Chapter 10: Code of Conduct and Investor Protection Measures (Part 1)

Learning Objectives

After studying this part of the chapter, you should:

• Understand SEBI’s Code of Conduct for Brokers.
• Understand the absolute importance of Risk Disclosure at the time of client onboarding and the KYC (Know Your Customer) process.
• Explore Suspicious Transaction Reporting (STR) and the regulatory environment surrounding investor safety.

10.1 SEBI’s Code of Conduct for Brokers

Schedule II of the SEBI (Stock Brokers) Regulations, 1992 prescribes a strict code of conduct for securities brokers. This code defines the minimum standards of ethical and professional behaviour that registered stock brokers must adhere to in order to maintain market integrity and protect investor interests. The code is divided into three key categories: General conduct, Duties to investors, and Dealings with other brokers.

A. General Conduct Requirements

Stock brokers are required to operate with the highest level of professionalism to preserve market equilibrium and trust.

• Integrity: Brokers must maintain high standards of integrity, promptitude, and fairness in the conduct of all their business operations.
• Exercise of Due Skill and Care: Brokers must act with due skill, care, and diligence across all business activities.
• Anti-Manipulation: Brokers are strictly prohibited from indulging in manipulative, fraudulent, or deceptive transactions or schemes. They must not spread rumours with a view to distorting market equilibrium or achieving personal gains.
• Prevention of Malpractices: No broker may create a false market, either singly or in concert with others. They must avoid any act that is detrimental to investors' interests or interferes with the fair, smooth functioning of the market.
• Compliance with Statutory Requirements: Brokers must diligently abide by all provisions of the SEBI Act, rules, and regulations issued by the Government, the Board (SEBI), and the stock exchanges.

B. Duty to the Investor

Brokers owe a fiduciary duty to their clients, requiring transparent execution, secure handling of client assets, and unbiased financial advice.

1. Execution of Orders

A stockbroker must faithfully execute client orders for buying and selling securities at the best available market price. Brokers cannot refuse to deal with a small investor simply based on the low volume of business involved. Furthermore, they must promptly inform the client regarding the execution or non-execution of an order, make prompt payments for securities sold, and arrange prompt delivery for securities purchased.

2. Segregation and Monitoring of Client Collaterals

In July 2021, SEBI introduced strict norms on the segregation and monitoring of collaterals at the client level.

• Core Purpose: These measures prevent the misappropriation or misuse of client securities. Specifically, they block the practice of using one client's securities to provide exposure, margin, or settlement for another client.
• Reporting Framework: Members must implement a framework for reporting client-wise collaterals. Collaterals must be bifurcated into categories such as cash and other collaterals, which are further segregated by type.
• Uploading Data: These detailed collateral breakdowns must be uploaded to the dedicated web portals provided by the clearing corporations and stock exchanges.

3. Issuance of Contract Notes

Trading members must issue a Contract Note to their clients without delay for all executed transactions, using the form specified by the stock exchange.

• Electronic Contract Notes (ECN): A broker can issue contract notes electronically (via ECN) only after obtaining explicit consent from the client. This consent must be captured either directly within the client agreement or through a separate, formal consent document.

4. Breach of Trust and Confidentiality

Brokers are prohibited from disclosing, discussing, or making improper use of the personal investment details of their clients. Any information of a confidential nature acquired through the business relationship must be kept strictly secure and private.

5. Unbiased Advice and Commissions

• Generating Excessive Brokerage: Stockbrokers must not encourage clients to buy or sell securities with the sole objective of generating brokerage or commission.
• Misleading Information: Brokers are barred from furnishing false/misleading quotations or giving misleading advice to induce clients into transactions merely to earn commissions.

6. Dealing with Defaulting Clients

A broker must not knowingly, directly or indirectly, transact business or execute an order for a client who has failed to carry out their commitments with another stockbroker.

7. Fairness and Conflict of Interest

When executing transactions, brokers must disclose whether they are acting as a principal or as an agent. They must ensure no conflict of interest arises; if a conflict does occur, the broker must inform the client immediately and must not place their own interests above the client's.

8. Provision of Investment Advice

• Suitability Assessment: A broker must not recommend acquiring, disposing of, or retaining any security unless they have reasonable grounds to believe the advice is suitable for the client. This suitability must be assessed based on facts disclosed by the client regarding their security holdings, financial situation, and investment objectives.
• Public Media Disclosures (Rule 7A): If a stockbroker or any of their employees renders investment advice through publicly accessible media (real-time or non-real-time), they must make a full disclosure of interest. This includes disclosing any long or short positions held in that security by:
  • The stockbroker
  • The employee rendering the advice
  • Their dependent family members
  • The employer

9. Staff Competence

Brokers must maintain adequately trained staff and operational arrangements to deliver fair, prompt, and competent services to their clients.

C. Dealing with Other Brokers

To ensure overall market stability, brokers must cooperate with their peers and settle transactions in a fair, non-disruptive manner.

10.2 Risk Disclosure to Client and KYC

The onboarding process requires thorough due diligence. A broker must satisfy themselves regarding Know Your Customer (KYC) norms and ensure the client signs a Risk Disclosure Document (RDD) before any trading commences.

