rejections due to internal errors are kept to the minimum and that it is not correct to compare the rejections due to KSL errors with the total rejections to pass judgment on the efficiency of KSL-DP operations as has been done in the said Inspection report. And that the 26.42% mentioned as errors due to KS is totally misleading. That the correct measure would be to derive the percentage of such errors to the total number of DRFs processed, on which it could be seen that out of 87402 DRFs, only 1456 have been rejected due to KSL errors, which is exactly 1.67% of the requests processed, which KSL claims to be considered quite reasonable in the light of the fact of considering the entire period since inception.

• It was also submitted that reason wise analysis shows that rejections due to ‘Certificates not received within 30 days’ is a high figure of 730 DRNs. KSL stated that it always endeavors to dispatch DRFs within the time frame allowed. And that NSDL requires the request to be reprocessed if the demat is not completed within 30 days. Also that since the demat process includes activities to be performed at the registrars end, it is not correct to term rejections due to non-completion of the process on time as being due to errors done by KSL. On excluding these rejections from the purview of rejections due to errors on behalf of KSL, the percentage of errors due to KSL comes down to 0.83, which they claim should be considered reasonable.

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• Thus KSL stated that it exercises adequate prudence to ensure minimal rejections due to internal errors.

CONSIDERATION OF THE ISSUES AND FINDINGS THEREOF 11. Before proceeding the matter, I would like to reiterate the facts which

led to the formation of the case:

• KSL extends to their clients a facility, which they term as “delayed payment facility”, which is similar to Margin Trading facility. In the said scheme, clients of KSL are permitted to trade based on initial margin deposited with them.

• Any client approaching KSL for availing Margin Trading facility has to first enter into an agreement with KSL. The agreement provides for the percentage margin that the client has to bring in either in the form of cash or securities. The present margin that the client has to bring in is 20%, the rest 80% is funded by KSL (from sample agreement forms it has been observed that the margin has come down from 30%, 25% to the present 20%). As per the agreement, KSL has a lien over the securities that will be purchased by the client and KSL can also open a separate beneficial owner account for the client.

• The beneficiary account for the client is opened in the name of Kotak Securities Limited and the first line of the address contains the name of the client, styled as A/c 'clients name' and adjacent to it the client broking code is given in brackets. All the margin trading accounts are opened in the name of KSL and are identified with the help of the short name in the depository system and the name of the client in the first line meant for address. For all such accounts opened by KSL, the address shown is that of their address at Bakhtawar, Nariman Point.

• KSL though opens a separate beneficiary account for each customer who avails margin trading facility with them, the account is in the name of KSL. This account is used for the purpose of transfer of shares purchased by the client and is operated and under the control of KSL i.e., KSL has the sole and full to operate the account.

• The shares purchased by the clients under the margin trading facility, are withheld by KSL in the respective client beneficiary account opened for this purpose. Since the right to operate the demat account is with KSL, the client cannot sell these shares as long as these securities are funded by KSL and are earmarked as custody for margin trading.

• In respect of these demat accounts, it was observed that these accounts were being used as a temporary in-transit account for crediting or debiting the clients obligations of such respective branches. The process involves the client of the respective branch to transfer their sale obligations to such designated account (demat

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account opened in the name of KSL a/c branch name), from where these securities are transferred to the pool account of KSL for on-market delivery obligations. Similarly, the obligations towards the clients (purchase positions) are transferred by KSL to the respective branch account, from where these securities are transferred to the respective investors’ account, which is in violation of Regulation 42(1) of the said Regulations.

• During inspection on September 15, 2003 it was found that there were many instances of Dematerialisation Request Forms (DRF), which were yet to be dispatched by KSL to the respective issuer company/RTA. It was observed that the DRF which were received between September 03, 2003 and September 05, 2003 by KSL at their various offices including at Mumbai were not dispatched by the DP within seven days of their receipt.

• Hence the said Adjudication proceedings were initiated to inquire into and adjudge under Section 15HB of the SEBI Act, the alleged violation of the provisions of Regulations 41, 42 (1) and 54 of the Depository Participant Regulations and the said Circular.

