Client codes modified! Fat fingers or tax evasion?
A SEBI order this week has raised 3 interesting issues - can client code modification, allowed for genuine fat finger errors, be used as a tax saving device! Did NSE do enough to regulate escalating modifications in March 2010 and was SEBI also caught unaware till the Finance Ministry prompted it to act? Sajeet Manghat investigates how fat fingers could result in a lower tax liability!
March 2010 – client codes were modified in trades worth 55468 crores rupees on the NSE. The number of client code modifications was 32% higher than that of February and 46% more than the modifications that took place in January that year. Modifications for that quarter far outdid any other quarter between Jan 2010 & June 2011.
But neither did NSE see anything untoward in this trend nor did SEBI spot it - till the Finance Ministry raised an alarm. In November 2010, the Department of Revenue wrote to SEBI asking it to check on substantial client code modifications taking place, especially before the fiscal year end. SEBI wrote to NSE asking for client code modification data and reasons. Several letters went back & forth and the data that emerged was indeed alarming!
For instance - most of the 55468 crore rupees of trades modified in March 2010 were traced back to 10 brokers. In the case of 3 of those 10 brokers, more than 75% of the modifications pertained to only 10 clients. India Infoline was among those responsible for the highest modifications. And 88% of India Infoline’s modifications were done for its top 10 clients. What about these top 10 clients prompted India Infoline to continuously err in punching in their codes?
Chief Compliance Officer, IIFL
“There were couple of HNI group clients who had requested for client code modifications so basically these are large HNI family clients , group clients and they were basically doing large scale arbitrage trading so that is why the client code is within those group entities.”
India Infoline makes it out to be an inoffensive practice. But SEBI Chairman UK Sinha says the regulator suspected it was more than that
U K SINHA
“We are not a tax implementation agency but there were suspicions.”
Suspicions that market insiders confirm while pointing to an age old practice on Dalal Street - booking artificial profits or losses in March to impact tax liabilities. The game requires buying or selling stocks intra-day so as to say consciously incur a loss and use that as a tax offset. But that can be done ordinarily - what do client code modifications have to do with it?
Well here's the modus operandi; imagine for a moment 2 clients; A- that wants to book a loss and B that wants to book a gain.
So A buys stock 'x' from B at a 100 rupees a share in anticipation that the price will drop to 90 rupees. But instead the stock, thanks to a volatile market, moves up to Rs 110. A then sells it back to B at 110 ending up with a 10 rupee profit instead of a 10 rupee loss and B is left holding a loss instead of the anticipated profit.
What the helpful broker does then is to swap the 2 client codes by 4:15 pm - gifting 'A' a loss and 'B' a profit. Since on the exchange the trades have been squared, there are no delivery obligations and everybody goes home satisfied with the day's work!
Market insiders say this subterfuge took on new, sophisticated proportions since 2004 with the advent of derivative trading and became rampant on the NSE as it was the only exchange with a liquid derivatives market. No broker will confirm this practice on record but the NSE data speaks for them - in the case of four out of the ten brokers named in SEBI’s order, more than 15% of the client code modifications were done for a single pair of clients. Take the case of East India Securities- 6,713 or about a sixth of all the trades it modified in March 2010 were between a pair of 2 clients.
Tax expert T P Ostwal says the data smells of massive tax manoeuvring!
Managing Partner, TP Ostwal & Associates
“The companies and the profiles of the clients using trading losses are of two types. one having significant losses and they want to and have lot of cash money in their hands and want to bring back that cash money to the books so that they want to take some profits and these are the accommodating profit entities and if they are not related entities within the group and trading loss or profit has been switched over to another entities all together different from a person originally entered into a transaction it is an indication that some settlement has taken place outside the books and that has resulted in shifting of the trading loss or trading profit to that entity. so similarly a entity who has made profit during the year and has not paid advance taxes at the end of the year he believes that by paying taxes he will have significant tax liability as well as interest liability so what he is trying to do possibly would be to shift his tax liability to another year or may be that he will take a loss and he will use his cash money to pay the person who has shifted the loss to him and against that loss he will set off his profits and he will not pay the tax. And if this happens generally in the month of Jan, Feb mar normally that is true as by 9 months you would know what his financial position – how much profit he has made so if he has made significant profit he will indulge into this transaction during this period.”
