ANALYSIS: SAT ruling in Kotak Bank case puts bourses on the back foot

1 September 2022

The recent order by the Securities Appellate Tribunal upholding an appeal by Kotak Mahindra Bank Ltd against National Stock Exchange of India's order to the bank to refrain from invoking the pledge of securities of defaulting broker Arcadia Share and Stock Brokers has again shined the spotlight on the bourses' jurisdiction over entities dealing with their members.

It also puts the bourses into a quandary on how to deal with a broker who siphons off securities from clients, pledging these to borrow funds for its own use and then refuse make good the shortfall of securities in client accounts.

The NSE had made a claim on the securities in the broker’s demat accounts saying it included clients’ securities and consequently the pledge of these securities was illegal.

The appellate body however said NSE did not have the legal jurisdiction to issue directions to banks and other entities other than its trading members.

While the NSE is expected to appeal against the SAT's ruling in the Supreme Court of India a recent difficult experience in the court on a similar matter will make it akin to walking on burning coal.

In a similar case the SAT had, in November last year, quashed NSE's order against Axis Bank directing it to freeze the bank accounts of defaulter broker Karvy Stock Broking to meet the claims of investors against the brokerage.

In that order, too, the SAT held that NSE's bye laws permitted it and its defaulter committee to issue directions only against a trading member, which was Karvy Stock Broking in the case being heard, and not against a third party, which was Axis Bank the appellant.

The NSE immediately went to Supreme Court of India appealing against SAT's order. The Supreme Court, however, dismissed the exchange's appeal on Feb 14 saying that "we are not inclined to interfere the order passed by the Securities Appellate Tribunal."

But there are reasons why NSE's hand can be seen to be stronger in the current case pertaining to Kotak Mahindra Bank.

For this one will have to first look at SAT's line of thinking in the Axis Bank case. The Securities and Exchange Board of India, which was a party to that case, had strongly argued before the  SAT that since the monies in Karvy's Stock Broking's bank accounts were proceeds from unlawful activities by the broker it had the first right of claims on it.

On the other hand, Axis Bank had argued that it had a banker's lien on Karvy's deposit accounts as it had extended loans to the broking firm which became non-performing.

The SAT made an important point in that ruling that it would have accepted SEBI's contention had evidence been shown to exist that the monies in the broker's bank accounts were linked to the siphoning off of clients' securities and were not the exclusive monies of the broking firm.

But now in the Kotak Mahindra Bank there may be evidence to show that a chunk of the securities lying in Arcadia Share and Stock Broker's demat account were not the broker's own shares bought by it from its own funds but were rather clients' securities that had been illegally siphoned off by the broker.

The NSE had got a forensic audit carried out on the broker's operations which had shown that it were the clients' securities that were illegally pledged by the broker. The SAT order mentions this aspect but does not consider the implications from it.

The NSE may consider using the evidence from the forensic auditor's report to tell the Supreme Court that the securities in the broker's demat accounts were unlawful and therefore the broker could not be considered as the legal owner of the securities as Kotak Mahindra Bank had argued before SAT.

The NSE had declare the broker a defaulter and expelled it from the exchange’s membership on Jul 2, 2021, for the misuse of clients' funds and securities and failure to resolve investor complaints against it.

The market regulator is also expected to see that stock exchanges' stand is vindicate since its own circulars require stock exchanges to direct banks and depositories to freeze bank and demat accounts when dealing with a case of broker default.