SEBI (Stock Brokers) Regulations and Portfolio Managers Regulations

What this chapter covers

This chapter carries 6 per cent of the III-A examination, and covers two sets of regulations.

LEARNING OBJECTIVES: After studying this chapter, you should know about some salient features of the: SEBI (Stock brokers) Regulations · SEBI (Portfolio Management Services) Regulations, 2020

12.1.1 Conditions of registration

The stockbrokers shall ensure that they comply at all times with the conditions of registration under regulation 10:

• the stockbroker holds the membership of any stock exchange.
• shall abide by the rules, regulations and bye-laws of the stock exchange.
• where the stockbroker proposes a change in control, he shall obtain prior approval of SEBI for continuing to act as such after the change.
• shall pay fees charged by the SEBI.
• shall take adequate steps to redress investors' grievances within 21 calendar days of the date of receipt of the complaint.
• shall at all times abide by the Code of Conduct.
• shall at all times maintain the minimum net worth.
• informs the Board, through a recognized stock exchange, of any material change in the information submitted at the time of registration.

Twenty-one calendar days for a grievance.

"Material change" is defined: change in control; (ii) change in designated director, key managerial personnel or compliance officer; (iii) change in name; (iv) change in registered office; (v) change in constitution; (vi) change in net worth below the minimum net worth requirement; (vii) change in 'fit and proper person' status as specified under Schedule II of the... (Intermediaries) Regulations, 2008; and (viii) any other changes as may be specified.

Eight heads — and note that intimation goes through a recognized stock exchange.

Cross-registration reliefs. No separate registration shall be required for a stockbroker registered with the Board to act as a clearing member in a clearing corporation of which he is admitted as a member, and conversely a clearing member registered with the Board does not need a separate registration to act as a stock broker in any segment of the recognised stock exchange subject to the approval of such recognised stock exchange.

And for tri-party repo: separate registration as a clearing member shall not be required for any person, who is registered with the limited purpose clearing corporation as a participant, for participating in the tri-party repo segment for undertaking proprietary trades in corporate bonds.

Authorised persons: a stockbroker may appoint one or more Authorised Person(s) after obtaining specific prior approval from the stock exchange concerned for each such person. The approval, as well as the appointment, shall be for a specific segment of the exchange. A written agreement must cover scope of the activities, responsibilities, confidentiality of information, commission sharing, termination clause, etc.

12.1.2 Books, records and obligations

Regulation 15(1) — ten books:

• a) Register of transactions (Sauda Book).
• b) Clients' ledger.
• c) General ledger.
• d) Journals.
• e) Cash Book.
• f) Bank passbook.
• g) Documents register containing... particulars of securities received and delivered in physical form and the statement of accounts and other records relating to receipt and delivery of securities provided by the Depository Participants in respect of dematerialized securities.
• h) Copy of contract notes issued to clients; Written consent of clients in respect of contracts entered into as principals.
• i) Margin deposit book.
• j) Client account opening form in the format as may be specified by SEBI.

Where they are kept: every stock broker shall intimate to recognized stock exchange the place where the books of accounts, records and documents are maintained.

Note the addressee — the recognized stock exchange, not SEBI, and intimation rather than prior approval. Which is why the first review question answers No.

Accounts: every stock broker shall furnish to a recognised stock exchange, of which it is a member, a copy of the audited balance sheet and profit and loss account within six months or a period as may be specified after the close of each accounting period.

Preservation — Regulation 16: every stock broker shall preserve the books of account and other records maintained under regulation 15 for a minimum period of 8 years.

Compliance officer — Regulation 17A: every stock broker shall appoint a compliance officer who shall be responsible for monitoring the compliance of the Act, rules and regulations... and for a redress of investors' grievances. The compliance officer shall immediately and independently report to recognized stock exchanges any non-compliance observed by him.

Note the reporting line here — to the recognized stock exchanges.

Protection of client funds and risk management

Under Regulation 18(2), the stock broker shall:

• ensure that the clients' funds are available at all times, as specified.
• adhere to the allocation and segregation of collaterals at the client level and upstreaming of client funds provisions.
• segregate the money and securities deposited by a client from its own account or account of any other client and shall not use the same for itself or for any other client or for any purpose other than the purposes mentioned in rules, regulations, circulars and guidelines.