A. Core Onboarding and KYC Technology Guidelines

SEBI’s master circular dated 15th October 2019 outlines the exact policies and procedures for KYC and the Anti-Money Laundering (AML) risk management framework.

1. Voluntary Use of Aadhaar and OVD alternatives

Under Section 11A of the Prevention of Money Laundering Act (PMLA) (inserted in 2019), the Aadhaar card is not a mandatory requirement for onboarding. It serves as voluntary evidence at the client's discretion. Clients can instead voluntarily provide any of the following Officially Valid Documents (OVD):

• Driving license
• Passport copy
• Voter’s ID
• NREGA job card

2. KUA and Sub-KUA Registration

Under SEBI’s circular dated February 8, 2023, members wishing to use e-KYC authentication services via the Unique Identification Authority of India (UIDAI) must register as a Sub-KUA under SEBI-approved KYC User Agencies (KUAs). KUAs are authorized entities that facilitate online Aadhaar authentication for registered intermediaries.

3. Technology-Driven KYC Procedures

Guidelines introduced in April 2020 permit digital, contactless onboarding by leveraging modern technology:

• Video-based Client Identification Procedure (VIP)
• Use of dedicated online mobile apps
• Integration with Digital Lockers for document retrieval
• Use of digital signatures and e-signatures (including cropped signatures)

B. Key Risks in the Risk Disclosure Document (RDD)

The Risk Disclosure Document must explicitly detail the following market and operational risks to ensure the client acknowledges them before trading:

1. Market Risk: Extreme price fluctuations in spot, futures, options, or other derivative contracts.
2. Macroeconomic Risk: Unexpected price movements driven by foreign exchange volatility, changes in global/local demand-supply dynamics, weather forecasts, government interventions, and tax policy changes.
3. Liquidity Risk: Situations where liquidity dries up on a contract, leading to adverse price movements, high transaction costs, or the inability to unwind open positions.
4. Basis Risk: The risk that the futures price moves differently from the underlying physical spot price.
5. Unhedged Position Risk: The risk of leaving market exposures completely unhedged.
6. Option Writing Risk: The high risk associated with holding short (selling) positions in options.
7. Broker Credit Risk: Counterparty default risks associated with the broker.
8. Operational/Technical Risk: Disruptions caused by technical glitches, communication failures, server outages at the broker or exchange level, or web-connectivity issues.
9. Regulatory Penalties: Penalties arising from open position limit breaches or margin shortfalls during sharp price movements.
10. Delivery Failure Risk: Risks regarding the quality of commodities or physical rejection of goods at exchange-accredited warehouses, which can cause a delivery default on short positions.

C. Client Risk Categorisation

To ensure effective anti-money laundering and surveillance monitoring, clients are classified into three distinct risk categories based on extensive due diligence:

Enhanced Due Diligence (EDD) and Close Monitoring

Brokers must apply enhanced due diligence and continuously monitor onboarding and transactions for the following high-risk profiles:

• Non-face-to-face clients.
• Clients operating multiple accounts under similar names or sharing common parameters (e.g., common partners, directors, promoters, addresses, email IDs, telephone numbers, or authorized signatories).
• Unexplained fund or position transfers between such multiple accounts.
• Unusual trading activity compared to past transaction history, or alternatively using different accounts to execute trades.
• Clients showing sudden, high-volume activity in dormant accounts.

D. Commodity Price Risks and Exposed Groups

Commodity price risk arises due to adverse fluctuations in the physical and derivative markets. The financial impact of these price movements is determined by the elasticity of demand and elasticity of supply for both raw materials and finished goods.

There are three primary groups exposed to these risks:

1. Producers: This group includes farmers, miners, processors, and manufacturers who are naturally long on finished goods and are exposed to falling prices (which reduce revenue). They are also exposed to rising input costs (e.g., raw materials, fuel).
2. Consumers: This includes individuals, commercial traders, and corporates who use commodities as raw materials in their production processes. They are naturally short on raw materials and are exposed to rising prices.
3. Exporters: Exporters face unique commodity risks due to the time lag between receiving an export order and the physical procurement/sale of the goods. They are also highly exposed to geopolitical developments, compliance regulations, and foreign exchange rate volatility, as most global commodities are priced in US Dollars (USD).

E. Unique Client Code (UCC) and PAN Verification

SEBI's circular dated March 8, 2021, mandates strict guidelines regarding client identification across commodity derivative segments.

• Mandatory UCC: Stockbroker members must use a Unique Client Code (UCC) for all clients transacting in the commodity derivatives segment. Exchanges are prohibited from allowing any trade execution unless the member has successfully uploaded the corresponding UCC details.
• Mandatory PAN: Members must collect and verify the authenticity of the client's Permanent Account Number (PAN) against the original card.
• Electronic PAN (e-PAN) Protocol: For clients providing an e-PAN, members must cross-check and verify its authenticity directly on the Income Tax Department's official website. A soft copy of the verified e-PAN must be securely maintained in the broker's records.

