SEBI issued a Show-cause Notice to National Stock Exchange for Client Code Modifications

The capital market regulator, the Securities and Exchange Board of India (SEBI) in a first issued a show-cause notice to the country's leading stock exchange, National Stock Exchange, following a probe into alleged client code modifications by its broker members.

The bourse was asked to explain the large number of client code modifications. NSE also has to justify why action should not be taken against it for not exercising caution over such transactions.

SEBI was alerted about the dealings by the Central Board of Direct Taxes, which noticed that a large number of trades were reversed by changing client codes for tax evasion. The tax department came across several instances where brokers transferred gains or losses from one individual to another by modifying client codes in the guise of rectifying an error. SEBI independently verified the information given by the income-tax authorities and found it to be true.

A show-cause notice is not an indictment; it however contains allegations of violation. A show-cause notice requires the entity to which it is served to explain its side of the story.

The Usual Practise

Stock exchanges allow client code modifications but only to rectify a genuine error that could have occurred at the time of placing or modifying the order. Every client is given a code which is registered with the stock exchanges. The broker is allowed to change it between 3.30 pm and 4 pm to rectify a genuine error that may have occurred while entering the code. The facility ensures smooth functioning of the system and is expected to be used more as an exception rather than routine.

The regulator had in July 2011 imposed a stricter penalty on such modifications to further strengthen the system. SEBI instructed bourses to impose a monetary penalty of 1% of the value of the transaction where the client codes were modified. According to brokers, the penalty is 50 times the yield in the F&O segment. The average yield in the derivatives segment is 0.02%. SEBI also directed the exchanges to conduct special inspection of trading members to check whether such modifications are being carried on as per the criteria.