Under Regulation 18(3): a broker shall have a sound risk management system for comprehensively managing risks and shall have adequate internal procedures and controls with the aim of protecting the interests of clients, their assets and ensuring proper management of risk; adhere to audit requirements; comply with the KYC Registration Agency Regulations, 2011; and ensure the confidentiality of all the details of the client and shall not disclose such details to any person except as required under any law, rules, regulations or with the express written permission of the client.

Further obligations cover:

• Cyber security and cyber resilience.
• Grievance Redressal Mechanism.
• Code of advertisement.
• Outsourcing.
• Compliance.
• Investor Charter.
• Execution of Orders.

Qualified stock brokers

SEBI may designate a stock broker as a qualified stock broker having regard to its size and scale of operations, likely impact on investors and securities market, as well as governance and service standards, on five parameters:

a) The total number of active clients; b) the available total assets of clients with the stock broker; c) the trading volumes of the stock broker; d) the end of day margin obligations of all clients of a stock broker; e) the proprietary trading volumes of the stock broker.

Six enhanced obligations:

• appropriate governance structure and processes.
• appropriate risk management policy and processes.
• scalable infrastructure and appropriate technical capacity.
• framework for orderly winding down.
• robust cyber security framework and processes.
• investor services including online complaint redressal mechanism.

Prohibited activities — Regulation 20

A stock broker shall refrain from:

(a) engaging in activities or schemes of indicative or guaranteed or fixed or periodic returns or payments, which are not permitted

(b) operating any schemes of unauthorised collective investments/portfolio management services

(c) engaging in any activity not permitted under rule 8(1)(f) and rule 8(3)(f) of the Securities Contracts (Regulation) Rules, 1957

(d) accepting cash from its clients either directly or by way of cash deposit to its bank account.

No cash at all — not even paid into the broker's bank account.

12.1.3 Inspection

Regulation 27 lets SEBI appoint one or more persons as inspecting authority to undertake inspection of the books of account, other records and documents, to ensure records are being maintained in the manner required and that the Act, rules, regulations and the SCRA are being complied with. SEBI along with the recognised stock exchange, clearing corporation or depository may conduct a joint inspection.

Procedure — Regulation 28: SEBI shall give a reasonable notice in writing to the stock broker and may dispense with the requirement of such notice in the interest of the investors or in public interest.

The broker's obligations on inspection: it is the duty of senior management, key managerial personnel, director, proprietor, partner, officer and employee to produce to the inspecting authority such books, accounts and other documents in his custody or control and furnish him with the statements and information; to allow the inspecting authority to have reasonable access to the premises occupied by the stockbroker or by any other person on his behalf and provide copies; to permit the authority to examine or record statements of any member, director, and employee; and to give to the inspecting authority all assistance in connection with the inspection.

Auditors: SEBI may also appoint a qualified auditor under Regulation 32, to investigate the books of account or affairs of any stockbroker, with the same powers and obligations — and where such inspection or investigation results in adverse findings... the Board shall be entitled to recover from the stockbroker, any expenses including fees paid to the auditors.

12.1.4 Action in case of default

A stock broker shall be liable for any action specified under securities laws, including for:

• (a) charging of brokerage which is in excess of brokerage specified.
• (b) failure to comply with directions issued by the Board.
• (c) ceasing to be a member of a recognised stock exchange.
• (d) being declared a defaulter by a recognised stock exchange and has not been readmitted as a member within a period of six months.
• (e) failure to co-operate with the inspecting or investigating authority.
• (f) indulging in market manipulation of securities or index.
• (g) dealing in securities without obtaining certificate of registration.
• (h) dealing in securities or providing trading floor or assisting in trading outside the recognized stock exchange.
• (i) failure without reasonable cause to produce books, appear, sign notes of examination, file returns, or furnish any information, books or other documents within 15 days of issue of notice by the Board.
• failure to pay penalty imposed by the adjudicating officer.

Six months for readmission; fifteen days to furnish information.

Early warning signals

SEBI has issued guidelines relating to early warning mechanisms to prevent diversion of client securities, thresholds being decided by the Stock Exchanges, Depositories and Clearing Corporations with mutual consultation.

Five families of signal. Deterioration in financial health — significant reduction in net worth, significant losses, delays in reporting, significant mark-to-market loss on proprietary account/related party accounts, repeated instances of pay-in shortages, sudden activation of a significant number of dormant client's accounts, significant number of UCC modifications, resignation of Statutory Auditors or Directors.

Pledge-related signals identified by depositories — multiple proprietary Demat accounts, movement of shares to / from a large number of clients' Demat accounts, transfer of large value of shares through off-market transfers other than for settlement purposes, invocation of the pledge of securities by lenders, and significant depletion of client's shares.

