Abstract
The Hon’ble Bombay High Court has stayed the contentious clause of the NSE’s circular1 that barred investments in group companies, noting the Ministry of Finance’s stance that the circular was issued without any consultation and expanded the scope of Rule 8 of the Securities Contracts (Regulation) Rules, 1957 (“SCR Rules“). This challenge to the NSE circular is currently pending before the Bombay High Court in the case of Kotak Securities Limited v. National Stock Exchange of India Ltd. [Writ Petition No. 25 of 2024, dated 24-7-2024].
While the proceedings are pending before the Bombay High Court, Ministry of Finance (Department of Economic Affairs) has come out with a consultation paper2 dated September 10, 2024 for public comments on Rule 8 of the SCR Rules. The purpose of this article is to trace the history and varied implementation by SEBI and stock exchanges, highlighting the need to amend Rule 8 of the SCR Rules to create ease of doing business and regulatory certainty.
The Call for Uniformity in Independent India
Post Independence of India, Ministry of Finance, Government of India in its report on the regulation of Stock Market in India (P.J. Thomas Committee, 1948) had noted:
“Unlike the exchanges under A group, no exchange in this group with the exception of two, namely the Calcutta Stock Exchange and the U. P. Stock Exchange, Cawnpore, prohibits its members from engaging in any other profession along with the membership of the exchange. Members of Calcutta Stock Exchange and the U. P. Stock Exchange are strictly forbidden from engaging whether as principal or employee in any other profession other than stock-broking. But members of every exchange are forbidden from becoming members of any other rival exchange in the same town; they are prohibited even from doing any trade in stocks and shares with the members of the latter.”
While noting the above, the P.J. Thomas Committee had recommended uniformity to be brought in by the Government of India by framing appropriate rules.
The Origins and Intent of Rule 8(1)(f) and 8(3)(f)
The Securities Contracts (Regulation) Act, 1956 (“SCRA“), along with the Securities Contracts (Regulation) Rules framed thereunder, forms the cornerstone for regulating the functioning and oversight of stock exchanges and their members in India. One of the critical provisions in these rules is Rule 8, which sets out the criteria for admission [Rule 8(1)(f)] and continuation of membership [Rule 8(3)(f)] in recognized stock exchanges. While Rule 8(1)(f) has not been as contentious, Rule 8(3)(f) has attracted significant scrutiny. The distinction lies in the practical difficulty for an applicant to challenge Rule 8(1)(f) when initially seeking membership or registration as a stockbroker with SEBI, whereas after admission, Rule 8(3)(f) can become a disqualification for continued membership. Notably, Rule 8(3)(f) specifically addresses the conduct expected of members to maintain their membership status. This article delves into the intricate interpretation and application of Rule 8(3)(f) over the years by SEBI, stock exchanges and the Securities Appellate Tribunal and questioning whether stock exchanges regulated by SEBI have potentially misconstrued its true purpose of the said rule. Through a detailed examination of legal provisions, regulatory directives, and judicial precedents, the article aims to unravel the complexities surrounding Rule 8(3)(f) and its implications for market participants and regulatory authorities.
Analysing Rule 8(3)(f): Key Provisions
Rule 8(3)(f) stipulates that a member of a recognized stock exchange must not engage in any business other than that of securities or commodity derivatives, except as a broker or agent not involving any personal financial liability. The same is reproduced:
“Qualifications for membership of a recognized stock exchange.
8. The rules relating to admission of members of a stock exchange seeking recognition shall inter alia provide that :
…
(3) No person who is a member at the time of application for recognition or subsequently admitted as a member shall continue as such if—
…
(f) he engages either as principal or employee in any business other than that of securities or commodity derivatives except as a broker or agent not involving any personal financial liability, provided that—
(i) the governing body may, for reasons, to be recorded in writing, permit a member to engage himself as principal or employee in any such business, if the member in question ceases to carry on business on the stock exchange either as an individual or as a partner in a firm,
(ii) in the case of those members who were under the rules in force at the time of such application permitted to engage in any such business and were actually so engaged on the date of such application, a period of three years from the date of the grant of recognition shall be allowed for severing their connection with any such business,
(iii) nothing herein shall affect members of a recognised stock exchange which are corporations, bodies corporate, companies or institutions referred to in items (a) to (n) of sub-rule (8)”
(emphasis supplied)
This rule is applicable even during the process of seeking membership with any stock exchange. This is because Rule 8(1)(f), which addresses eligibility for membership election, stipulates that individuals seeking membership should not engage as principal or employee in any business other than that of securities or commodity derivatives except as a broker or agent not involving any personal financial liability unless he undertakes on admission to sever his connection with such business.
