How Investors Can Avoid Stock Broker Defaults

Defaults by stockbrokers are a source of worry. The misuse of investor cash and securities is the main cause of such defaults. The increased supervisory involvement of the regulators may have caused a rapid spike in the reported number of broker failures.

Broker defaults resulting from improper use of securities have primarily been brought on by investors‘ powers of attorney (PoA) granted to the brokers. The PoA is designed to make the reception and payment process for a deal easier; for example, the broker can release the investor’s sold shares without providing a physical delivery instruction slip (DIS).

Some brokers, however, take advantage of this PoA by transferring investor shares to their pool accounts and then pledging them to generate money for their own uses or to satisfy the margin needs of other investors.

The regulator has mandated that shares supplied as collateral must stay in a person’s demat account and must be noted in the depository system as “pledged” in order to remedy this abuse. Brokers are not allowed to utilise investor securities as collateral, according to the regulator.

In addition, the regulator has now established an electronic DIS system that enables shareholders to sell shares without a POA with the broker. Investors need to be aware that the regulator and exchanges do not consider PoA to be a necessity.

Another factor contributing to broker defaults has been the misuse of investors’ idle cash. To prevent this, the regulator put in place a running account authorisation system wherein unused money are refunded to investors on a set schedule.

Therefore, if investors chose a running account, they need deliberately check to make sure the broker pays the account at the predetermined frequency (30 or 90 days’ settlement). Investors should also avoid leaving idle cash with their stock broker since, in the event of a broker default, the stock exchanges will not recognise claims for these assets in the event of abuse.

Brokers are now required to declare the specific client-level allocation of money in order to prevent the use of one customer’s cash to satisfy the margin requirements of another.

Our research of a few broker default instances reveals that investors are drawn to fixed, guaranteed, or regular returns or capital protection programmes, which are outside the realm of what a broker is permitted to provide.

Investors should avoid signing loan arrangements where brokers charge interest on the money the investor offers. Any breach of such an agreement disqualifies exchanges from making a claim against broker defaults.

Several operational standards for handling client funds and securities have been released by Sebi. The regulator has also developed procedures for improved oversight and early warning to find any misappropriation and money-diversion.

These early warning signs are noted in the event that the stock broker’s or depository participant’s financial situation worsens; pledge transactions; an increase in complaints related to unlawful trading; unauthorised delivery instructions; and the non-receipt of money and securities.

In addition, brokers are required to participate in internal audits on a semi-annual basis, during which they must attest to their compliance with or lack thereof in areas such as the execution of POA, the upkeep of client- and scrip-specific registers, and the separation of client funds and securities from broker funds and securities.

However, given that broker defaults occur despite strong regulatory measures, exchanges’ supervisory responsibilities must be strengthened and they, along with internal auditors, must be held accountable.

Investors needing to exercise greater caution is one component of the answer. Investors can achieve this by carrying out certain checks, including making sure their KYC information is current, validating the emails and SMSs sent by exchanges regarding their trades with the contract notes obtained from the broker, and promptly verifying the funds and securities balance statement sent by the exchanges on a weekly basis.

In addition, investors must confirm and reconcile their Consolidated Accounts Statement (CAS) with their stock holdings and refrain from giving their brokers a general Power of Attorney (PoA).

Therefore, it is crucial that investors adhere to the ‘Caveat emptor’ maxim: let them be knowledgeable and take greater responsibility for their money.

Kuldeep Thareja, Mitu Bhardwaj & Rasmeet Kohli are working with National Institute of Securities Markets. Views are personal.
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