Rising complaints alleging un-authorized trading / unauthorized delivery instructions being processed and non-receipt of funds and securities.

Risk-Based Supervision alerts — including failure to upload weekly data regarding monitoring of clients' funds... for 3 consecutive weeks and pledging securities in case of clients having credit balance and using the funds so raised against them for own purposes.

And terminal disablement in the previous quarter.

Preventive actions by exchanges include blocking off a certain percentage of available collaterals towards margin, checking registers and balances, impos[ing] limits on proprietary trading, prescrib[ing] and monitor[ing] shorter time duration for settlement of Running Account of clients, meeting the designated directors, uniform action of deactivation of trading terminals by all Stock Exchanges, inspection, cross-checking, and where diversion is suspected, appoint a forensic auditor to trace trails of entire funds and securities of clients.

By depositories:

• restriction on a further pledge of client securities... by freezing the stockbroker client account for debit.
• imposition of 100% concurrent audit on the depository participant.
• cessation / restriction on uses of Power of Attorney (POA), clients then issuing instructions electronically or through Delivery Instruction Slip (DIS).

And SEBI directed exchanges and depositories to map the existing Unique Client Code (UCC) UCCs with the Demat account of the clients and to weed out inactive, non-operational UCCs.

12.1.5 Code of conduct

Integrity: a stock-broker must maintain high standards of integrity, promptitude and fairness in the conduct of all his business.

Diligence, honesty and fairness:

• act honestly, fairly and with due skill, care and diligence and in the interest of investors.
• not indulge in manipulative, fraudulent or deceptive transactions or schemes or spread rumours with a view to distorting market equilibrium or making personal gains.
• not create false market either singly or in collusion with others.
• not involve itself in business in the market beyond reasonable levels not commensurate with its financial soundness.
• not resort to unfair means to solicit clients from other stock brokers.
• not neglect or fail or refuse to submit the required returns.

Competence: have arrangements to render fair, prompt and competent services and take all reasonable steps to ensure that its employees are adequately trained.

Duty to the investor:

• take all reasonable steps to promptly execute client orders in accordance with clients' instructions.
• promptly inform its client about the execution or non-execution of an order.
• issue a contract note to its client, within specified timeline, for all transactions in the form specified.
• not disclose or discuss with any other person or make improper use of the details of personal investments.
• not encourage sales or purchases of securities with the sole object of generating brokerage or commission.
• not furnish false or misleading quotations.
• not deal or transact business knowingly, directly or indirectly or execute an order for a client who has failed to carry out its commitments in relation to securities with another stock-broker.

Conflict of interest: a stock broker, when dealing with a client, shall ensure that no conflict of interest arises between it and the client. In the event of a conflict of interest, it shall disclose the conflict to the client accordingly and shall not seek to gain a direct or indirect personal advantage from the situation. A stock broker shall not consider clients' interests inferior to its own.

Which is the basis of the second review question — a broker must disclose the capacity in which it deals. Section 15 of the SCRA requires him, when acting as a principal with a non-member, to secure consent and to disclose in the note, memorandum or agreement of sale or purchase that he is acting as a principal, and the code requires disclosure of any conflict.

As an underwriter, a broker must make all efforts to protect the interests of its clients, act ethically, make no misrepresentation of the services that the underwriter is capable of performing or its underwriting commitment, avoid and resolve conflicts, keep issuer information confidential, not deal in the issuer's securities without disclosure, inform clients of any change in registration status or any penal action, transfer outstanding business on such an event, avoid unfair competition, and not be party to creation of false market, price rigging or manipulation, or passing of unpublished price sensitive information.

12.1.6 Client money and securities

It shall be compulsory for all member brokers to keep the money of the clients in a separate account and their own money in a separate account. No payment of transactions in which the member broker takes a position as a principal will be allowed to be made from the clients' accounts.

Securities too:

• separate accounts must distinguish client securities from the member's own, providing for securities received for sale or kept pending delivery in the market.
• securities fully paid for, pending delivery to clients.
• securities received for transfer or sent for transfer.
• securities that are fully paid for and are held in custody by the Member as security/ margin etc., with proper authorisation from the client.
• fully paid for client's securities registered in the name of the member, if any, towards margin requirement.

Two timelines: the member brokers need to make the payment to their clients or deliver the securities purchased within two working days of payout unless the client has requested otherwise, and it is compulsory for the member broker to issue the contract note to the client for its purchase or sale within 24 hours of the execution of the contract.

