The plot thickened in the Karvy case on Wednesday as the lenders to the brokerage failed to win relief after three days of frenetic legal manoeuvres. The Securities Appellate Tribunal (SAT) refused to allow lenders to retain shares belonging to Karvy clients, which had been illegally pledged to avail of loans. However, the SAT did ask the lenders to make another appeal to the Securities and Exchange Board of India (Sebi) by December 6. It also asked the market regulator to pass a final order on this by December 12.
According to the petitions submitted to SAT, institutions such as Bajaj Finance, HDFC Bank, IndusInd Bank and ICICI Bank lent money to Karvy on the basis of shares pledged to them. But the pledged shares did not belong to Karvy; they belonged to its 95,000 clients, who are mostly retail investors. On Monday, the National Securities Depository Ltd (NSDL) transferred Rs 2,013.77 crore worth of shares back to the accounts of 83,306 clients of Karvy. The lenders appealed to the SAT to stop these transfers by NSDL to the beneficial owners, claiming the pledged securities should be transferred to them if Karvy is not able to settle its debts.
The fact is that Karvy’s pledging of shares that did not belong to it was unethical. Ordinary investors, whose assets were pledged without their knowledge, should not be made to suffer for the brokerage’s transgressions. The principles of natural justice are pretty clear in such cases: If a debt is raised and collateralised by pledging stolen assets, the legal owners of those assets will always retain the right to reclaim them. Given the SAT order, it is now up to the market regulator to ensure that the shares in question are returned to their rightful owners, and that this happens in an orderly fashion, without causing a stock market crisis.
It may be true, as the lenders have claimed, that loans against shares are a common practice and they may have had no reason to believe that the shares pledged by Karvy did not belong to it. However, it is incumbent on lenders to carry out due diligence, no matter how common the practice of pledging shares might be. The fact that loans were handed out against assets that did not belong to the debtor does not reflect well on the lenders. Given that this is a common practice, there is an urgent need for market regulators to ensure that the due diligence process for such loans is made more stringent. All dimensions of the case will only be clear once the ongoing forensic audit is completed. It is also unclear to what extent other brokerages have indulged in such shady practices. This case will undoubtedly lead to a situation where lenders become more cautious about sanctioning such loans.
That is actually well and good. It is not a healthy situation for stock market speculations, or real estate transactions, to be carried out on the basis of pledged assets, which don’t belong to the borrower. There has already been some degree of contagion as other brokerages have had problems settling accounts. Sebi should not only ensure that this doesn’t spread, but also protect the interest of ordinary investors, so that they don’t end up paying for loans taken in such unethical fashion by service providers.