Restriction On Stock Brokers From Engaging In Other Businesses

Restriction On Stock Brokers From Engaging In Other Businesses

Regulators in India are increasing looking at the businesses of entities and seeking to restrict the business activities to specified categories that they believe should be carried out by such regulated entities. One such interesting case relates to the activities of a registered stock broker in India.

The Bombay High Court on July 24, 2024, stayed an order passed by the National Stock Exchange of India Ltd. (“NSE”) against Kotak Securities Limited, in relation to the stock broker engaging as a principal in a business other than securities which involved personal financial liability to the broker.

The NSE in its order dated October 13, 2023, observed that Kotak had made investments in four associate companies in an aggregate amount of INR 6.24 billion as of March 31, 2022. The NSE held that the investments made by the entity were in violation of Rule 8(3)(f) of Securities Contracts (Regulation) Rules,1957 (“SCRR”), read with NSE Circular dated January 7, 2022 (“NSE Circular”), as the investments were neither in connection with, nor incidental to nor consequential upon the securities or commodities derivatives business of the entity, nor was the entity acting as a broker or agent. The NSE had imposed a penalty of INR 500,000 on the entity and directed it to submit a restructuring plan related to the divestment of the investments within 45 days of the date of the order.

SCRR

Rule 8 of SCRR relates to the qualification for membership of a recognized stock exchange while sub-rule 8(3) provides for continuous compliance requirements by a member of the stock exchange. Rule 8(3)(f) of SCRR specifies certain restrictions on the conduct of business by a stock broker. The Madras High Court, while interpreting Rule 8(3)(f) of SCRR in The Madras Stock Exchange Limited v. S.S.R. Rajakumar, held that the Rule has two parts. “The first part prohibits the Member of the Exchange from being the principal or employee of any business other than that of securities. The second part permits his functioning as a broker or agent in a business other than securities, provided he does not incur any personal financial liability by functioning as such broker or agent.”

As a result, a stock broker should not be engaged in any business unconnected with securities business which may impose a personal financial liability on the stock broker. However, the term “any business” has not been defined under the SCRR or in circulars issued by the Securities and Exchange Board of India (“SEBI”) or the NSE.

ANALYSIS OF THE TERM ‘ANY BUSINESS’

The SEBI had issued a circular on May 7, 1997 clarifying that borrowing and lending of funds by a stock broker, in connection with or incidental to or consequential upon the securities business, would not be in violation of Rule 8(1)(f) and 8(3)(f) of the SCRR. However, it did not elaborate further on the scope of the term ‘any business’ in this circular.

An early attempt by the SEBI in 2017 to define the term ‘any business’ in the context of Rule 8(3)(f) of SCRR was in the matter of Geojit BNP Paribas Financial Services Ltd. The question was whether the loan given by the stock broker to its subsidiary can be treated as a business activity. While answering the question, SEBI held that “to be classified as business activity there should be several activities with several clientele” and thus concluded that loans given by the stock broker to its subsidiary cannot be treated as a business activity and therefore not a violation of Rule 8(3)(f) of SCRR.

However, when a similar issue arose in the matter of Inventure Growth and Securities Ltd. decided on November 14, 2022, the SEBI held that “the word “business” in Rule 8 (3)(f) of SCRR has to be interpreted in a broader sense so as to rule out any activity/affairs of a trading member which may result in creating personal financial liability for the trading member that may cause prejudice to the interests of its investors clients. It is immaterial whether the other activity/affairs of the trading member was restricted to its related parties or it was temporary in nature.” Accordingly, the SEBI held that the stock broker, by extending loans to its subsidiary had engaged in a business activity other than that of securities, thereby violating Rule 8(3)(f). From the above, it appeared that the number of the transactions was not material in order to determine whether any activity is considered a ‘business activity’ and one yardstick was that the activity should result in imposing personal financial liability on the stock broker.

One of the aspects of an interpretation of the term ‘any business’ under Rule 8(3)(f) of SCRR is whether it includes “investments” made by the stock broker. The NSE Circular has given an illustrative list of activities that would be construed as non-compliance with Rule 8(1)(f) and 8(3)(f) of SCRR and investments made in group companies such as subsidiaries and associates, not in connection with or incidental to or consequential upon the securities or commodity derivative business, is one such restricted activity.

WHETHER ‘INVESTMENTS’ CAN BE CONSIDERED ‘BUSINESS’

The Securities Appellate Tribunal (“SAT”) in the matter of Magnum Equity Broking Ltd. v. NSE dated November 29, 2023 while considering whether a temporary investment of its surplus funds by a stock broker would amount to business, held that investment of surplus funds generated from the securities business cannot lead to an inference that the stock broker is engaged as a principal in business other than that of securities involving personal financial liability.

RECENT DEVELOPMENT

During the appeal from the NSE Order before the Bombay High Court, the Union of India (“Government”) took a different stance than the NSE. In its affidavit filed before the High Court, the Government submitted that “In the normal course, investment of surplus funds and conducting of business are generally to be considered separate activities.” Further, the Government was of the view that from the perspective of protecting the integrity of the securities market, there may need be limits imposed on the surplus funds that can be invested by the stock broker. The Government proposed that it would issue a consultation paper on this matter and invite comments from market participants, including the SEBI and the stock exchanges.

CONCLUSION

The expression ‘any business’ has been interpreted to include within its scope any activity which is carried on systematically and requires skill and / or labor, as distinguished from pleasure and need not necessarily be carried on with a profit motive. In the context of Rule 8(3)(f) of SCRR, considering SCRR does not define the term ‘any business’, the purpose for which the rule was drafted, assumes relevance. One of the purposes, apart from prevention of misuse of client’s funds, was to ring-fence the primary activity of the stock broker by preventing the stock broker from incurring any of personal financial liability by engaging in other business in order to protect the interests of its clients and the integrity of the securities market.

On the question of whether investments by the stock broker should be considered to be a business in the context of Rule 8(1)(f) and 8(3)(f) of the SCRR, a balance needs to be struck between the investment activity of the stock broker and its primary business to ensure that the stock broker is exercising due skill, care and diligence in the conduct of its primary business. Although in Magnum Equity Broking Ltd., the SAT held that investment of surplus funds is a distinct activity compared to carrying on a business, necessary guardrails need to be put with respect to the investment activity of the stock broker with a view to maintain the sanctity of the primary business of the stock broker. Some of them can be in the form of a quantitative threshold on the amount that can be invested from the surplus funds and a condition that the stock broker is required to maintain an audit trail of surplus funds.

The Government recently issued a public consultation paper inviting comments from the public for amendments, if any, to Rule 8(1)(f) and 8(3)(f) of SCRR. In the consultation paper, the Government has suggested that a proviso may be inserted to the above Rules stating that “investments made by a member shall not be construed as business except when such investments involve client funds or client securities or relate to arrangements which are in the nature of creating a financial liability on the broker.”

The proposed amendment by the Government is welcome. It brings clarity to the provisions of the SCRR and prevents protracted litigation in future. It would help protect the interests of clients of the stock broker and also meet the commercial requirements of the stock broker. In the overall context of the permissible business activities of a stock broker, the stock broker should review its investments in light of the increased regulatory scrutiny.