12.1.7 Client documentation

Client registration documents are segregated into mandatory and non-mandatory parts. Client agreement, Know Your Client (KYC) and the Risk Disclosure Document (RDD) constitute the mandatory part.

The agreement must cover:

• immediate written notice of changes in client information.
• the client's responsibility for all investment decisions and that the client has read and signed the Risk Disclosure Document.
• the nature of services provided by the broker.
• the rate of brokerage/commission/fee, which shall not exceed the maximum permitted.
• the client's liability to pay margins... within the stipulated time, including additional margins the broker imposes.
• the broker's authority to liquidate /close positions of the client for non-payment of margins, outstanding debts with loss charged to the client.
• that client money shall be kept in a separate account by the member, distinct from his own account.

KYC must capture complete details of client information, bank and depository account details, financial details of the constituent, investment / trading experience, references, financial documents and signature of the client, plus the photograph, proof of address and identity and the Board resolution for corporate clients, and the segments in which the client wishes to transact. The KRA system shall be applicable for all new client accounts opened from January 1, 2012.

RDD informs clients of the various risks associated with dealing in the securities market, and is mandatory for every client as per SEBI regulations.

Uniform documents: a Client Registration Form uniform across all the segments and exchanges, and a Member Clients Agreement uniform across exchanges but a separate agreement in the same format would be required for each of the exchanges. Additional clauses may be added if not in conflict with the model. The requirement of obtaining the client registration form may be waived for SEBI registered Foreign Portfolio Investors (FPIs), Mutual Funds (MFs), Venture Capital Funds (VCFs) and Foreign Venture Capital Investors (FVCIs), Scheduled Commercial Banks (SCBs) etc.

Unique Client Code: mandatory for all clients, with the Permanent Account Number (PAN) collected and maintained; particulars furnished to exchanges and clearing corporations updated on a monthly basis, reaching the exchange within 7 working days of the following month; and exchanges maintaining historical records of all quarterly submissions... for a period of 7 years.

Contract notes must be issued within 24 hours of execution, with copies and proof of delivery/despatch kept, containing the signature of the authorised person, the UCC and PAN details of the client along with the trade price... and the brokerage charged, a running serial number, the dealing office and the PAN number of the trading member / broker.

Electronic contract notes may be issued authenticated by means of digital signatures, subject to four conditions:

• sent only to those clients who have opted to receive the contract notes in an electronic form.
• delivered through email, the client providing an account available at all times.
• digitally signed, encrypted, non-tamperable and shall comply with the provisions of the IT Act, 2000.
• in the format prescribed by the stock exchange.

Running account settlement

The trading member (TM), after considering the End of the Day (EOD) obligation of funds across all the Exchanges, shall settle the running accounts at the choice of the clients on quarterly and monthly basis, on the dates stipulated by the Stock Exchanges.

And settled funds must not be reused: funds received from clients, whose running account has been settled, remain in the "Up Streaming Client Nodal Bank Account" and no such funds shall be used for settlement of running account of other clients.

SEBI discontinued title transfer of securities to the demat account of Trading Member for margin purposes, collateral being accepted only by way of 'margin pledge' created in the Depository system.

What may be retained where a client has an outstanding position: entire pay-in obligation of funds outstanding at the end of the day on settlement of running account, of T Day & T-1 day, and margin liability as on the date of settlement... and additional margins (maximum up to 125% of total margin liability on the day of settlement) — so Trading Member may retain 225% of the total margin liability in all the segments across the exchange.

Settlement must be real: client's running account shall be considered settled only by making actual payment into client's bank account and not by making any journal entries. Journal entries in the client account shall be permitted only for levy/reversal of charges.

And it must be notified — an intimation shall be sent to the client by SMS on the mobile number and also by email, including transfer details, with a retention statement along with the statement of running accounts.

12.2 Direct Market Access

DMA is a facility that permits the brokers to offer clients direct access to the exchange trading system through the broker's infrastructure without manual intervention by the broker.

Its advantages: direct control of clients over orders, faster execution of client orders, reduced risk of errors associated with manual order entry, greater transparency, increased liquidity, lower impact costs for large orders, better audit trails and better use of hedging and arbitrage opportunities.

Initially restricted to institutional clients, DMA was later extended to FPIs for participation in Exchange Traded Currency Derivatives (ETCDs), and may be used by the client or an investment manager of the client, a SEBI registered entity being permitted to act as such.