Historical Context: The Evolution of Rule 8(3)(f)
Before going into the history of the said rule, one can also question the applicability of the said rule to either individual members or corporate members or both. The language of Rule 8 and the provision embodied thereunder may indicate that Rule 8(1)(f) and 8(3)(f) may be applicable only to individual brokers. The same can be inferred from provisions under Rule 8. Rule 8(1) and Rule 8(3) use the term ‘person,’ which, in the context of these provisions, refers to an individual human being rather than corporations or other business entities. This is further underscored by the fact that Rule 8(4) and Rule 8(4A) pertain to companies, Rule 8(5) applies to firms, and Rule 8(6) addresses limited liability partnerships. Therefore, the restrictions outlined in Rule 8(1)(f) and Rule 8(3)(f) are, therefore, only relevant to individual members and not to corporations or other institutions. At the extent time, Rule 8(1) and Rule 8(3) was also linked to other eligibility criteria such as minimum ‘age of 21 years’ and being a ‘citizen of India’. The same was also discussed in the Ministry of Finance’s Report of the High Powered Committee on Stock Exchange Reforms of 1984 (Chaired by G.S Patel).
What was meant to be, has lost its meaning by different views by SEBI and exchanges over the years in various inspections and enforcement proceedings leading to increased litigation and regulatory uncertainty.
Nevertheless, the said provisions have been in existence since the enactment of the SCR Rules which primarily focuses to prevent conflicts of interest and ensure that members remain focused on their primary role within the exchange, thus maintaining the integrity and smooth operation of the stock exchange. It was to introduced to mitigate risks to the interests of trading members’ clients.
Since 1993, SEBI has emphasized the clear segregation between clients’ funds and those belonging to the broker. This delineation was reinforced through a circular dated November 18, 1993, wherein SEBI prohibited stockbrokers from utilizing clients’ funds for purposes other than their designated transactions.3
On April 27, 1995, SEBI reiterated the enforcement of Rule 8(1)(f) and 8(3)(f) to corporate members. In a letter, SEBI directed all corporate members to promptly “sever connections with businesses other than securities business” and requested NSE to provide a report on compliance.4
Over time, SEBI and the Stock Exchanges, under SEBI’s guidance, have issued numerous circulars and directives clarifying the scope and application of Rule 8(3)(f). One such significant clarification was issued by SEBI in 1997, explicitly stating that borrowing and lending of funds by a trading member, in connection with or incidental to or consequential upon the securities business, would not be treated as a disqualification under Rule 8(3) (f) of SCR Rules.5
SEBI has also issued several orders for violations of Rule 8(1)(f) and 8(3)(f) over the years. Notably, some of the earliest cases involved actions against members of the Calcutta Stock Exchange for extending loans from clients’ accounts to other brokers6 and against another member for having been indulged in lending and borrowing of funds despite adequate credit balances in clients’ accounts, funds were borrowed, lent, given, and received without any accompanying share transactions.7
Regulatory Challenges: The Misinterpretation of ‘Business’
It is crucial to analyze the limitations set forth in Rule 8(3)(f) regarding the involvement of stockbrokers or members of a stock exchange in activities beyond stock broking. Rule 8(3)(f) reads as “he engages either as principal or employee in any business other than that of securities or commodity derivatives except as a broker or agent not involving any personal financial liability”
Therefore, any stockbroker:
(a) Cannot engage as a principal or employee in any business other than securities or commodity derivatives;
(b) If he is engaged as either as a principal or employee in any business other than that of securities or commodity derivatives, such a business cannot be in capacity as a broker or agent;
(c) Such a business shall not involve any personal financial liability.
Hence, a thorough examination of the provision reveals that to ascertain any breach of Rule 8(3)(f), the initial step is to establish whether the activity under consideration constitutes a ‘business.’ Once confirmed, the subsequent evaluation involves determining whether the business activity in which the member engaged as a principal or employee was ‘other than that of securities or commodity derivatives, except as a broker or agent.’ Finally, it must be examined whether this activity would create any ‘personal financial liability.’ Only if these criteria are met can the member be said to have contravened the rule.
In 2015, SEBI clarified that “business in goods related to the underlying” and/ or “business in connection with or incidental to or consequential to trades in commodity derivatives”, by a member of a commodity derivatives exchange, would not be disqualified under Rule 8(1)(f) and Rule 8(3)(f) of SCR Rules.8
As previously mentioned, the accurate interpretation of the rule entails initially determining whether the broker’s activity qualifies as a ‘business.’ Thus, the question arises: would actions such as investing in subsidiaries or providing loans from funds other than clients’ funds be categorized as a ‘business’? While the term ‘business’ is not explicitly defined in either the SEBI Act, 1992, or the SCRA, 1961, reference can be made to the Income Tax Act, 1961. Section 2(13) of the Income Tax Act defines business as encompassing ‘any trade, commerce, or manufacture, or any adventure or concern in the nature of trade, commerce, or manufacture.’ Neither providing loans nor making investments typically fall within this definition of business. Even the Hon’ble Supreme Court in the case of Bengal & Assam Investors Ltd. v. CIT 9 had stated that “the assessee, be it an individual or a company or any other entity must carry on business in respect of shares; that is to say, the assessee must deal in those shares. It is evident that if an individual person invests in shares for the purpose of earning dividend he is not carrying on a business. The only way he can come under s. 10 is by converting the shares into stock-in-trade, i.e. by carrying on business of dealing in stock and shares as did the assessee in CIT v. Bai Shirinbai K. Kokka[1962] 46 ITR 86 (SC).”
