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The authors are Triya Ghosh and Pranav Athreya, 3rd Year students at Maharashtra National Law University, Mumbai.
The Primary Aim of Rule 8
The Securities Contracts (Regulation) Act, of 1956 was enacted to achieve a stable market condition and stop undesirable securities trades. Rule 8 of the Securities Contracts (Regulation) Rules, 1957 concentrates on eligibility conditions and other working restrictions applicable to the stockbroker in furtherance of the objective of the act. More particularly, Rule 8(1)(f) and Rule 8(3)(f) prohibit brokers from doing businesses not directly related to securities, but merely as brokers or agents, and not involving any personal financial liability. While aimed at protecting investors, these provisions often conflict with broker interests, they have been a bone of contention between broker prosperity and investor protection. This is due to the limitation on brokers to conduct “any business” other than brokerage.
Judicial and Regulatory Perspectives on Rule 8
Decisions from the courts buttress the policy considerations for such rules. In Madras Stock Exchange Limited v. S.S.R. Rajakumar, the Madras High Court emphasised the need to penalise brokers to ensure conformity and prevent the misuse of client funds. Furthermore, in the case wherein SEBI imposed a fine of Rs. 30 lakh onto Geojit BNP Paribas, SEBI clarified that Rule 8(1)(f) prohibits brokers from investing client funds in unrelated businesses, thus protecting the interests of investors. The Securities Appellate Tribunal (“SAT”) in the case of Jitendra Pukhraj Jain v. NSE pointed out that these regulations were necessary for keeping the safety and integrity of the securities ecosystem. These decisions underscore that it is imperative to preserve the client investment under these very provisions, however, it is being done at the cost of diversification for stockbrokers. This takes shape as the nebulous term "any business".
The circular dated May 7, 1997, issued by SEBI attempted to bring some clarity by permitting borrowing and lending incidental to securities business, with restrictions placed on those businesses not in connection or incidental or consequential to trade in commodity derivatives. However, it did not define the term ‘any business’ beyond that. This created confusion as activities that brokers may assume harmless could be considered a violation of Rule 8 by SEBI on a whim. There were attempts at defining the term made by SEBI, such as in the case of Geojit BNP Paribas, which classified several activities with clientele as business activities on the basis of their frequencies. However, in the case of Inventure Growth and Securities Ltd, the scope of “any business” was expanded by concentrating more on the possibility of financial liability, rather than the nature or scale of the transactions, as done in Geojit BNP Paribas. Furthermore, SEBI identified three parameters for disqualification under Rule 8(3)(f): firstly, the business must not be the broker's primary activity; secondly, it must not be incidental to securities trading; and thirdly, it must not create financial liability for the broker. However, in the guise of clarifying the meaning of the term, it effectively cripled brokers to stay in a narrow regulatory circle to prevent penalties.
The Broader Implications of Rule 8 of SCRR
Considering the proactive intention of SEBI to protect investors, its restrictions on non-securities businesses may overly constrain stockbrokers. The NSE circular dated January 7, 2022 and BSE circular dated January 07, 2022, provides a list of activities such loan agreements with clients or entities, investments made in group companies such as subsidiaries & associates not in connection with or incidental or even providing a platform to clients for buying and selling of digital gold or any product not covered under the definition of securities as per SCRR. This, coupled with interpretations in Inventure Growth and Securities Ltd, stockbrokers are left unable to diversify business activities and enter newer directions, making them dependent on commission from trading activities.
Additionally, SEBI’s Rule 8 does not take into account that there are several levels of brokers, all of whom do not have the financial and logistical capabilities to adopt the level of monitoring that SEBI hopes for, while not being able to enter into activities that can earn them revenue to allow them to grow such as loan agreements, or investments and more. Additionally, The SEBI (Stock Brokers) Regulations, 1992 and circulars issued thereunder put in place minimum net-worth requirements for brokers to ensure the solvency of the brokers. The computation methodology, prescribed vide SEBI circular dated 16th June 1998, excludes investments in group companies, marketable securities at a discount of 30%, prepaid expenses, and more. However, it leaves ambiguous how funds over investments in other companies, including group companies, not in securities business are to be considered ‘business’. This, again, stifles the ability of the broker to diversify into fintech or advisory services. This forces them to stay vigilant and not be allowed to innovate their solutions. Furthermore, Rule 8 does not differentiate between different types of stockbrokers such as small, medium, independent or large stockbrokers, a lost opportunity for SEBI to remove unnecessary compliance hurdles for stockbrokers depending on their size.
Misuse of Client Funds: Is the line drawn sufficient?
The need has been rising to re-invent and rethink these rules more critically, primarily about changing business landscapes. With the emergence of companies like Groww & Zerodha, which are registered stockbrokers and fintech platforms, offering mobile trading, real-time market data requires an innovative regulatory framework within which brokers can adapt technology to diversify. As such, the definition of permissible activities needs to be relaxed to embrace other modern services. Ancillary services like compliance reporting, news aggregation, and other similar services are an important part of today's trading ecosystem and must therefore be explicitly permissible under the regulations.
These rules are redundant to the level already covered by judicial decisions and regulatory steps in India. Karvy Stock Broking Fraud in 2019 and the Anugrah Stock & Broking Case in 2020 have led to stricter rules on collateral management, daily reporting, and real-time monitoring of client funds. In the HDFC Securities Margin Fraud, client fund management rules were violated by Client Margins for its trading. SEBI responded by reinforcing its requirement for segregation of Client and proprietary accounts while pushing for electronic monitoring and corporate governance failures at the broader level. SEBI’s swift response to these scandals—introducing measures like Demat Debit and Pledge Instructions (“DDPI”) and mandatory upstreaming of client funds—has significantly reduced the scope for misuse of client assets.