Operational specifications: a sound audit trail for all the DMA orders and trades with identification of actual user-id, retained for at least 5 years; sufficient security features including password protection for the user ID, automatic expiry of passwords at the end of a reasonable duration and re-initialisation of access on entering fresh passwords; and a periodic system audit with a certificate to the exchange.

Authorisation: brokers shall specifically authorise clients or investment managers... after fulfilling Know Your Client (KYC) requirements and carrying out due diligence.

Cross trades: brokers shall not be allowed to cross trades of their clients with each other. All orders must be offered to the market for matching.

Liability: the broker shall be fully responsible and liable for all orders emanating through their DMA systems.

12.3 Algorithmic trading

Algorithmic trading includes any type of automated route-based trading where decision making is delegated to a computer model. High-Frequency Trading is a type of algorithmic trading that is latency-sensitive and is characterised by a high daily portfolio turnover and high order to trade ratio (OTR).

Permission and testing: a broker may provide algo trading only upon the prior permission of the stock exchange, whose initial conformance tests ensure the checks are in place.

Audit: brokers shall subject their algorithmic trading system to a system audit every six months, undertaken by a certified system auditor, deficiencies reported by the stockbroker to the stock exchange immediately on completion of the system audit with immediate corrective action. Where deficiencies are serious or uncorrected, the stock exchange shall not allow the stockbroker to use the trading software.

Six minimum risk controls:

• Price check — no order in breach of the price bands.
• Quantity check.
• Order Value check.
• Cumulative Open Order Value check, being the total value of its unexecuted orders released from the stock broker system.
• Automated Execution check, accounting for all executed, un-executed and unconfirmed orders with pre-defined parameters for an automatic stoppage in the event of algo execution leading to a loop or a runaway situation.
• tagging with a unique identifier provided by the stock exchange in order to establish audit trail.

Five undertakings to the exchange:

• proper procedures, systems and technical capability.
• arrangements to safeguard algorithms from misuse or unauthorized access.
• real-time monitoring systems to identify algorithms that may not behave as expected, with the exchange informed immediately.
• logs of all trading activities to facilitate the audit trail.
• notification of any modification or change to the approved algos.

12.4 Margin trading

Margin Trading facility is offered to an investor in buying of shares and securities from the available resources by allowing him to pay a fraction of the total transaction value called a margin.

Initial margin is the minimum amount, calculated as a percentage of the transaction value, to be placed by the client, with the broker, before the actual purchase. Maintenance margin is the minimum amount, calculated as a percentage of the market value of the securities, calculated with respect to the last trading day's closing price, to be maintained by the client.

Eligible securities: Equity shares and units of Equity ETFs that are classified as 'Group I security'.

Conditions: collateral and funded stocks shall be identifiable separately and no comingling shall be permitted; both shall be marked to market on a daily basis; further exposure may be granted on an increase in collateral value subject to applicable haircuts, but no such exposure shall be permitted on the increased value of Funded stocks; and margins must be maintained at all times with necessary margin calls on a shortfall.

Liquidation: the broker shall list out situations/conditions in which the securities may be liquidated in the Rights and Obligations Document, and shall not liquidate or use in any manner the securities of the client in any situation other than the conditions as stipulated by SEBI.

Eligibility: only corporate stockbrokers with a net worth of at least Rs.3.00 crore shall be eligible, submitting a half-yearly certificate, as on 31st March and 30th September... from an auditor confirming the net worth... not later than 30th April and 31st October of every year.

Sources of funds: own funds or borrow funds from scheduled commercial banks and/or NBFCs regulated by RBI, borrow funds by way of issuance of CP and by way of unsecured long-term loans from their promoters and directors — and no other source. Critically: the stockbroker shall not use the funds of any client for providing the margin trading facility to another client, even if the same is authorized by the first client.

Leverage limits: total indebtedness... shall not exceed 5 times its net worth; maximum exposure shall not, in any case, exceed the borrowed funds and 50% of his "net worth"; exposure to any single client at any point of time shall not exceed 10% of the broker's maximum allowable exposure; and exposures must be well diversified under a Board approved policy.

Disclosure of gross exposure with client name, holding category, PAN, scrip names and lender details is due on or before noon on the following trading day.

Records: separate client-wise ledgers for funds and securities, a separate record of details of the funds used and sources of funds, and books audited on a half-yearly basis with an auditor's certificate to the exchange within one month of the half-year end.

And a limit on protection: SGF and IPF shall be available for transactions done on the exchange, whether through a normal or margin trading facility. However, any losses suffered in connection with the margin trading facility availed by the client from the stockbroker shall not be covered under IPF.