Thus, making mere investment in shares cannot be considered as business to be considered as violation of Rule 8(3)(f).
SEBI’s Clarification of Rule 8(3)(f)
In the matter of Anugrah Stock Broking Pvt. Ltd, SEBI vide order dated March 28, 2023 interpreted Rule 8(3)(f) of SCR Rules to mean that the same can only attract upon satisfaction of the following three conditions:
“18. Upon examining Rule 8(3)(f) of SCRR along with the relevant clarifications issued by SEBI, it is observed that for a business to be disqualified in terms of Rule 8(3)(f) of SCRR, the following three parameters have to be satisfied:
18.1. The other business in question should not be the primary dominant activity of the intermediary i.e. it cannot be securities business.
18.2. The other business in question should not be in connection with or incidental to or consequential upon the securities business.
18.3. The other business in question should incur financial liability for the intermediary.”
(emphasis supplied)
It is SEBI’s own stand that an activity is deemed to contravene Rule 8(3)(f) only if such business (which is not primary dominant activity and not in connection with or incidental to or consequential upon the securities business) incurs financial liability for the intermediary. Investing in any company or providing loans to third parties from surplus funds by a member broker cannot be deemed to incur personal financial liability. Liability arises only when an amount is owed to a third party, and not otherwise.
Other Regulatory Precedents and Interpretations
In the case of Geojit BNP Paribas Financial Services Limited10, the Adjudicating Officer, SEBI had held that in case of usage of surplus fund to give advances, violation of Rule 8(3)(f) of SCR Rules will not be attached and the following was observed:
“18. I note as per law there is no restriction on the inter corporate loans given by a SEBI registered intermediary. An inter-corporate loan given by a stock broker out of the surplus funds, which exceed the minimum networth requirement applicable to stock broker as well as the working capital requirement for its business, as a temporary financial accommodation would not pose the risk to the business of the stock broker and affect the clients dealing with them. The main purpose of rule 8(3)(f) of SCRR was to prohibit the brokers to invest the clients’ money in other businesses. However, in the present case, there is a clear demarcation of the clients’ fund and its own fund. The loan that was advanced to GCPL was the excess fund of the Noticee. In no way was the fund of the client used to advance loan to the subsidiary. The clients’ money was never exposed to any risk. The Noticee extended loans from its own excess funds”
(emphasis supplied)
Even under the informal guidance issued to HDFC Securities Limited dated February 14, 2022 where HDFC proposed to refer its clients to third party RIAs and receive referral fees from them and to this SEBI had stated that ‘in absence of any personal financial liability, the said referral activity would not attract the prohibition prescribed under Rule 8(3)(f) of the SCRR, 1957 and there is no bar for HSL, acting as a broker/distributor, to tie up with third party RIAs to offer advice to its distribution clients.’
Stock Exchanges’ Expanded Interpretation and Regulatory Conflicts
However, recently the scope of the said rule has been expanded by the Stock Exchanges by way of issuing clarificatory circulars and there also have been conflicting decisions by SEBI in past with respect to interpretation of this rule especially in cases where inter-corporate loans have been given out of surplus funds by the member. Reference is drawn to NSE’s and BSE’s circular dated January 27, 202211 wherein these stock exchanges have expressly prohibited extending loans or giving deposits / advances to any entity, including group companies such as subsidiaries & associates and also investing in such companies which are not in connection with or incidental to or consequential upon the securities/ commodity derivatives business. The same are reproduced below:
“9. Entering into any arrangement for extending loans or giving deposits / advances to any entity, including group companies such as subsidiaries & associates etc., not in connection with or incidental to or consequential upon the securities/ commodity derivatives business
10. Investments made in group companies such as subsidiaries & associates etc., not in connection with or incidental to or consequential upon the securities/ commodity derivatives business. (Ex: Investment in companies engaged in other businesses such as NBFC, Real Estate etc.)”
Thus, these clauses inserted by the exchanges clearly expanded the scope of the provision which never prohibited making any investment or providing a loan out of brokers own funds. The penalty imposed by NSE for violation of Rule 8(3)(f) is Rs. 5,00,000/- + Direction to recover the loans extended to the entities within 3 months from the date of the order failing which member / stock broker will be prohibited from registering new clients.12
The SEBI circular dated May 07, 1997, was designed to facilitate ease of doing business by granting permissions rather than imposing restrictions. This indicates that SEBI intended for the provision to be interpreted liberally rather than strictly. However, NSE’s circular broadens the scope of the provision beyond what was stipulated by Parliament or SEBI, which contradicts the legislative intent. Despite referencing the SEBI circular dated May 07, 1997, the NSE circular imposes a restrictive interpretation and includes an illustrative list of prohibited activities for its members which is neither provided under any of the SEBI Circulars or SCR Rules.
Concerns Over Overreach and Legislative Intent
Upon examination of Rule 8(3)(f) and the SEBI Circular dated May 07, 1997, it becomes apparent that the legislature’s intent was never to prohibit brokers from investing their own funds but rather to restrict their ‘business’ activities. Investment cannot reasonably be categorized as ‘business’. It is well settled that a circular cannot broaden the scope of a provision, and subordinate legislation cannot restrict the parent statute and if the legislature intended to prohibit brokers from investing their own funds, it would have expressly stated so in the provision itself.
