Securities and Exchange Board of India (SEBI) has recently declared Geofin Comtrade and Anand Rathi Commodities as not ‘fit and proper’ to act as commodity derivatives brokers in for their suspected involvement in the Rs 5,600-crore National Spot Exchange (NSEL) scam. Both commodities brokers have been directed to “cease to act, directly or indirectly” as commodity derivatives brokers, as per the two orders passed on  February 25, 2019. Besides these two commodity brokers, the regulator is also probing commodity arm of some industry giants like Motilal Oswal and IIFL. Earlier, SEBI had listed out around 300 broking firms for their alleged role in the settlement scam on the spot exchange way back in 2013.

It all started when (Serious Fraud Investigation Office) SFIO, an organization dedicated to detecting white collar crimes, approached SEBI to put a number of commodity brokerage house through its ‘Fit and Proper’ test. The test examines the capabilities of broker companies and their promoters or directors as a broker.

One of the star controversies of the commodity market, NSEL fraud is back in limelight after some top players in the industry fail the fitness test conducted by SEBI. Here is what you need to know about the NSEL Case.

Background of the Scam

NSEL (National Spot Exchange Limited) was conceptualized in the year 2004, pursuant to the then Prime Minister’s vision to create a single market across the country for both manufactured and agricultural produce.  There was a dire need to set up a national-level, integrated market for agricultural products, to reap the benefit of a spot market.

NSEL was set up as a company incorporated under the Companies Act, 1956 on 18 May 2005 with its registered office in the State of Maharashtra. NSEL was incorporated by MCX and the nominees of FTIL. The shareholding of MCX and nominees were transferred and consolidated later in 2005 with FTIL. National Spot Exchange Limited (NSEL), commenced live trading on October 15, 2008, and was the first commodity spot exchange of the country.

In order to boost volume, the three exchanges NSEL, NSPOT, and National AFMC were allowed to conduct forward trading in one-day contracts. The NSEL became the country’s first ever electronic commodity exchange for ‘spot delivery’ of contracts, including agricultural products. The exchange is blamed to take as long as 25 to 35 days to settle some contracts. The permitted time period to do so was up to 11 days.

Against the regulations, short-selling, too, was allowed in many cases. The then regulator Forward Market Commission (FMC), then intervened and asked NSEL to wind down existing contracts. This ended in payment default.

The crisis came to light when the physical commodities were short of the record. Warehouse Receipts were not backed by any physical commodity. When investors claimed commodities worth their money, the borrowers could not provide them, as goods were way short in warehouses. This is how the most controversial scam of the commodities market was born.

The scam first seemed like a fraud conducted by the promoters and key employees. However as the investigation paced, large brokers and financial players came under the radar. They were allegedly involved in deliberately introducing their clients to this trading circle. The brokers failed in their duty by marketing fake schemes and lure the investors into trading in the commodity segment. In the majority of the cases, they are allegedly found to have traded on behalf of the ignorant investors.

The investigations continue since then. A number of brokers, defaulters, investors and key decision makers are under the radar.

What roles have brokers played?

The primary allegation against the brokers was that they had made false promises to the clients in order to attract their investment in commodities. The assurance was given to the extent of risk-free returns to the clients. They promoted arbitrage opportunity in the spot market by way of pair contracts. The clients were made to believe that pair trades are backed by collaterals in the form of stocks.

SEBI also doubts that the brokers had manipulated client code modifications. Though it is not established yet.

Also, SEBI in its order against the brokers had said that these brokers did trades in clients’ name without their permission. These brokers allegedly allowed clients to execute trades despite debit balance in their accounts. These brokers did not segregate funds between clients account and the organization’s account.

The alleged brokers made statements that goods in the warehouse are backed by insurance cover; which are in violation of provisions of various circulars, rules, and bye-laws of NSEL and sections 21(g) of the FCRA.

Also, these brokers had failed to report suspicious transactions to the Financial Intelligence Unit thereby violated a provision of NSEL Circulars. The accused brokers did not segregate funds between clients account and the organization’s account.

What lies ahead for the brokers?

The designated team of three adjudicating officers of SEBI has already submitted their report on April 11, 2017. They believe that the conduct of the brokers was questionable and their general reputation, the record of fairness, honesty, and integrity had eroded. They have suggested to ban them from commodities derivatives trading and also initiate prosecution for the irregularities.

Normally, designated authorities recommend civil proceedings in accordance with the intermediaries regulation. But the NSEL case, they have also suggested prosecution.

However, the lawyers involved in this case believe that prosecution should be involved in exception criminal cases only and that it should be an extreme solution in this case.