12.5 Authorised persons

An Authorised Person is any person, individual, partnership firm, LLP or body corporate, who is appointed as such by a stock broker (including Trading Member) and who provides access to the trading platform of a Stock Exchange as an agent of the Stock broker.

Conditions of appointment:

• a written agreement(s) in the form(s) prescribed by the Exchange covering scope of the activities, responsibilities, confidentiality of information, commission sharing, termination clause.
• the Trading Member shall be responsible for all acts of omission and commission of the Authorised Person and all acts... shall be deemed to be that of the Trading Member.
• the AP shall not receive or pay any money or securities in its own name or account.
• he shall receive his remuneration... only from the Trading Member and he shall not charge any amount from the clients.
• a person shall not be appointed as an Authorised Person by more than one Trading Member.
• a partner or director of an Authorised Person shall not be appointed as an Authorised Person.
• proprietary trading should be permitted only on his own funds and securities and not using any of the client's fund.

12.6 Underwriting by stockbrokers

Underwriter is a person who engages in the business of underwriting of the issue of securities of a body corporate; underwriting means an agreement to subscribe to or to procure subscription for securities which is issued or offered for sale remaining unsubscribed.

Every stockbroker having a valid certificate of registration would be entitled to act as an underwriter, and must enter into an agreement that is valid with the body corporate on whose behalf it acts.

The agreement must cover:

• the period in force.
• the allocation of duties as well as responsibilities.
• the number of underwriting obligations.
• the period within which the underwriter must subscribe.
• the commission amount or brokerage payable.
• details of arrangements for fulfilling obligations.

Three key responsibilities:

• no direct or indirect benefit from underwriting the issue apart from the commission or brokerage.
• the total underwriting obligations under all agreements should not exceed 20 times the net worth.
• subscription in 45 days of the receipt of such intimation when called upon.

Twenty times net worth; forty-five days to subscribe.

And a disclosure rule on advice: a stockbroker or employee must not render, directly or indirectly any investment advice about any security in the publicly accessible media, real-time or non-real-time, unless a disclosure of its interest including its long/short position in the said security has been made.

The broker cases

Case 12.1 — Karvy Stock Broking. On NSE's preliminary report SEBI passed an ex-parte ad interim order dated November 22, 2019 prohibiting KSBL... from taking new clients, directing the depositories not to act upon any instruction given by KSBL in pursuance of power of attorney given to KSBL by its clients, to monitor movement of securities, and to bar transfers from a named DP account except to the respective beneficial owner who has paid in full.

SAT disposed of the appeal with a direction to the WTM to consider the request and pass an appropriate order after hearing.

What followed. NSDL announced securities transferred to around 82,559 beneficial owners. SEBI held that in the absence of any authorisation from Karvy's clients, the transfer of clients' securities by Karvy to its own DP account amounted to misappropriation and hence, the pledge created in favour of Lenders was invalid — a PoA could have been acted upon only after an order or instruction was received from such clients for trading on the stock exchanges. And the SEBI circular of June 20, 2019... prohibited stockbrokers from pledging clients' securities except for meeting clients' pay-in obligations.

By the confirmatory order of November 24, 2020, funds and securities worth Rs 2,300 crore belonging to about 2.35 lakh investors had been settled, and NSE has expelled KSBL and also declared KSBL as a defaulter.

Case 12.2 — Reflection Investments. NSE suspended the member's membership over shortfall of client funds reported in weekly enhanced supervision submissions, with a penalty of Rs. 5,47,900 and a 45 days window to infuse funds — but suspension was effected the very next day.

SAT granted limited relief, observing that suspending or closing down the business of a broker is in nobody's interest unless it is conclusively proved that the broker is working against the interest of the investors or that of the securities market, and that although the shortfall was a serious offence it may not require an immediate cessation of all activities.

The order required payment of the penalty within one week, permitted trading in the cash segment through one Terminal on infusing Rs 1 crore by 31 January 2020, subject to enhanced supervision of NSE and no further shortfall, with the remaining Rs. 5.75 crores in two instalments. NSE expelled and also declared Reflection Investment as a defaulter on 12th March 2021.

12.7 Portfolio Managers Regulations, 2020

Portfolio manager means a body corporate, which pursuant to a contract with a client, advises or directs or undertakes on behalf of the client (whether as a discretionary portfolio manager or otherwise) the management or administration of a portfolio of securities or goods or funds of the client.