Even in 2021, based on the direction of SEBI, NSE issued a circular dated August 10, 2021 prohibiting its members to provide a platform to their clients for buying and selling of digital gold as the same was in contravention to Rule 8(3)(f).13
SEBI appears to have supported the circulars issued by BSE and NSE that expand the scope of the original provision, as evidenced by informal guidance provided on this matter. In the informal guidance issued to VLS Finance Limited on September 19, 2022, VLS sought to: (a) invest in commercial real estate to earn rental income, (b) invest in subsidiary companies through loans and/or capital contributions for real estate investments, (c) acquire equities of companies owning real estate, and (d) invest in entities not engaged in the securities business. However, SEBI directed VLS Finance Limited to comply with the NSE and BSE circular dated January 07, 2022, which prohibits extending loans or giving deposits to any entity, including group companies, subsidiaries, and associates.
Current Legal Challenge and Government Stance before the Bombay High Court
Due to the same reasons i.e. expansion of scope of Rule 8(3)(f) by stock exchanges, the said circular itself is under challenge which is pending before the Hon’ble Bombay High Court in the case of Kotak Securities Limited (supra) which also contests the NSE order directing Kotak Securities Limited to disinvest Rs.624.66 crores in four entities and imposing a penalty of Rs. 5 lakhs.
Although Rule 8(3)(f) itself was not challenged, the Hon’ble High Court deemed it appropriate to implead the Union of India as a party to the petition and vide order dated December 11, 2023 it was observed:
“3…rules on the basis of which the challenge is raised in the petition are the rules framed by the Central Government. Hence, the Central Government would become a necessary party to this petition.
4. We put the added respondents Union of India to a notice, that in sofar as the consequence which is brought about by the impugned Circular dated 7 January, 2022 issued by respondent no.1 whether would amount to modifying Rules 8(1)(f) and 8(3)(f) of the 1957 Rules, would be an issue, requiring consideration in the present proceedings, even on the prayers of the petitioners for interim reliefs.”
(emphasis supplied)
Further, it seems from the court proceedings that even the Ministry of Finance, Government of India is against the decision taken by NSE. According to Ministry of Finance, Government of India, NSE has provided the interpretation enlarging the scope of the Rule 8(3)(f) of SCR Rules through a circular without any consultation with the Government of India. Order dated July 24, 2024 of the Hon’ble High Court records the stand taken by the Ministry of Finance, Government of India which is as follows:
“1 There is an affidavit filed by one Leena Kumar affirmed on 15th February 2024 on behalf of respondent no.3. Respondent no.3 is the Union of India.
Paragraphs IV of the said affidavit reads as under :
“IV. Submissions made by Respondent No.3 (Union of India)
a. The Department of Economic Affairs, Ministry of Finance would like to draw the attention of the Hon’ble Bombay High Court to the following:
(i) The Securities Contracts (Regulation) Rules, 1957 (SCRR) have been made by the Government of India as a subordinate legislation as per powers under section 30 of the Securities Contracts (Regulation) Act, 1956 (SCRA). They were also previously published as required under sub-section (3) of section 30 of SCRA.
(ii) NSE has vide issued circular 02/22 dated January 7th 2022, published illustrative list of activities that are construed as non-compliance to Rule (1Xf) and Rule 8(3)(f) of the said SCRR rules. One such activity mentioned at para 10 constitutes “Investments made in group companies such as subsidiaries & associates etc., not in connection with or incidental to or consequential upon the securities/ commodity derivatives business. (Ex: Investment in companies engaged in other businesses such as NBFC, Real Estate, etc.).”
(iii) Any interpretation of the SCRR (Rule 8 in this case) or any modification that has the potential to enhance or restrict the scope of the rule should be done by the Government of India.
(iv) NSE has provided the interpretation enlarging the scope of the rule through a circular without any consultation with the Government of India.
(v) As per Section 31, SCRA, 1956 the Securities and Exchange Board of India (SEBI) is required to make regulations consistent with the provisions of SCRA and the SCRR made there under to carry out the purposes of the Act. However, SEBI’s regulations also do not cover the aspect interpreted by the NSE.
(vi) Prima facie, it appears that the NSE, vide its circular dated 07th January 2022, has interpreted “investments made in group companies” to mean “any business” for the purposes of Rule 8(1)(f) and Rule 8(3)(f). In the normal course, investment of surplus funds and conducting of business are generally to be considered separate activities
(vii) The said Circular also does not throw any light on why investments is companies other than the group companies are acceptable. It is also noted that the investment in the four group companies in case of the Kotak Securities Ltd. is not in companies having activities in the Indian stock market.
(viii) The purpose of the rules and the regulations should be to provide appropriate safeguards for activities in the securities market without placing unreasonable restrictions on normal investments and business activities. The circular issued without due consultation, prima-facie, seems to have placed excessive restrictions on normal investment of surplus funds without bringing out the rationale.
(ix) From the marker integrity perspective, there may be a case to put certain safeguards or limits on the investment of the surplus funds or business activities including financial management activities in either group companies or other entities. However, that should be done through prior public consultation.
