2023 (12) TMI 1437 - AT - SEBI

Violations of the SEBI laws - violation of 1993 circular - Funds of the credit balance clients utilized by the appellant for settlement obligations of the debit balance clients - appellant had violated the 1993 circular by mixing clients funds with its own funds in the pool account and used the mixed funds for its own purposes. It was also alleged that funds pay out from the stock exchange towards client trades were not transferred to the designated client bank account and that G Value of trades on number of days had come out negative - HELD THAT - The 1993 circular nowhere stipulates any formula for computation of deemed misuse of client funds. The 1993 circular only provides the principles of segregation of the client funds from brokers own fund. We find that this Tribunal in the matter of Arihant Capital Markets Pvt. Ltd. (supra) was not called upon to decide whether the funded portion of the bank guarantee was to be taken into consideration while calculating the balances with the stock exchange / clearing corporation. The treatment of bank guarantee introduced in the 2016 circular was not existing in the 1993 circular and the treatment of this bank guarantee introduced in 2016 circular was not considered by this Tribunal in Arihant Capital Markets Pvt. Ltd. 2021 (10) TMI 1463 - SECURITIES APPELLATE TRIBUNAL MUMBAI matter and in other cases cited by the respondent. Thus merely picking up the phrase from the order passed by this Tribunal does not give any right nor can it hold that the 2016 circular was a reiteration of the 1993 circular. There is no misuse of the clients funds and since there is no failure on the part of the appellant to segregate monies of the client nor monies of the client have been misused by the appellant for its own purposes no penalty under Section 23D of the SCRA could be imposed. However we find that the appellant has failed to change the nomenclature of the bank accounts of the client as required to be done under the 1993 circular. Even though it is a technical breach and there is no misuse of the client funds nonetheless if something is required to be done in a particular manner and the same is not done in that fashion then there is a violation of that circular. Considering the aforesaid that it is only a technical breach we are of the opinion that in the given circumstances for the two show cause notices a penalty of Rs. 20 lakh in total would be sufficient for the purpose of this case.

Summary

The core legal questions considered by the Tribunal in these appeals revolve around the alleged violations of the Securities and Exchange Board of India (SEBI) circular dated November 18, 1993 (hereinafter '1993 circular') by a stockbroker. Specifically, the issues are:

1. Whether the appellant violated the 1993 circular by failing to designate client bank accounts with the mandatory nomenclature "client account".

2. Whether the appellant misused client funds by mixing proprietary funds with client funds in a pool or control account before transferring monies to the settlement account, thereby violating the segregation requirements under the 1993 circular.

3. Whether the appellant misused client funds as indicated by a negative "G" value calculated by excluding the non-funded portion of bank guarantees, applying the formula introduced by the SEBI circular dated September 26, 2016 (hereinafter '2016 circular'), retrospectively to the inspection period April 1, 2011 to January 31, 2017.

4. Whether the penalty imposed under Section 23D of the Securities Contracts (Regulation) Act, 1956 (SCRA) and the restraint order barring the appellant from onboarding new clients for two years were justified.

Issue 1: Failure to Designate Client Bank Accounts Properly

Legal Framework and Precedents: The 1993 circular mandates that stockbrokers must maintain client funds in separate bank accounts clearly designated as "client account" to ensure transparency and facilitate monitoring by exchanges and SEBI.

Court's Interpretation and Reasoning: The Tribunal noted that during inspections, 26 client bank accounts were not titled as "client account." Although the appellant renamed most accounts prior to the show cause notices, two accounts remained improperly titled. The Tribunal emphasized the mandatory nature of the nomenclature requirement, stating that "if something has to be done in a particular manner then the law mandates that the same is required to be done that manner only."

Key Findings and Application: The failure to rename the accounts as "client account" constituted a violation of the 1993 circular. However, since this breach was technical and did not result in misuse of client funds, the Tribunal treated it as a non-substantive violation.

Treatment of Competing Arguments: The appellant's justification for non-renaming was considered but rejected as insufficient to excuse the breach. The Tribunal upheld the violation but distinguished it from substantive misuse.

Conclusion: The appellant violated the 1993 circular by failing to properly designate client bank accounts, albeit this was a technical breach without misuse of client funds.

Issue 2: Mixing of Client Funds with Proprietary Funds in Pool Account

Legal Framework and Precedents: Clause (1) of the 1993 circular mandates strict segregation of client funds and proprietary funds in separate accounts. The circular prohibits mixing these funds.

Court's Interpretation and Reasoning: The appellant maintained separate client and proprietary accounts but also used a pool/control account into which both client and proprietary funds were transferred before settlement with the stock exchange. The appellant contended this was for administrative convenience, as the exchange required net settlement of client and proprietary obligations in one lump sum.