12. I have carefully perused the written and oral submissions and

documents available on record. The issues that arise for consideration in the present case are:

A. Whether the beneficial owner accounts opened by KSL can be

termed as belonging to them and thus the accounts have been opened in violation of Regulation 41 of SEBI (Depositories and Participants) Regulations and in violation of circular no. SMDRP/POLICY/CIR-36/2000 dated August 04, 2000?

B. Whether KSL has violated Regulation 42 (1) of SEBI (Depositories

and Participants) Regulations, 1996, by co-mingling, mixing each of the beneficial owners securities with the securities of the other beneficial owners?

C. Whether KSL has violated Regulation 54(4) of SEBI (Depositories

and Participants) Regulations, 1996 by delaying the dispatch of the DRF received by them, by more than seven days?

D. Whether the aforesaid issues after consideration call for monetary

penalty?

And If so, what would be the quantum of penalty that could be imposed taking into consideration various factors relating to their violations?

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Consideration of Issues: 13. During discussions at the time of the personal hearing with the Noticee

with reference to not entering into agreement as stipulated in the Regulation 41 of the said Regulations and the procedure being followed by them for opening of the beneficial owner account, KSL stated that there was no need to enter into an agreement with the clients, since the account has been opened in their name i.e., KSL and is identified by the extension/short name (name of the client).

14. Regulation 41 of the said Regulations states in clear and mandatory

terms, the following: ‘Agreement by participant- Every participant shall enter into an agreement with a beneficial owner before acting as a participant on his behalf, in a manner specified by the depository in the bye-laws.

15. In this regard it is of the view that the beneficiary account cannot be

termed as that of KSL and KSL cannot obliterate itself from entering into agreement with the client, in view of the following reasons:

� Regulation 41 of SEBI (Depositories and Participants) Regulations, 1996 states that every participant shall enter into an agreement with the beneficial owner before acting as a participant. The term ‘shall’ signifies the mandatory character of the provision.

� Under normal conditions KSL will not sell the securities without receipt of the execution orders from the client.

� The client is forwarded a statement of account after every transaction.

� The client is charged for the maintenance, debit etc, of that specific beneficiary account.

16. Thus, Regulation 41 of the said Regulations does not give any kind of leeway or scope to anybody, whosoever and it is on the face of it, a mandatory provision, which has been violated by KSL.

17. As far as the contention of the Noticee is concerned, that they (KSL-DP

and KSL-Broker) are one entity and a contract needs atleast two parties as is stipulated in the Indian Contract Act and that KSL cannot enter into agreement with itself, this argument does not hold good as KSL is acting in two completely different capacities and the functions and work of KSL as a DP is completely different from the functions of KSL as a Broker, which is described in this Order. Thus their activities cannot merge in any case and thus, they are two different capacities even if both are merged in one entity. This is a case of same entity but acting in different capacities, on which aspect the Hon’ble Supreme Court has

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deliberated upon in some cases. In Shah Mathuradas Maganlal & Co vs. Nagappa Shankarappa Malage 1 the Apex Court had categorically stated that the mere fact that the two capacities are united in the same physical person cannot result in a merger because the two capacities are totally different. Therefore if we apply this judgment to the present situation, the legal treatment of a person acting in two different capacities is different in both cases even if they are based in the same person. Further, in Member, Board of Revenue v. Arthur Paul Benthall2 the Supreme Court held that if one person holding properties in two different capacities, each unconnected with the other, executes a power of attorney in respect of both of them, the instrument should logically be held to comprise distinct matters. Moreover, the Noticee itself has stated that if KSL was not registered as a depository participant, KSL-Broker would have opened a depository account in its own name with some other depository participant for complying with the aforesaid regulation. In such a case, KSL would have entered into an agreement with such depository participant. However, it is to be noted that Regulation 41 does not give any discretion to the Participant regarding entering into agreement. When KSL-Broker would have entered into agreement had it been some other depository participant, it should have entered into agreements with the clients to whom the securities belong. Applying the Supreme Court ratio to the present situation, KSL has acted in two totally different capacities and should have complied with Regulation 41 of the said Regulations.