(x) An appropriate course of action may be that the Government should issue the interpretation or carry out the required amendment to the Rule, if required. For doing so, a consultation paper would be brought by the Government inviting inputs from the market participants and views of the SEBI, exchanges and market intermediaries. It is most respectfully submitted that this exercise make require around 6 months.”
The stand taken by Ministry of Finance, Government of India before the Hon’ble Bombay High Court clearly demonstrates that neither NSE had power to issue this circular placing excessive restrictions on normal investment of surplus funds without bringing out the rationale nor NSE consulted with the Ministry of Finance, Government of India prior to the issuance of this circular. Vide order dated July 24, 2024, the Hon’ble High Court was pleased stay a part of the circular after noting the contents of the affidavit filed by Ministry of Finance thereby observing:
“6 As regards the Circular dated 7th January 2022 is concerned, the Circular to the extent the words used in unnumbered paragraph 5 “or activities or transactions” and whole of “clause 10” is stayed. This order is applicable only for petitioner.
7 We clarify that the “activities or transactions” stayed is only restricted to clause 10 which reads as under : “10. Investments made in group companies such as subsidiaries & associates etc., not in connection with or incidental to or consequential upon the securities/commodity derivatives business. (Ex. Investment in companies engaged in other businesses such as NBFC, Real Estate etc.”
Since the circular and the interpretation of rule 8(3)(f) are itself under consideration, SEBI as well as the stock exchanges should await the outcome of the said petition. Further, it is not the first time that the interpretation of Rule 8(3)(f) has come into question before a constitutional court as even before the Madras High Court in the case of Madras Stock Exchange v. S. S. R. Rajkumar14, the said rule was in question and there the Hon’ble Madras High Court observed that the said rule was not very well drafted. It was observed Court:
“50. We have already set out Rule 8(3)(f) of Securities Contracts (Regulation) Rules. That Rule cannot be said to have been very well drafted. However, that by itself is no reason for not giving effect to it. Effect must be given after ascertaining the real purpose and intendment of the Rule. That Rule is in 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.”
(emphasis supplied)
SEBI’s Historical Perspective on the Rule
Additionally, as stated above, SEBI itself in the case of Geojit (supra) in 2017 had taken a view that usage of surplus fund to give advances would not attract violation of Rule 8(3)(f) of SCR Rules. However, the said view of the Ld. Adjudicating Officer in Geojit (supra) was not concurred by SEBI subsequently the Ld. Whole Time Member in the case of Inventure Growth and Securities Ltd.15 differed with the aforesaid view taken in Geojit (supra) by stating:
“17. IGSL has placed reliance on the Adjudication Order in the matter of Geojit BNP Paribas Financial Services Ltd. to justify inter corporate loans given by an intermediary. I have perused the said Adjudication Order. I note that the said Adjudication Order was passed based on a very narrow interpretation of the purpose of Rule 8 (3)(f) of SCRR by the Adjudicating Officer which as per him was to prohibit the stock brokers from investing the clients’ money in other businesses. I do not concur with the said view of the Adjudicating Officer. As noted in the preceding paragraphs, under Rule 8 (3)(f) of SCRR any kind of business activity which may incur financial liability on the trading member is prohibited if the said business activity is not incidental to or consequential upon the securities business and not merely if the purpose of the loan is investing clients’ money in its other businesses. In any event, findings given in an order by an authority of SEBI is not binding in nature. Such findings and observation could at the best may have persuasive value and in the instant proceedings, for the reason stated above, I prefer to defer from the findings held in the order relied upon by the Noticee”
(emphasis supplied)
Over the years, even SAT has provided interpretation to the said rules in few cases including in the case of SMC Global Securities Ltd v. SEBI16 wherein the SAT had observed that the appellant therein was engaged in an activity involving personal financial liability which was in contravention to Rule 8(3)(f). Similarly, in Jitendra Pukhraj Jain v. NSE17 wherein the Hon’ble SAT observed that giving loans to other entities, including employees/ family members of the appellant was in violation the said Rule 8(3)(f).
As of November 14, 2022 i.e. the date on which order by Whole Time Member was passed in Inventure (supra), conflicting interpretations existed regarding the application of Rule 8(3)(f) within the same organization (SEBI). However, the recent landmark judgment by the Hon’ble Securities Appellate Tribunal (SAT) has provided clarity on this matter. In the case of Magnum Equity Broking Limited v. National Stock Exchange of India Limited18, the Hon’ble SAT explicitly held that investment of surplus funds cannot lead to an inference that the entity is engaged as a principal in business other than that of securities involving personal financial liability. The following was observed:
“7. The Appellant contended that they had made temporary investment of their own surplus funds with the NBFC. It was similar to investment in liquid funds with a bank or mutual fund purely to earn interest on available surplus funds. It was erroneous on the part of the Committee to treat the investments as loans and thereby allege that the Appellant had engaged as principal in business other than that of securities….