The Tribunal found the appellant's explanation reasonable and held that the creation of a pool account did not violate the 1993 circular since the segregation was maintained at the client and proprietary account level. The Tribunal reasoned that once funds are debited from the client account, they cease to be client funds, and their transit through a pool account before reaching the settlement account is immaterial.

Key Evidence and Findings: The flow of funds chart and admissions by the respondent confirmed the process. The appellant ceased this practice in 2014, transferring proprietary trading to a sister concern, ending the mixing issue thereafter.

Treatment of Competing Arguments: The WTM had disbelieved the appellant's contention, holding that funds became fungible once in the pool account, leading to misuse. The Tribunal rejected this view as erroneous and untenable.

Conclusion: The use of a pool account for administrative convenience, with segregation maintained at the client and proprietary account levels, does not constitute a violation of the 1993 circular's segregation requirement.

Issue 3: Misuse of Client Funds Based on Negative "G" Value and Application of 2016 Circular Retrospectively

Legal Framework and Precedents: The 1993 circular does not provide any formula for calculating client funds or address treatment of bank guarantees. The 2016 circular introduced a formula (calculation of "G") to monitor misuse of client funds, specifically excluding the non-funded portion of bank guarantees from client funds calculation, effective from July 1, 2017.

Court's Interpretation and Reasoning: The AO applied the 2016 circular's formula retrospectively to the inspection period (2011-2017), excluding the non-funded portion of bank guarantees and concluding that the appellant misused client funds on 18 days during this period.

The Tribunal held that the 2016 circular cannot be applied retrospectively as it was not a continuation or addendum to the 1993 circular. The 1993 circular does not mention bank guarantees or their treatment. The Tribunal emphasized the principle of strict interpretation and the need for participants to know the rules in advance, rejecting the notion that the "spirit" of the 1993 circular included the 2016 circular's provisions.

Key Evidence and Findings: The Tribunal noted that prior inspections never raised concerns about the funded portion of bank guarantees. The appellant's admitted practice was consistent with the 1993 circular and SEBI's earlier understanding of bank guarantees as cash equivalents.

Treatment of Competing Arguments: The respondent's reliance on prior Tribunal decisions was distinguished on the ground that those decisions did not address the treatment of bank guarantees introduced by the 2016 circular. The Tribunal rejected the argument that the 2016 circular crystallized the 1993 circular in this respect.

Conclusion: The retrospective application of the 2016 circular's formula to exclude non-funded portions of bank guarantees for the period prior to July 1, 2017, is erroneous. There was no misuse of client funds under the 1993 circular during the inspection period.

Issue 4: Justification of Penalty and Restraint Order

Legal Framework: Section 23D of the SCRA provides for a penalty up to Rs. 1 crore if a registered stockbroker fails to segregate client securities or monies or uses client monies for self or others.

Court's Interpretation and Reasoning: Since the Tribunal found no misuse of client funds and no failure to segregate monies, the imposition of the maximum penalty and the restraint order preventing the appellant from onboarding new clients for two years were not justified.

However, the technical breach of failing to rename client accounts as mandated by the 1993 circular was affirmed. Considering the nature of this breach, the Tribunal reduced the penalty to Rs. 20 lakh in total.

Key Findings: The Tribunal also criticized the bifurcation of proceedings by the AO for the same cause of action, suggesting that a single proceeding would have been more appropriate.

Conclusion: The penalty and restraint order were set aside except for a reduced penalty for the technical breach of account nomenclature.

Significant Holdings:

"If something has to be done in a particular manner then the law mandates that the same is required to be done that manner only."

"The pool account does not violate the 1993 circular. The 1993 circular does not prohibit the pool account."

"The 2016 circular came into effect from July 1, 2017 and cannot have retrospective operation to be applied for the period April 1, 2011 to January 31, 2017."

"The finding that the appellant had violated the 1993 circular both in letter and spirit is in complete defiance of the regulatory instructions and is patently erroneous."

"The principles of strict interpretation have to apply. The participants must know the rules of the game before the game has begun which cannot be changed midway retrospectively."

"Since there is no misuse of the clients funds and since there is no failure on the part of the appellant to segregate monies of the client nor monies of the client have been misused by the appellant for its own purposes, no penalty under Section 23D of the SCRA could be imposed."

In sum, the Tribunal affirmed the violation of the 1993 circular in respect of improper nomenclature of client accounts but set aside all other findings of misuse of client funds or failure to segregate funds. The restraint order was quashed, and the penalty was reduced to Rs. 20 lakh for the technical breach. The Tribunal underscored the importance of strict adherence to regulatory mandates and cautioned against retrospective application of regulatory changes.