18. KSL has many branches spread across the country. For each branch they

have opened a demat account in the name of KSL, with the name of the city in the first line of the address and also in the short name, for their internal identification purposes. As regards the second issue w.r.t violation of Regulation 42 (1) of the said Regulations, in respect of the demat accounts, it was observed that these accounts were being used as a temporary in-transit account for crediting or debiting the clients obligations of such respective branches. The process which has been explained earlier is reiterated here, which involves client of the respective branch to transfer their sale obligations to such designated account (demat account opened in the name of KSL a/c branch name), from where these securities are transferred to the pool account of KSL for on-market delivery obligations. Similarly, the obligations towards the clients (purchase positions) are transferred by KSL to the respective branch account, from where these securities are transferred to the respective investors account.

1 1976 3 (SCC) 660 2 AIR 1956 SC 35

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19. The above operational procedure adopted by KSL is in violation of Regulation 42 (1) of SEBI (Depositories and Participants) Regulations, 1996, i.e, securities of different clients have been mixed with each other. Regulation 42 (1) states "Separate accounts shall be opened by every participant in the name of each of the beneficial owners and the securities of each beneficial owner shall be segregated, and shall not be mixed up with the securities of other beneficial owners or with the participants own securities".

20. Though it may be argued by KSL that this aspect of the operation is not

in there hands, since it is performed by the broking entity and may not be in their knowledge and know how. But the fact is that the account has been opened by the DP and it is in its knowledge as to the purpose behind opening such account and the signatories are the same, those who are at the helm of the DP and broking operations. Thus KSL has violated Regulation 42 of the said Regulations clearly.

21. Generally, apprehensions have been raised time and again about misuse

of clients’ securities, by broker or other depository participants. In this regard, there two situations have been depicted below, which are the findings of the SEBI Inspection team, where it is possible that misuse of the client / investor securities can take place.

i. The first situation depicted is where the broker/other participant misuses the client securities by debiting the securities unauthorized from the clients beneficiary accounts for own benefit/obligation and subsequently returning/making good such securities back into the beneficiary account. Such type of misuse can be masked by the participant by making certain that these unauthorized transactions are not reflected in the clients’ periodic transaction statement forwarded by the broker DP. This way the investor will never come to know that his securities have been temporarily misused by the participant.

In misuses of the above type, the detection is possible if all the transactions are not backed by the relevant debit instruction with the valid client signature.

ii. The second type of possible misuse is of those clients who have given their power of attorney to the broker who is also a participant, for operating their accounts for the various facilities extended by the entity, such as, portfolio management schemes, margin trading, net broking etc,. The apprehension here is that in this kind of misuse detection becomes difficult since the signatory for such accounts is the entity themselves and all the transactions being in the nature of on-market selling, it may be difficult to

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ascertain whether the transaction has been executed based / done only on the clients instructions.

To curb such kinds of misuse it is suggested in the findings of the Inspection Report that a mechanism has to be put in place, wherein the broker has to take periodic (say weekly), written, signed confirmation from the client / investor that the transactions executed during the said period were based on his valid instructions.

OBSERVATIONS RELATED TO DEPOSITORY PARTICIPANT OPERATIONS

22. Networth Requirements as per the Regulations: Kotak Securities which

is a DP registered with both NSDL and CDSL, has a networth of Rs 93.17 crore as on March 31, 2003 certified by their CA firm, M/s D B Ketkar & Co. Kotak Securities is holding custody of investors securities worth around Rs 3,858.10 crore. As per the amended regulations, there is no custody holding limit for a broker participant having networth above Rs 10.00 crore.

