Sucheta Dalal :More loopholes in the depository system
Sucheta Dalal

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More loopholes in the depository system  

Mar 27, 2006

A variety of systemic problems have cropped up in the depository system that need to be addressed through regulatory intervention.


By Sucheta Dalal


On Friday, a pink newspaper reported that the Securities and Exchange Board of India (Sebi) had asked banks to dematerialise shares pledged as collateral in order to prevent fraud. This advice was reportedly based on the regulator’s finding that some listed companies had obtained duplicate shares after the originals were pledged with banks and then sold the duplicates in the secondary market making a neat profit.

If the regulator has indeed found such a fraud, it is outrageous. It is well known that the conversion of physical shares into electronic form nearly seven years ago had provided a one-time opportunity for all kinds of defective paper and faulty transfer deeds to be cleaned up. One example is the infamous ‘benami’ shares of the 1992 scam which are never talked about anymore, because most of them were laundered in the dematerialisation process in collusion with share transfer departments of companies.

Subsequently, two other kinds of mischief were detected. The first racket was one where company promoters dematerialised share in excess of the company’s issued capital. The best known example was DSQ Software, where Dinesh Dalmia issued 50% extra capital in the year 2000, under the guise of making a preferential offering to three Mauritius-based companies. He also delivered physical shares with the same series of distinctive number to his Kolkata cohorts. This case is still under Sebi’s scrutiny.

Several other promoters were caught having dematerialised shares in excess of their issued capital and some of them were asked to buy back the shares from the open market and extinguish them. The second racket was that of investors pledging shares with banks and getting the same shares reissued as duplicates. I recollect that banks were asked to accept such pledges only in electronic form nearly five years ago. If banks have continued to accept physical share certificates then this needs investigation and punishment not a bland circular. Clearly, banks could not have accepted physical certificates as a pledge without an element of collusion with the borrowers. The multiple application fraud, perfected by Roopalben Panchal, ought to activate the Reserve Bank of India to start another investigation into the pledge of shares.

After the National Securities Depository Ltd (NSDL) went on record to claim, post the demat scam, that it is not a self regulatory organisation (SRO), Sebi has started to assume greater responsibility for monitoring and investigating the depository system. Part of this process is a systems audit of the NSDL; but clearly a lot needs to be done.

Earlier this week, I reported that the Income-Tax Department had exposed how the depository system was used to launder several hundred crore rupees of black money. It also discovered that there is absolutely no check on frequent dematerialisation and re-materialisation of shares.

IT sleuths even found one company with a paid up capital of Rs 7.3 crore, which showed Rs 20 crore worth of rematerialisation/dematerialisation in the last two years (this is conversion from physical share certificates to electronic entries and vice versa). This is another systemic loophole that needs to be plugged by the regulator.

It is patently clear that there are glaring design deficiencies in the depository system, which



ought to have been configured to throw up various alerts to detected multiple applications or frequent and excessive re-materialisation of shares. An insider with a top Depository Participant (DP) points to another investor related problem. He has sent me a list of eight companies which are flagged as defaulters for failing to comply with demat requests for over two years.

The list starts with Alexcon Foamcast, which has a request pending from July 2003, to Anil Products, which has a request pending from September 2004. This is only a partial list that includes Otoklin, Arihant Industries, Sharp Industries, Punsumi India equity, Shree Acids and Opal Industries.

What does this long pending demat default mean? It means that some investor has taken the trouble to open a demat account with a DP, paid the requisite fees, complied with all the conditions and handed over her physical shares in these companies for dematerialisation. Two years later, the investor is probably running around trying to get the shares dematerialised, or has simply given up the struggle.

Can a system that had made dematerialisation mandatory for secondary market transactions allow companies to have such long pending demat defaults? Who is responsible for ensuring 100% compliance? And what action has been initiated against such companies? As far as I know, this list of defaulters is not even in the public domain, unlike those of companies with investor complaints pending against them.

If there are no investor complaints about this delay, that too raises several questions. According to my sources, Sebi should design an integrated system that flags violations of

its guidelines and procedures even before an investor is forced to complain. This can be done by configuring the depository system to throw up appropriate alerts when various processes are pending beyond a certain time limit. An industry insider says, “Today, none of the capital market processes operate on auto-feedback through an integrated digital interface. Everything happens in post-mortem mode where investors are forced to run from pillar to post - from exchanges/depositories to Sebi in order to have their grievances redressed”. Technology today allows the regulator to achieve a lot more though monitoring systems, but despite India’s claimed Information Technology prowess, nothing changes unless there is a problem.

A powerful, IT based monitoring system that operates on a “Global RFI (request for information)”, will also allow various regulators such as RBI, Sebi, and the insurance and commodity regulator to share information effectively and improve surveillance across markets to make them safer.

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-- Sucheta Dalal