F. KYC Registration Agency (KRA) Regulations, 2011

The SEBI (KYC Registration Agency) Regulations, 2011 govern the centralized upload and maintenance of client identification data.

• KRA Registration: All members of the commodity derivatives market must be registered with one or more SEBI-registered KRAs.
• KYC for New Clients: If a client's KYC data is not already available with a KRA, the member must perform the initial due diligence. They must upload the verified KYC information (for both individuals and non-individuals) with proper authentication to the KRA system. Scanned images of the documents must be sent to the KRA, while the physical documents are retained by the member.
• Timeline for Upload: Members must upload the authenticated KYC details to the KRA system within 10 days of receiving the documents from the client.
• KYC for Existing Clients: For existing registered clients whose records are missing from the KRA system, the member must upload the data, obtain any missing details from the client, and transmit the scanned documents to the KRA.
• Strict Use of Data: KRA data must never be shared with third parties (including affiliates or associates) for commercial gain. It must be used strictly for its designated regulatory purpose.
• Ultimate Responsibility: The member retains the ultimate responsibility for verifying the client's identity by applying enhanced KYC measures matched to their risk profile. They must maintain robust internal controls to ensure data security and authenticity.

G. Suspicious Transaction Reporting (STR) to FIU

Brokers are legally obligated to monitor client transactions to prevent money laundering, tax evasion, and illegal trading.

• Suspicious Activity Examples:
  • Reversal trades (entering into opposite transactions to transfer profits/losses).
  • Profit transfer trades.
  • Trades associated with Dabba Trading (illegal parallel trading outside recognized exchanges).
• Reporting Authority: Stockbrokers must report these transactions to the Financial Intelligence Unit (FIU), a specialized intelligence arm under the Ministry of Finance. STRs must be submitted through the online portal provided by the FIU.
• Strict "Anti-Tipping-Off" Rule: Under the law, brokers are strictly prohibited from informing the client about the STR filing. Tipping off the client is highly illegal.
• Independent Internal Systems: Members cannot rely solely on the stock exchange's surveillance alerts. They must maintain their own robust internal risk systems, surveillance controls, and diagnostic procedures to identify suspicious behavior.

Key Terms & Exam-Relevant Concepts

• Schedule II (SEBI Regulations, 1992): The regulatory schedule containing the mandatory Code of Conduct for Stock Brokers.
• Segregation of Collaterals: Regulations implemented in July 2021 to report and safeguard client-wise collateral, separating cash and non-cash assets to prevent misappropriation.
• Electronic Contract Note (ECN): A digitally issued contract note that requires a client's explicit prior consent before it can be sent.
• Rule 7A (Media Advice): Rules requiring brokers and their employees to disclose any personal long or short positions when offering investment advice on public media platforms.
• Officially Valid Documents (OVD): Driver's license, passport, voter ID, and NREGA cards that can be used for onboarding instead of Aadhaar.
• Unique Client Code (UCC): A mandatory identifying code that must be uploaded for every client before the exchange allows any trade execution.
• KRA (KYC Registration Agency): SEBI-registered centralized repositories where brokers must upload verified KYC data within 10 days of client onboarding.
• STR (Suspicious Transaction Report): Reports of suspected money laundering or tax evasion that must be filed secretly with the Financial Intelligence Unit (FIU).

Practice Questions

Question 1

Under SEBI’s Code of Conduct for Brokers, when can a registered stockbroker issue an Electronic Contract Note (ECN) to a retail client?

(a) Automatically upon successful execution of the first trade.
(b) Only after getting the client’s explicit consent either in the client agreement or separately.
(c) Only for institutional clients and Foreign Portfolio Investors, as residents must receive physical copies.
(d) Immediately, since paper-based contract notes have been permanently banned by SEBI.

Answer: (b)

Question 2

Under Section 11A of the Prevention of Money Laundering Act (PMLA), which of the following is correct regarding Aadhaar card submission during client onboarding?

(a) It is a mandatory requirement for opening any trading account.
(b) It is voluntary, and clients can instead provide alternative Officially Valid Documents (OVD) like a driving license or passport copy.
(c) It is only required for high-risk clients subject to Enhanced Due Diligence.
(d) It is required only if the client does not possess a verified Permanent Account Number (PAN).

Answer: (b)

Question 3

Which of the following matters does NOT directly relate to KYC and anti-money laundering control procedures for a commodity derivatives broker?

(a) Suspicious Transaction Reporting to the Financial Intelligence Unit.
(b) Independent In-Person Verification (IPV).
(c) Position limits violations by a client.
(d) Client risk categorization into Low, Medium, or High Risk.

Answer: (c)

Question 4

When a trading member detects a suspicious profit-transfer transaction in a client's account and prepares a Suspicious Transaction Report (STR), what is the legal protocol regarding client communication?

(a) The broker must immediately send an email notification to the client requesting clarification.
(b) The broker must hold a face-to-face meeting with the client to verify their sources of income before submitting the STR.
(c) The broker must report to the FIU and is strictly prohibited from tipping off or informing the client about the report.
(d) The broker is required to wait for the stock exchange surveillance team to issue a formal directive before filing.

Answer: (c)