23. Extent, Segregation of Operations and Infrastructure: KSL has 41, 412

beneficiary accounts with them. The break-up of the accounts is as given below:

Particulars Number of Beneficiary Accounts

Individuals 34,300

Corporate Bodies & HuF's 7,109

Clearing Members 03

24. It was looked into, whether KSL which is also registered with SEBI as a

Member broker of BSE, NSE & OTCEI is segregating their broking operations from their depository and other operations.

25. It was observed that separate areas were assigned to each of their

activities, including separate work area/counter for front office and back office for activities pertaining to their depository operations such as, account opening, dematerialisation, debit instructions etc,. But it cannot be said that there is a chinese wall segregation in their broking, other activities and depository participant operations.

26. The DP has back office software called Debos, developed by a local

vendor to suit their specific needs. The back office software is used for DIS, DRF, billing etc, across all their branch offices.

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27. Personnel - DP Operations: The DP operations are headed by an official of the rank of Vice-President. It has been stated that all the personnel assigned to depository operations are the employees of KSL, are on their pay rolls and no work has been assigned to an outside agency and neither is out-sourced. The data entry work related to daily transactions such as account opening, dematerialization requests, debit instructions etc, are done by the employees of KSL.

28. Account opening process is described in the following paragraphs. 29. Procedure followed: The account opening forms along with the relevant

documents are received either at the front office of their main office at Worli, Mumbai or at any of their branch offices, spread across the country. The staff does the preliminary verification of the form and the enclosed documents and these application forms are forwarded to the head office for further processing and data entry of the application details in the DPM for opening of the beneficiary account. A client master report is generated from the DPM listing the details of the client and the same dispatched to the client along with few DRF forms and DIS booklet.

30. Observations: Sample of the beneficiary account applications for the

period before and after August 2000 were scrutinised for any discrepancies related to account opening procedure specified by SEBI. Sample applications pertaining to the two different periods were deliberately chosen to verify whether the participant had complied with the said SEBI circular regarding account opening procedure for beneficial owners account.

31. The account opening applications i.e, accounts opened for the margin

trading clients have been opened without entering into an agreement, without following the account opening procedure as mentioned in the said SEBI circular.

32. A random check of Account Opening Forms was carried out. The

following types of discrepancies were observed during scrutiny: i. Identity proof of the applicant was not obtained: BO ID: 10093371,

10097491, 10097266, ii. Photographs were found to be stapled to the application form. BO ID –

10123682, 10123617, 10123594, 10123537, 10127004, 10126994, 10126873, 10117977.

iii. Unstamped agreement. BO ID – 10175311, 10269896. iv. During scrutiny it was observed that KSL is strictly not following the

procedure mentioned in the above circular, regarding verification of the original documents/certificates with the copies submitted by the client. As

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per the circular the officer of the DP should verify under his signature, the documents and certificates submitted by the investor in support of his identity and address proof. The following are some of the beneficial accounts where the signature of the verifying officer of the DP was not there on the photocopy of the documents and certificates submitted by the beneficial owner along with the account opening application form.

BO ID - 10114075, 10114067, 1011, 3991, 10114680. 33. However, during the personal hearing held on November 18, 2008, KSL

has submitted the stamped agreements in instances specified above. 34. Dematerialization: Beneficial owners submit the filled in

Dematerialization Request Form (DRF) along with the share / debenture certificate(s) to KSL for dematerializing their shares. On receipt of the request, the details are verified by the officer on the counter by cross checking the number of certificates, availability of security in demat, ISIN number and names of holders etc. The receipt of the DRF is acknowledged at the counter and the DRF number is given as the reference number for future use to the investor. The DRF is sent to the concerned section for verification and data entry into the back office system and further upload into the depository system (DPM) for generation of the Dematerialisation Request Number (DRN). The certificates along with a covering letter are dispatched to the Issuer company/RTA.

35. Observations regarding the same are given as follows. 36. Delay in Dematerialisation: During inspection it was found that there

were many instances of Dematerialisation Request Forms (DRF), which were yet to be dispatched by KSL to the respective issuer company/RTA. It was observed that the DRF forms which were received between September 03, 2003 and September 05, 2003 by KSL at their various offices including at Mumbai were not dispatched by the DP within seven days of their receipt.