…
9. A plain reading of the Rule 8(3)(f) of SCR Rules and Rule 5(b) of the Chapter II of the Rules of the Exchange would indicate that a trading member cannot engage as a principal or employee in any business involving any personal financial liability other than that of securities. SEBI’s circular dated May 7, 1997 clarified that borrowing and lending funds by a trading member, in connection with or incidental to or consequential upon the securities business would not disqualify a trading member under Rule 8(3)(f) of the SCR Rules.
10. In our view, investment of surplus funds, generated as a consequence of securities business, with an NBFC registered with RBI cannot lead to an inference that the Appellant is engaged as a principal in business other than that of securities involving personal financial liability. The Respondent Committee given a clear finding that the funds were advanced from the account of the Appellant therefore there is no dispute that the funds were their own moneys…“
(emphasis supplied)
The aforementioned decision by the Hon’ble SAT in Magnum (supra) invalidated the perspective of the Ld. Whole Time Member in Inventure (supra), rendering it redundant. Furthermore, SEBI has subsequently endorsed the stance of the SAT in the matter of Evermore Share Broking Private Limited19 wherein the Ld. Adjudicating Officer, citing the SAT’s decision in Magnum (supra), concluded that parking surplus funds in another entity does not constitute a violation of Rule 8(3)(f):
“24.2. As per the provisions of Rule 8(3)(f) of Securities Contracts (Regulation) Rules, 1957, a stockbroker shall not engage either as principal or employee in any business other than that of securities except as a broker or agent.
24.3. In this regard, the Noticee has submitted that Vayoo Nandan is a NBFC Company, and the Noticee has always been parking its surplus funds with the NBFC to earn interest, so that the interest cost on the funds borrowed for working capital requirements could be reduced. The Noticee has further submitted that on a net basis, and as also observed by the inspection team, the Noticee has paid interest of Rs. 1616879 to Vayoo Nandan, which indicates that the Noticee has borrowed more than what it has actually parked as surplus with Vayoo Nandan. Noticee has also submitted that Vayoo Nandan has not traded through the Noticee in the FY 2021-22 and has traded through the Noticee on only three days in FY 2022-23. The account of Vayoo Nandan has already been closed on October 14, 2022. In this regard, the account closure request form has been submitted by the Noticee with its reply to the SCN. Noticee has also relied on the judgement of Hon’ble SAT in the matter of Magnum Equity Broking Limited v. National Stock Exchange of India Limited dated November 29, 2023 (Appeal No 461 of 2022), where it was inter-alia observed….
…
24.4. I note that Noticee has parked its surplus funds and borrowed funds from Vayoo Nandan which is an NBFC. In view of the submissions made by the Noticee, there does not appear to be any violation as alleged.”
(emphasis supplied)
SEBI has recently provided much-needed clarity regarding the treatment of investments and loans derived from surplus funds by adhering to the principles established by the Hon’ble SAT in the Magnum Equity Broking (supra). Specifically, SEBI has emphasized that investments made or loans given out of surplus funds generated through securities business activities do not equate to engaging in a separate business involving personal financial liability.
On July 22, 2024, the Ld. Adjudicating Officer, SEBI in the matter of Indian Finance Guaranty Limited20 has clarified that broker taking loans from associate companies cannot attract violation of Rule 8(3)(f).
Further, In the case of Phillip Capital India Private Limited21, SEBI had alleged that loans were advanced by the entity to its group companies of Rs. 2,363.40 crore and the same was in violation of Rule 8(3)(f). However, the Ld. Adjudicating Officer vide order dated June 25, 2024 explicitly held that lending of surplus funds would not violate Rule 8(3)(f) by observing:
“15.1. It was observed from the Noticee’s Financial Statements for the FY 2021-22 that the Noticee was involved in certain transactions with its group companies, during the inspection period. Upon perusal, it was observed that the Noticee had advanced loans to its group companies. The cumulative amount of loans given by the Noticee to three group entities during the year 2021-22 amounted to Rs. 2,363.40 crore. Thus, it was alleged that the Noticee has violated the provisions of Rule 8(3)(f) of the SCR Rules,1957.The summary of the transactions is provided in the table below:
15.8. From the aforementioned regulatoryprovisions, Noticee’s submissions and observations of the Hon’ble SAT, I am of the view that the lending of surplus funds, which are generated as a consequence of the securities business, with the intent to earn interest, cannot be considered non-compliance of Rule 8(3)(f)of Securities Contract (Regulations) Rules, 1957. Further, there is no observation that the surplus funds were not owned funds of the Noticee.
15.9.In view of the foregoing, I find that the alleged violation of the provisions of Rule 8(3)(f) of the SCR Rules, 1957, does not stand established.”
