The Securities and Exchange Board of India (“SEBI”) has held that preventing and detecting fraud or market abuse is a key pillar of investor protection. Consequently, SEBI has been relentless in introducing and amending rules, regulations, and circulars to regulate practices tantamount to fraud or market abuse.
In line with this effort, on June 27, 2024, SEBI notified the SEBI (Stock Brokers) (Amendment) Regulations, 2024 (“Amendment”). The Amendment inserted a new chapter in the SEBI (Stock Brokers) Regulations, 1992 (“Stock Broker Regulations”), titled “Institutional Mechanism for Prevention and Detection of Fraud or Market Abuse”.
In this article, we delineate the various obligations placed for detection of frauds and setting up of surveillance mechanisms. We also discuss key steps the stockbroker may take to comply with these obligations.
Surveillance and customer identification obligations by stockbrokers
In February 2023, to solicit comments from securities market participants, SEBI issued a consultation paper on an institutional mechanism for stockbrokers to ensure prevention and detection of fraud or market abuse (“Consultation paper”).
The objective of the mechanism, inter alia, is to hold broking firms and their senior management accountable for such detection / prevention of fraud or market abuse and setting up of robust surveillance and control systems.
Consequently, SEBI issued this amendment, placing the following obligations on stockbrokers ensure the following:
- Internal controls and procedures regarding surveillance systems
- Client identity verification and potential mule accounts detection
- Surveillance systems and internal controls for monitoring trades and fraud reporting
- Whistleblower policy and mechanism
- Suspicious activity escalation and reporting mechanism
Internal controls and procedures regarding surveillance systems
Brokers will now mandatorily maintain policies and procedures relating to the surveillance systems and internal controls.
The amendment delineates that the policy clearly define the roles and responsibilities of the stockbroker’s employees to identify and prevent fraud and market abuse. As part of the policies, they also have to document the procedure for reporting the instances identified.
It would be advisable to include as part of the policy the rationale behind setting the thresholds, the review process and frequency, and the procedure for dealing with false positives.
As this is a new requirement, most stockbrokers likely do not have policies regarding surveillance systems and internal controls, hence the amendment mandates that they not only draft and implement new policies and procedure but also obtain necessary approvals.
Client identity verification and potential mule accounts detection
The Prevention of Money Laundering Act, 2002 (“PMLA”) along with the Prevention of Money Laundering (Maintenance of Records) Rules, 2005 (“PML Rules”), mandate intermediaries in securities market to perform Client Due Diligence. “Know Your Customer” (“KYC”) records, which include the details submitted for the client’s account opening, play a crucial role in ensuring Client Due Diligence. Aligning with this requirement, SEBI had, among other things, mandated that stockbrokers perform KYC checks at the time of account opening and update the same in accordance with the regulatory requirements.
The amended regulations have broadened the scope of this requirement. Regulation 18G(1) of the amended regulations mandate that stockbrokers now establish and maintain “know your client surveillance systems”. However, neither the amended regulations nor the consultation paper mentions the minimum requirements or capability of the system.
The requirements apply not only to clients but also to persons proposing to have accounts with the stockbroker.
The amended regulations, among other things, mandates that the stockbroker establish processes and system to detect mule accounts and document these processes and systems.
Thus, it is advisable that stockbrokers have a robust policy in place, which shall, among other things, document the various roles and responsibilities and procedures the stockbroker has implemented to ensure compliance.
Surveillance systems and internal controls for monitoring trades and fraud reporting
One of the mandates in the amended Stock Broker Regulation expects that the stockbroker to put in place adequate systems for surveillance of trading activities and internal control systems to detect, prevent, and report potential fraud or market abuse by its clients, employees, or authorised persons.
The Regulation 18E(b), alsostates that “fraud” retain the same meaning as assigned under SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 (“PFUTP Regulations”). Regulation 2(c) of the PFUTP defines “fraud” in an inclusive manner to include any act undertaken to induce another person to trade in securities. The act will amount to fraud, irrespective of whether or not it was done in a deceitful manner and whether or not it involved wrongful gain or avoidance of loss.
Additionally, Regulation 18E(e) of the amended Stock Broker Regulation defines “market abuse” as a manipulative, fraudulent, and unfair trade practice including through a mule account.
Although the amendment prescribes that the broker’s surveillance system detect and prevent probable fraud and market abuse, it does not describe the scenarios the surveillance system needs to monitor. Relying on SEBI’s consultation paper, which has prescribed a minimum list of instances/indicators of fraud or market abuse, the broker’s system should be equipped to monitor (including but not limited to) the creation of misleading appearance of trading, price manipulation, front running, insider trading, mis-selling, unauthorised trading, pump-and–dump, and spoofing.
The amendment mandates that the surveillance system detect potential market abuse not only by clients but also by employees and authorised persons.
Whistleblower policy and mechanism
The amendment mandates that stockbrokers document and implement a whistleblower policy to provide, among other things, a channel to raise concerns about (including but not limited to) violations of legal requirement or governance vulnerabilities. The whistleblower policy shall extend not only to the stockbroker’s employee but also to a wider set, i.e., the stakeholders.
This policy shall also extend adequate safeguards to the whistleblowers.
The amendment also provides a reporting matrix for whistleblower complaints, among other things, stating that complaints received against the designated person the Audit Committee or any analogous stockbroker bodies, while complaints received against other employees shall be addressed by the Compliance Officer.
Suspicious activity escalation and reporting mechanism
The amendment also mandates that stockbrokers report to the stock exchanges the suspicious activities within forty-eight hours of detection. Therefore, it is advisable that stockbrokers have robust processes in place to document the exact time of detection of the suspected activity.
In addition to this event-based reporting, stockbrokers are mandated to conduct and submit a half-yearly reporting to the stock exchange, summarising the suspicious activities identified and the subsequent actions taken.
Although the amendment mandates that stockbrokers report suspicious activity, it does provide any clear modalities on the reporting procedure.
Onus placed on Key Managerial Persons and Designated Directors
The Amendment places the onus of compliance not only on the stockbroker but also on key managerial personnel, designated directors as per PMLA and rules thereunder, senior management, Board of Directors, and other persons of analogous rank (“designated persons”).
Following are the key obligations placed on the designated person:
- The Board of Directors or persons of analogous rank are mandated to review systems, processes and control procedures in place at least once a year, with the mandatory review extending not only to the system and controls introduced by this amendment, but also across all the systems and internal controls.
- The Board of Directors or Audit Committee or person analogous to the same shall also review the compliance with the requirements introduced in this amendment.
Conclusion
This amendment places major obligations on stockbrokers to detect and prevent fraud. As stockbrokers must also report to the Exchanges all suspicious activities their surveillance systems identify, it could lead to the Exchanges or SEBI initiating investigations.
While this is a step in the correct direction to curb fraudulent practices and enhance the KYC mechanisms, implementing these obligations will be an uphill battle for most stockbrokers.
For further information, please contact:
Sara Sundaram, Partner, Cyril Amarchand Mangaldas
sara.sundaram@cyrilshroff.com