37. Regulation 54(4) of SEBI (Depositories and Participants) Regulations,

1996 states that "The participant shall, within seven days of the receipt of certificate of security referred to in sub-regulation (1) furnish to the issuer details specified in sub-regulations (2) alongwith the certificate of security." The following are the instances observed, wherein the DP had not forwarded the DRF to the issuer company/RTA within seven days of its receipt:

Branch

Office

DRN Date of Receipt and Issuer

Company

Period of

Delay

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90700 September 04, 2003 – Rama Petro 11 days

90693 September 05, 2003 –Premier Auto 10 days

90667 September 05, 2003 – MRPL 10 days

90659 September 05, 2003 – Lloyd Steel 10 days


Kolkatta

Branch

90616 -

90619

September 05, 2003 – Euro Textiles 10 days

90680 September 03, 2003 – NOCIL 12 days

90679 September 03, 2003 – Nirlon Syn 12 days

90678 September 03, 2003 – Nirlon Syn 12 days


New Delhi

Branch

90750 September 03, 2003 – The Morarjee 12 days

Indore

Branch

90712 September 05, 2003 – Remi Metals 10 days

90699 September 05, 2003 – Rama Newsprint

10 days

Bangalore

Branch

90690 September 03, 2003 – Pidilite 12 days

90670 September 05, 2003 – MTZ India 10 days

Mumbai 90713 September 05, 2003 – REPL Engg 10 days

38. The plea taken by the Noticee during the personal hearing granted on November 18, 2008, is that the NSDL bye laws use the term “seven working days” whereas Regulation 54 (4) of the Depository Participant Regulations uses the term “seven days” and not working days. And that both have to be harmoniously construed and no overriding must take place and that they have to be viewed in entirety. However, this is not permitted because the Regulations clearly override bye laws and when both are placed together, it is the Regulations which prevail over the bye laws and thus, as per the said Regulations, it can only be construed as ‘seven days’. Thus in all the instances, the Noticee has not adhered to the stipulated time of seven days given in the Regulation. Even if we agree to their argument, any way KSL has not complied with seven working days either as there are no public holidays during that time. Thus, clearly they are in violation of Regulation 54 of the said Regulations.

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39. During scrutiny of the rejected Demat Request Norms (DRNs) it was observed that there were higher incidences of DRN rejections due to the mistakes committed at the participants end.

Reason for Rejection Dematerialisation Request Number

Incorrect ISIN 81785, 82831, 82204, 83976, 85571, 82205, 85040

Mis-match in the details of share certificates

82058, 83441, 85376, 82746, 83909, 84390, 85648, 85849, 86569, 85850

Scrip not available for dematerialization

82236, 83802, 85331, 85676

Share certificate forwarded to the wrong RTA

82545, 82883, 85338, 82578, 82928, 86560

Incorrect holders name 82807, 82878, 84610, 83406, 83565, 85809

Mis-match of details on the DRF and enclosures

82376, 82964, 82383

40. Rejection of the DRN, due to the mistakes committed by the DP or its

staff results in opportunity loss to the investor, the dematerialization of the shares are delayed, the investor is compelled to spend more time by re-submitting the share certificates for dematerialization and also the investor maybe charged again for dematerialization of the share certificates.

41. This issue has not been addressed in the Act or the Regulations, but

rejection of DRN is akin to delay in dematerialization, in view of the reasons already mentioned above.

42. I have perused all the documents forwarded in their written

submissions. They have argued taking the plea that they cannot enter into contract with itself since the beneficiary owner account is opened in its own name and thus they are not in violation of Regulation 41 of the said Regulations. But Regulation 41 does not have any exceptions whatsoever and no scope is given under the said Regulation, thus their plea is not valid.

43. These facts I can not afford to ignore. 44. Therefore, these facts give me enough liberty to impose penalty for non-

compliance of the Depository Participant Regulations and the said SEBI Circular.