(emphasis supplied)
Further, in the case of Ventura Securities Limited, the Ld. Adjudicating Officer vide order dated June 28, 2024, exonerated Ventura by observing that the investments made out of surplus funds do not in any manner violate Rule 8(3)(f) of the SCR Rules. The relevant extract of the SEBI order dated June 28, 2024 are reproduced hereinbelow:
“108. With regard to violation of Rule 8(3)(f), Noticee submitted that all investments made in VASPL and KILPL were carried out using its surplus funds, no funds were ever invested, whether from clients’ bank accounts or from clients’ funds. Noticee has also relied on the judgement of Hon’ble SAT in the matter of Magnum Equity Broking Limited v. National Stock Exchange of India Limited dated November 29, 2023 (Appeal No 461 of 2022), where it was inter-alia observed that: “10. In our view, investment of surplus funds, generated as a consequence of securities business, with an NBFC registered with RBI cannot lead to an inference that the Appellant is engaged as a principal in business other than that of securities involving personal financial liability. The Respondent Committee given a clear finding that the funds were advanced Adjudication Order in the matter of Evermore Share Broking Private Limited from the account of the Appellant therefore there is no dispute that the funds were their own moneys ….”
109. I note that Noticee has invested its surplus funds in its associate companies viz. VASPL and KILPL. Further, I also note the above submissions made by the Noticee and also the submission that it has already disinvested its entire shareholding in KILPL and initiated the process of disinvestment of shares in VASPL long back, which is solely dependent on NSE as the permission to merge VASPL with Ventura is pending at NSE. 110. In view of the above, I hold that the allegation that the Noticee violated the provisions of Rule 8(3)(f) of Securities Contracts (Regulation) Rules, 1957, does not stand established.”
(emphasis supplied)
Proposed Amendments by the Ministry of Finance
The key judicial and regulatory precedents suggest that merely investing surplus funds or providing loans from a broker’s own funds does not necessarily constitute engaging in a prohibited business under Rule 8(3)(f). The principle that such activities must not involve personal financial liability is crucial in determining compliance. The ongoing litigation in the Kotak matter and recent judgments highlight the need for a clear and consistent interpretation of Rule 8(3)(f), which balances legislative intention, regulatory objectives with practical business considerations.
Further, the following has been now proposed by the Ministry of Finance under their recent Consultation Paper:
| Current Framework of Rule 8(1) / 8(3) of SCRR | Proposed Framework of Rule 8(1) / 8(3) of SCRR by MOF Consultation paper |
| Qualifications for membership of a recognized stock exchange. | |
| 8. The rules relating to admission of members of a stock exchange seeking recognition shall inter alia provide that : | |
| … | |
| (1) No person shall be eligible to be elected as a member if— | |
| (f) he is engaged as principal or employee in any business other than that of securities or commodity derivatives except as a broker or agent not involving any personal financial liability unless he undertakes on admission to sever his connection with such business : | (f) he is engaged as principal or employee in any business other than that of securities or commodity derivatives except as a broker or agent not involving any personal financial liability unless he undertakes on admission to sever his connection with such business: |
| Provided that nothing herein shall be applicable to any corporations, bodies corporate, companies or institutions referred to in clauses (a) to (n) of sub-rule (8). | Provided that nothing herein shall be applicable to any corporations, bodies corporate, companies or institutions referred to in clauses (a) to (n) of sub-rule (8). |
| Provided further 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. | |
| Qualifications for membership of a recognized stock exchange. | |
| 8. The rules relating to admission of members of a stock exchange seeking recognition shall inter alia provide that : | |
| … | |
| (3) No person who is a member at the time of application for recognition or subsequently admitted as a member shall continue as such if— | |
| … | |
| (f) he engages either as principal or employee in any business other than that of securities or commodity derivatives except as a broker or agent not involving any personal financial liability, provided that— | (f) he engages either as principal or employee in any business other than that of securities or commodity derivatives except as a broker or agent not involving any personal financial liability, provided that— |
| (i) the governing body may, for reasons, to be recorded in writing, permit a member to engage himself as principal or employee in any such business, if the member in question ceases to carry on business on the stock exchange either as an individual or as a partner in a firm, | (i) the governing body may, for reasons, to be recorded in writing, permit a member to engage himself as principal or employee in any such business, if the member in question ceases to carry on business on the stock exchange either as an individual or as a partner in a firm, |
| (ii) in the case of those members who were under the rules in force at the time of such application permitted to engage in any such business and were actually so engaged on the date of such application, a period of three years from the date of the grant of recognition shall be allowed for severing their connection with any such business, | (ii) in the case of those members who were under the rules in force at the time of such application permitted to engage in any such business and were actually so engaged on the date of such application, a period of three years from the date of the grant of recognition shall be allowed for severing their connection with any such business, |
| (iii) nothing herein shall affect members of a recognised stock exchange which are corporations, bodies corporate, companies or institutions referred to in items (a) to (n) of sub-rule (8)” | (iii) nothing herein shall affect members of a recognised stock exchange which are corporations, bodies corporate, companies or institutions referred to in items (a) to (n) of sub-rule (8) |
| Provided further 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 proposals made by the Ministry of Finance in its consultation paper may not resolve the issue completely. Therefore, a careful examination is necessary to determine whether the proposed framework effectively addresses the shortcomings of the current regulatory landscape, particularly concerning loans extended to or investments made using surplus funds by stockbrokers.