The present meaning of Rule 8 would kill the ingenuity of the broker to evolve in response to new market scenarios. Broadening the framework to allow financial services and ancillary activities would help brokers maintain their competitive edge while adhering to the SEBI aim of protecting investors. This would also ensure India is on par with global best practices in securities regulation.
Contrasting SEBI’s rules with the EU’s MiFID II
Global markets provide a more balanced view of broker supervision, contrasting compliance with understanding broker's limitations.
EU’s MiFID (Markets in Financial Instruments Directive-II) promotes investor protection and boosts investor confidence without unnecessarily stifling brokers, but also faced challenges in its initial phases where initially a tiered approach was not followed. However, after 2018, the small and medium-sized brokers and independent brokers were also unable to keep up with the MiFID-II’s stringent reporting demands. It was evidenced in the EU, in 2018, that only the largest investment firms prevailed in the wake of stricter measures. The EU was required to review the MiFID in 2020, and they finalized amendments in October 2023. The EU’s MiFID II mandates capital requirements but offers more flexibility regarding the net worth assessment. Investment firms are categorized based on their activities, with lighter capital requirements for smaller firms, providing them more breathing space. These proportional capital requirements were designed to reduce the burden on firms that do not pose a systemic risk.
There are now 3 classes of investment firms in the EU, based on their size, class-I firms (systemic and large), class-II firms (non-systemic), which are smaller and have proportionate requirements, and class-III firms that are small and interconnected and have lighter reporting requirements. This ensures that smaller firms aren't overburdened, as keeping high capital reserves could undermine operational flexibility. At the same time, regulatory authorities can ensure large firms remain stable. Through these amendments, they introduced a proportionality principle when it came to regulation.
MiFID II introduced new requirements for firms to disclose all costs and charges associated with investment products and services, making it clearer for clients how much they are paying and what for, this is especially crucial in India with several brokerage firms offering attractive returns but bogging clients down with hidden costs and fees. Firms in the EU must also explain the cumulative impact of costs on client investments over time, providing a clearer picture of long-term expenses, a provision Indian investors could benefit from as well.
Why would SEBI’s Rule 8 SCRR benefit from the EU’s Approach?
This becomes a significant lesson for Rule 8, as it introduces its compliance framework that allows specified due diligence for stock brokers depending on their size. The changes created in the MiFID-II, if adopted in the Indian scenario, would also be adequate in dealing with companies like Groww & Zerodha, which provide a plethora of services in addition to brokerage. SEBI could benefit from a similar tiered approach that was introduced, smaller brokers could benefit from less stringent rules when it comes to providing investment advice and trading non-equity instruments. There could be different levels of oversight introduced depending on the size of the brokers, the smaller the broker, the more leeway when it comes to non-core businesses.
Segregating client funds would ensure that brokers do not put their clients’ securities and money in jeopardy when making non-core business investments, an activity the client may not have signed off for. As long as the maintenance of client fund segregation is as per the SEBI regulation, there is no harm in allowing brokers to pursue non-core businesses like real estate investments and commodities trading. The model of these circulars by SEBI is already strict enough to protect client funds, as they have been created through the cases mentioned above.
In the USA as well, tiered capital requirements allow for brokers to conditionally engage in non-core businesses, based on the following three main rules of the SEC/FINRA: firstly, the client funds are not used; secondly, adequate capital reserves as per the Net Capital Rule are maintained; and finally, that the broker complies with the transparency requirements. Without learning from the impact of the 2018-2020 MiFID-II period, the SEBI is likely to commit the same mistakes in disproportionately impacting and sending smaller brokerages out of business, a pattern that was seen in the EU.
Critiquing the Proposed Annexure 8 to Rule 8 of SCRR
The Ministry of Finance, through its finance and markets division, released proposed amendments to Rule 8 of the SCRR in September of 2024. This working paper highlighted the key issues in Rule 8 and proposed amendments. The first Amendment was to Rule 8 (1)(f) and 8(3)(f), which stated that it shall not be construed as “any business” unless it includes client funds or securities, or creates undue financial liability on the broker. These amendments try to address the issue of broker freedom but fail to do it proactively enough to provide a framework within which both brokers and clients are adequately safeguarded.
The proposed amendments to sub-rules 1 and 3 only address that activity by the broker shall not be considered a business unless it involves client funds or securities, or creates a financial liability to the broker. This provision can be improved by introducing a tiered system. Like in other global frameworks, a tiered framework ensures smaller brokers are not bogged down by compliance and restriction, while larger brokerage firms can be kept in check.
The board must consider a methodology to categorize brokers, the size of the broker could be computed using net worth, number of clients, or types of ancillary services provided. Further, SEBI must keep in mind multi-service platforms like Groww, and Zerodha while making such changes, as they delve into other business activities other than just brokerage. In the online world, the market is more than just trading, it is also diversifying into many other facets.
As for client and investor protection, the SEBI circulars provide a comprehensive framework that could be improved by providing tiered compliance structures. Mainly because these circulars came out as a direct response to cases that caused disruption and faced investors with undue risks; thus these circulars are comprehensive in dealing with the challenges that may come up.
Conclusion
Summarily, these provisions could be further improved and streamlined to allow for broker freedom while also ensuring that clients are protected. The cases discussed demonstrate that the current provision and its amendment are neither sufficient in dealing with investor protection nor afford brokers freedom with safeguards. The most crucial takeaway from analyzing these provisions is that SEBI must understand that for a thriving market, brokers must have enough legroom, the board only acts as the guardrail between freedom and fraud.
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