Chief Compliance Officer, IIFL
“I am not aware whether it was the intention of any tax avoidance or that kind of benefit to the client. Basically what we found is we undertake certain checks before permitting any client code modification. there should be a request from the client and number two the other client to who it is seeking transfer should also give consent and number three both the client should be from the same group. and they should have adequate margin we ensure there is nothing like, so we ensure that genuinely from one group to another group trades are not transferred and within the family and within the group within the family it is broadly in the market, this is the market practice that within the group accounts client codes changes do take place or some request comes in.”
Tax tangles aside, how come the NSE was not alarmed by the magnitude of modifications that year? Well NSE told SEBI it had no way of knowing why the modifications were taking place.
You see client code modifications have been permitted for the last 10 years, shortly after unique client codes were introduced in 2001. The modifications permit brokers to rectify human errors when a client inadvertently provides a wrong code or when or a wrong code is punched in by the broker whilst executing the trade - a fat fingers error! Modifications are also commonly accepted if the client is issuing transaction instructions on behalf of an FII representing various sub-accounts or mutual fund representing various schemes. The client may communicate a code at the time of placing of the order and after the trade is executed, he may want to correct the client code from among those belonging to the same family/ corporate group/ FII/ mutual fund. But that would happen only in the case of institutional trades and NSE’s data shows that 6 of the 10 brokers had no material institutional clients. Besides institutional trades were barely a tenth of the total trades modified that march. So why didn’t NSE take any action?
NSE offered no comment on this story but SEBI put it down to the Exchange’s laid back attitude.
In his order, Whole Time Member Prashant Saran says, "NSE has taken a laid back attitude towards the problem and either totally ignored or perfunctorily imposed minor penalties to the brokers. it failed to apply its mind to the unusualness of the happenings. I therefore find that NSE acted negligently in discharge of its regulatory duties." The order says suspending/ interrupting the working of the stock exchanges is not an appropriate penalty as it involves negative externalities and could be considered only in extreme cases. And hence it has given a penalty of warning to the National Stock Exchange.”
What about the 2010 modifications though?
Managing Partner, TP Ostwal & Associates
“One particular broker or few particular brokers indulging in huge transaction everyday that is an alarming fact and the SEBI's order has brought out that 10 brokers indulge in shifting in the client code very regularly therefore in such situation he avoidance or evasion cannot be ruled out. One has to examine this on a case to case basis and who is the person who can examine its only the tax department SEBI has no powers to examine this aspect.”
On its end NSE claims it sent notices to 82 brokers between January 2010 & January 2011 in the matter of client code modifications. in its submissions the exchange also claims disciplinary action proceedings have been initiated against 6 of the 10 most modifying brokers. and since February last year, NSE has introduced the penalty structure in its equity and currency derivatives segments, increased the penalties for repeat offences of modification and last year in august the exchange also issued a circular stipulating specific criteria to identify the genuineness of the client code revisions.
Chief Compliance Officer, IIFL
“We have communicated to all the branches even in terms of our systems as well as the risk management processes we have incorporated lot of control points wherein the client code modifications do not take place at the branch level or at the relationship manager level or at the trader level. so if at all there is a request - yes it is an error that has taken place and that error has to be escalated to a senior person and he will examine the error first and see whether this is genuine error or not and with his recommendation he will send it to the risk management which will again check with the orders and the entire process and then only if it is proved yes this a genuine error then we permit that client code change. This is the system which has been put in place for the last one and half years or so.”
And it seems to have worked. NSE data says the last year in March the total modifications were 12,500 crore rupees in value- a fourth of the 55,000 crores of trades modified in March 2010. We may not have all the answers as to why, who and how but the problem has been solved for now.
In Mumbai, Sajeet Manghat.