Discretionary portfolio manager is one who exercises or may exercise, any degree of discretion as to the investment of funds or management of the portfolio. Portfolio means the total holdings of securities and goods belonging to any person. Principal officer is the employee responsible for the decisions made by the portfolio manager and all other operations.

No person shall act as portfolio manager unless he holds a certificate of registration granted by SEBI.

Registration

SEBI considers:

• whether the applicant is a body corporate.
• whether it has the necessary infrastructure like adequate office space, equipment and the manpower.
• has appointed a compliance officer.
• whether the principal officer has a professional qualification in finance, law, accountancy or business management or a Post Graduate Program in the Securities Market (Portfolio Management) from NISM of a duration not less than one year or a CFA charter, experience of at least five years in related activities in the securities market, of which at least 2 years of relevant experience is in portfolio management or investment advisory services, and the relevant NISM certification.

Plus at least one further employee with graduation and an experience of at least two years in related activities; and any employee with decision-making authority related to funding management must meet the principal officer's standards.

Other considerations:

• disciplinary action against connected persons.
• the net worth requirement, which shall be not less than Rs.5 crores.
• litigation connected with the securities market.
• conviction for any offence involving moral turpitude or guilt of any economic offence.
• being a fit and proper person.
• whether the grant of certificate to the applicant is in the interest of investors.

Conditions of registration include prior approval of SEBI in case of change in control; forthwith informing SEBI where information previously submitted... are found to be false or misleading; paying fees; redressal of grievances of the investors within 21 calendar days; and maintaining net worth at all times. The certificate shall be valid unless it is suspended or cancelled by the Board.

Contract, disclosure document and responsibilities

The portfolio manager shall, before taking up an assignment... enter into an agreement in writing with such client clearly defining the inter se relationship, and setting out their mutual rights, liabilities and obligations, covering fifteen listed matters from the investment objectives and the services to be provided to custody of securities and, for a discretionary manager, a condition that the liability of a client shall not exceed his investment with the portfolio manager.

**Investments in related parties or associates require the prior consent of the client.

The Disclosure Document must be given prior to entering into an agreement, with a certificate in Form C, and must contain fees, portfolio risks including risk specific to each investment approach, related party transactions, conflicts of interest, related-party investments, the diversification policy, the performance of the portfolio manager, and the audited financial statements of the portfolio manager for the immediately preceding three years.

Its contents shall be certified by an independent chartered accountant, and it must be filed with SEBI before it is circulated to any client or whenever any material change including change in the investment approach is effected, within 7 working days from the date of the changes.

**And a change in the Principal Officer must be disclosed to the Board and the clients within 7 working days of effecting the change — the fourth review question.

On fees: the manager shall charge an agreed fee... without guaranteeing or assuring, either directly or indirectly, any return, which may be a fixed fee or a return-based fee or a combination of both — and no up-front fees shall be charged by the portfolio manager directly or indirectly to the clients.

Twelve general responsibilities include:

• managing funds individually and independently... in a manner which does not partake the character of a Mutual Fund.
• not accepting funds or securities worth less than fifty lakh rupees.
• acting in a fiduciary capacity.
• segregating each client's holdings.
• keeping funds in a separate account... in a Scheduled Commercial Bank.
• not deriving any direct or indirect benefit out of the client's funds or securities.
• not borrow[ing] funds or securities on behalf of the client.
• not lending client securities except as permitted.
• handling complaints promptly.
• supervising distributors.
• complying with the Investor Charter.

Fifty lakh rupees — the minimum investment per client, with exceptions for an accredited investor and the Co-investment Portfolio Manager.

Portfolio management restrictions

The discretionary portfolio manager shall invest funds of his clients in the securities listed or traded on a recognized stock exchange, money market instruments, units of Mutual Funds and other securities as specified by SEBI. A manager offering non-discretionary or advisory services... may invest or provide advice for investment up to 25% of the assets under management of such clients in unlisted securities, rising to hundred percent for large value accredited investors.

Mutual fund units only through the direct plan, with no kind of distribution-related fees charged.

Prohibitions:

• no leveraging for investment in derivatives.
• no deployment in bill discounting, badla financing or for the purpose of lending or placement with corporate or non-corporate bodies.
• no investment in the portfolio managed or administered by another portfolio manager.
• no investment based on the advice of any other entity.
• no speculative transactions settled otherwise than by delivery, except derivatives.
• no off-market transfers in the client's account save five listed exceptions.