Concerns with the Proposed Amendment
The Ministry of Finance’s consultation paper proposing amendments to Rule 8(3)(f) of the Securities Contracts (Regulation) Rules, 1957 (SCRR) presents certain potential issues and ambiguities that may lead to challenges in interpretation and enforcement. While the intent behind the amendment is to provide clarity regarding permissible business activities of stock brokers, the proposed language introduces some infirmities. Key issues in the proposed amendment are outlined below:
Ambiguity in the Definition of “Investments”:
The proposed amendment introduces a provision stating that investments made by a broker shall not be construed as “business” unless they involve client funds, client securities, or create a financial liability on the broker.
However, the definition of “investments” remains unclear. It does not specify whether it includes financial products such as fixed deposits, bonds, or equity stakes in companies. It is also unclear if investment in a group company or an inter-corporate deposit or an advance to a company within the same promoter group, which is otherwise a legitimate transaction, is prohibited under the proposed amendment. The scope of “investments” should be more precisely defined to avoid confusion about which types of financial instruments or investments are permissible without being considered a separate business.
Additionally, both SAT and SEBI has, through several precedents as cited above, distinguished between the use of surplus funds and activities that amount to engaging in a separate business. The proposed amendment does not fully integrate these precedents, leaving room for future disputes over what qualifies as a permissible investment.
Unclear Financial Liability Criteria:
The proposal states that investments should not create “financial liability” on the broker. While this is a useful clarification, it is overly broad and lacks clarity regarding what constitutes a “financial liability.”
There could be various forms of financial liabilities (such as contingent liabilities or guarantees) that do not result in immediate outflow of funds but still create potential risks for the broker. The proposed provision does not clarify whether such contingent liabilities or other indirect liabilities would disqualify an investment under Rule 8(3)(f). Today, the brokers anyways live under the strict regime of SEBI and stock exchanges where their net worth as well as other financials are tightly monitored, to ensure that there is no risk to clients / investors. Additionally, there is no explanation as to how financial liabilities are to be quantified or measured. This lack of specificity could lead to inconsistent interpretation and enforcement.
Inconsistent with Judicial Precedents:
The proposed amendments do not fully align with the principles established by the SAT / SEBI in cases like Magnum Equity Broking Limited (supra) and Ventura Securities Limited (supra). These cases have consistently held that parking surplus funds or lending them out of business proceeds does not violate Rule 8(3)(f) if they do not involve client funds or securities or create personal financial liability.
SEBI’s recent adjudications have provided greater clarity regarding the permissibility of loans and investments using surplus funds derived from the securities business. The proposed amendments, instead of building on these principles, introduce a new layer of uncertainty, particularly regarding what types of financial liabilities might be prohibited.
SAT rulings emphasized that investments made out of surplus funds, such as loans to NBFCs or associate companies, do not amount to conducting separate business if they do not expose the broker to personal financial liability. The proposed amendment fails to clearly incorporate these judicial interpretations, leaving ambiguity as to how these types of investments will be treated.
Lack of Distinction Between Own and Borrowed Funds:
The proposal does not adequately differentiate between investments made using a broker’s own surplus funds and those made using borrowed funds. This distinction is critical, as using borrowed funds to make investments could result in additional financial risks and liabilities that may not be immediately apparent.
Previous SEBI rulings have underscored that investments made using a broker’s own funds are generally permissible under Rule 8(3)(f) as long as they do not create financial liability. The proposed amendment does not draw this distinction clearly, potentially leading to broader restrictions on the use of borrowed funds for permissible investments.
Uneven Treatment of Corporates:
The exemption granted to corporations, bodies corporate, and institutions referred to in clauses (a) to (n) of sub-rule (8) remains unchanged in the proposed amendment. However, the rationale for exempting these entities from the prohibitions on engaging in non-securities businesses is unclear and potentially inconsistent with broader regulatory objectives of ensuring financial stability and transparency in the securities markets.
The continued exemption for corporate entities could create an uneven playing field, where corporate brokers are allowed to engage in certain types of financial activities that other brokers are prohibited from pursuing. This could lead to competitive disadvantages for smaller, individual brokers. This can be considered to be an anti-competitive policy in an international arena.
Risk of Over-Regulation:
The proposed amendment appears to adopt a somewhat conservative stance regarding the scope of permissible investments, which could stifle legitimate business activities that do not create undue risk. The blanket prohibition on investments that might “create a financial liability” could be overly restrictive in situations where the financial liability is manageable or immaterial or in line with the accounting standards or international standards.
This could deter brokers from engaging in prudent financial management practices, such as short-term lending or investing in low-risk instruments to enhance profitability, which do not necessarily conflict with the primary securities business.
Conclusion:
The Ministry of Finance’s proposed amendments to Rule 8(1)(f) / 8(3)(f) of the SCRR, while aimed at clarifying permissible business activities for brokers, raise several concerns regarding ambiguity, lack of specificity, and inconsistency with judicial precedents. Notably, this is a rare instance where the Ministry of Finance has made an effort, independent of SEBI or Stock Exchanges, to facilitate ease of doing business—an approach that deserves recognition.
However, to address the identified concerns, the amendment should be further refined to provide a clear definition of “investments,” outline permissible financial liabilities, and incorporate established judicial interpretations on the treatment of surplus funds. Moreover, additional safeguards should be included to protect client interests and ensure greater transparency.
The views are personal.