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45. The Hon’ble Supreme Court of India in the matter of SEBI vs. Shri Ram Mutual Fund3 held that “once the violation of statutory regulations is established, imposition of penalty becomes sine qua non of violation and the intention of parties committing such violation becomes totally irrelevant. Once the contravention is established, then the penalty is to follow.”

46. Thus, the aforesaid violations by the Noticee make it liable for penalty

u/s. 15HB of the SEBI Act, 1992 which reads thus: 15HB. Penalty for contravention where no separate penalty has been provided. Whoever fails to comply with any provision of this Act, the rules or the regulations made or directions issued by the Board thereunder for which no separate penalty has been provided, shall be liable to a penalty which ma extend to one crore rupees.

47. While determining the quantum of penalty u/s. 15HB, it is important to

consider the factors stipulated in S.15J of SEBI Act, which reads as under:- 15J. Factors to be taken into account by the adjudicating officer. While adjudging quantum of penalty under S.15-I, the adjudicating officer shall have due regard to the following factors, namely:-

(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. 48. In a case of such nature, to quantify exactly the disproportionate gains or

unfair advantage by an entity, perhaps, the costs of entering into beneficial owner agreements with the clients, had the Noticee entered into agreements with its clients, should be considered. I have noted that the inspection report also does not dwell on the extent of specific gains made by the Noticee. Suffice to state that keeping in mind the practice of Noticee not entering into agreements with the clients, its costs and the costs incurred by the investors due to delay in processing DRFs needs to be considered. Thus, the same happens to be the significant criterion. Thus, before any direct loss to the investors happens, people who indulge in not following the accepted practices in the securities market should be suitably penalized for the said acts of commissions and omissions. And the nature of default was also repetitive in nature. In this regard, I have taken a serious note that in the all the beneficiary owner

3 (2006) 68SCL 216 (SC)

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accounts pertaining to individuals, corporate bodies as well as clearing members, the agreements are not entered into. Further, if the Noticee were not sure in this regard since according to them KSL-DP and KSL-Broker are one and the same entity then at least the Noticee should have sought clarification from SEBI at that point. However I do not find any efforts made by the Noticee in this regard, from the records available with me. Though there was no direct loss/harm caused to clients of the Noticee the fact that violation of the concerned provisions of the Regulations cannot be ignored and the Noticee ought to comply with these provisions strictly.

ORDER:

49. After taking into consideration all the facts and circumstances of the case I come to conclusion that this is a fit case for imposing the monetary penalty against the aforesaid Noticee. I impose a penalty of Rs.10,00,000/- (Rupees Ten Lakhs only) on the Noticee viz., Kotak Securities Limited in terms of section 15HB of the SEBI Act, 1992 exercising the powers conferred upon me u/s 15- I (2) of the SEBI Act for violation of Regulations 41, 42 (1) & 54 (4) of the Depository Participant Regulations and Circular No. SMDRP/POLICY/CIR-36/2000 dated August 4, 2000. I am of the view that the said penalty is commensurate with the violation committed by the Noticee.

50. The penalty shall be paid by way of a duly crossed demand draft drawn

in favour of “SEBI- Penalties Remittable to Government of India” payable at Mumbai within 45 days of receipt of this order. The said demand draft shall be forwarded to Suresh B Menon, Chief General Manager, Market Intermediaries Regulation and Supervision Department (MIRSD), Division of Policy and Supervision-2 (DPS-2), Securities and Exchange Board of India, Plot no.C4-A, ‘G’ Block, Bandra Kurla Comlex, Bandra (E), Mumbai- 400 051.

51. In terms of the Rule 6 of the Adjudication Rules, copies of this order are

sent to Kotak Securities Limited and also to the Securities and Exchange Board of India. The matter is disposed of accordingly.

DATE: December 24, 2008 SANDEEP DEORE

PLACE: Mumbai ADJUDICATING OFFICER

BEFORE THE ADJUDICATING OFFICER SECURITIES AND … · KOTAK SECURITIES LTD, BAKHTAWAR 1ST FLOOR,...

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