Aggregation: securities are ordinarily purchased or sold separately per client, but on aggregation inter se allocation shall be done on a pro-rata basis and at the weighted average price of the day's transactions, with no open position in respect of allocation.

Segregation and custody: funds and securities must be segregated from the manager's own, securities must not be held in its own name on behalf of its clients, and every portfolio manager shall appoint a custodian, save an advisory-only manager and a Co-investment Portfolio Manager.

Records, audit and reports

Five books: balance sheet, profit and loss account, auditor's report, a statement of financial position, and records in support of every investment transaction or recommendation which will indicate the data, facts and opinion leading to that investment decision. They are preserved for a minimum period of five years.

Audit: the books will be audited yearly by a qualified auditor, with a certificate to SEBI within six months of the close of the portfolio manager's accounting period; the portfolio accounts... shall be audited annually by an independent chartered accountant with a copy of the certificate given to the client; and the client may appoint a chartered accountant to audit the books and accounts of the portfolio manager relating to his transactions.

**Deficiencies in the auditor's report must be rectified within two months from the date of the auditor's report.

Reports to clients are furnished not exceeding a period of six months, covering the composition and value of the portfolio, transactions, beneficial interest received, expenses incurred in managing the portfolio, details of risk foreseen, defaults and downgrades, and details of commission paid to the distributor(s) for the particular client.

Compliance officer: every portfolio manager shall appoint a compliance officer, and the role of compliance officer shall not be assigned to the principal officer or the employee of the portfolio manager. He shall immediately and independently report to SEBI any non-compliance observed by him.

Grievances: redressed promptly but not later than twenty-one calendar days from the date of receipt — the third review question, True.

Code of conduct and guidelines

• High standards of integrity and fairness.
• money should be deployed by the portfolio manager as soon as possible for that purpose and money due and payable to a client should be paid forthwith.
• due diligence... proper care and... independent professional judgment, avoiding conflicts or ensuring fair treatment to all his customers, and never placing his interest above those of his clients.
• no trade against the interest of the clients in its proprietary account.
• no unfair competition.
• no exaggerated statement.
• obtaining in writing the client's interest in various corporate bodies which enables him to obtain unpublished price-sensitive information.
• no disclosure of confidential information.
• taking steps for transfer of the clients' securities and for claiming and receiving dividends, interest payments and other rights.
• providing true and adequate information without making any misguiding or exaggerated claims and the best possible advice.
• not being party to creation of a false market, price rigging or passing of price-sensitive information.
• no dealing on unpublished price sensitive information obtained... during the course of any professional assignment.
• disclosure of long or short positions when rendering public advice.
• compliance with the SEBI (Prohibition of Insider Trading) Regulations, 2015.

SEBI's February 13, 2020 guidelines add:

• no upfront fees, with transaction charges through self or associates capped at 20% by value per associate (including self) per service.
• prominent disclosure of the option for direct on-boarding, with no charges except statutory charges on direct onboarding.
• content requirements for an Investment Approach.
• a net worth certificate within 6 months from the end of the financial year and a compliance certificate within 60 days.
• annual audit of firm-level performance data.
• an expanded definition of material change.
• use only of distributors who have a valid AMFI Registration Number or have cleared NISM-Series-V-A exam, paid only on a trail basis and only from the fees received by PM.

Case 12.4 — P N Vijay Financial Services. SEBI found the manager had no agreement with the Stockbroker about control over client funds and accounts, no control over funds and securities of its clients to determine whether the minimum investment limit... has been adhered to, deficient KYC forms, incomplete disclosure documents and missing fee undertakings.

The central finding: it relied more on business relationships with TSL for having control over its clients' funds and securities rather than having agreements in place, and by allowing its designated broker to directly accept its clients' funds/securities and by not directly taking up the assignment of the management of funds and portfolio of securities on behalf of its clients, it violated the regulations.

And the reasoning on responsibility: a Portfolio Manager is an intermediary which manages and controls the investments of its clients in the complex securities markets... the primary responsibility in this regard has been entrusted to the Portfolio Managers.

A lenient view on account of corrective action taken and penalty of Rs 5 lakhs imposed.

The chapter's review questions confirm that a stockbroker need not pre-intimate SEBI about shifting the place where its books are kept — the intimation goes to the recognised stock exchange; that it is True that a broker dealing with a client must disclose whether it acts as principal or agent; that it is True that a portfolio manager must take adequate steps to redress investor grievances; and that a change in the identity of the Principal Officer must be disclosed to SEBI and clients within 7 working days.