Chapter 10: Sales Practices and Investors Protection Services

Finance Sector and Investor Protection:

1. Role of the Finance Sector:

• Responsible for ensuring stable markets and supporting the real economy.
• Primary function is to provide sustainable financial services.
• Good advice and excellent customer service are essential for long-term success.

2. Customer-Oriented Approach:

• Sales of products should be customer-led and accompanied by efficient and appropriate advice.
• “Customers have the right to get good advice; finance employees have the duty to give good advice.”
• Cooperation between the company, employees, and intermediaries is crucial for increasing customer satisfaction.

3. Investor Caution:

• Naïve investors are increasingly targeted for financial abuse and fraud.
• Investors should be cautious while investing in financial products.

4. High Return or “Risk-Free” Investments:

• Be careful of opportunities that promise spectacular profits or “guaranteed” returns.
• No investment is risk-free; returns are related to the risk taken.

5. Investment Advisor Services:

• Investment advisors should act in the best interest of clients.
• Investors should review monthly account statements and conduct annual reviews of investment plans.

6. Unsuitable Investment Recommendations:

• Be cautious about investment products that do not meet specific investment objectives and risk profiles.
• Review the risk profile of each investment recommendation.

7. Churning:

• Churning refers to unnecessary and excessive trades for generating commissions.
• Review monthly account statements for abnormally high trading activity.

8. Investor Seminars:

• Be cautious of unsuitable product pitches at investor seminars.
• Seek objective third-party advice before committing funds.

9. Contact with Consumers:

• Sales agents should make calls at reasonable times and identify themselves and their purpose.
• Take account of the consumer’s personal circumstances and comply with diversity obligations.
• Cease contact if inconvenient, unwelcome, or inappropriate.

10. Professional Conduct:

• Sales agents should be courteous, professional, and avoid misunderstandings.
• Avoid high-pressure or luring tactics.
• Maintain records of consumer contact for handling complaints or queries.

Understanding Risk Profile and Investment Objectives:

Topic	Notes
Definition of Risk	– Risk refers to the chance of not getting the desired return on an investment. – Different types of investments have different levels of risk. – Risk/return trade-off exists. The higher the risk, the greater the potential return.
Risk-Averse vs. Less Risk-Averse Investors	– Risk-averse investors prefer more secure investments with higher allocations to debt and fixed income instruments. – Less risk-averse investors prefer greater exposure to equity and other risky investments.
Importance of Understanding Risk Tolerance	– Financial independence and self-improvement goals require a level of risk tolerance. – Willingness to accept smaller returns for greater certainty. – Satisfaction with financial situation affects self-worth and self-esteem.
Challenges in Assessing Risk Profile	– Difficulty in expressing attitudes about risk. – Unrealistic investment objectives. – Limited understanding of financial concepts. – No one-size-fits-all model for risk tolerance. – Various parameters influence risk tolerance.
Factors Affecting Risk Tolerance	– Age, personal and family income, dependents, occupation, marital status, education, inherited wealth. – Financial advisors should consider these factors to assess risk tolerance accurately.
Investment Horizon and Risk	– The longer the investment horizon, the more risk can be integrated. – Clear understanding of investor’s objectives is essential to provide suitable advice and meet short-term and long-term needs.

Risk Disclosure Document:

1. Introduction:

• Equities have historically outperformed other asset classes and delivered superior returns over the long term.
• However, there have been instances of underperformance and negative returns in the short run.
• Investing in stocks carries more risk for investors with a short investment horizon compared to those with a long-term horizon.

2. Purpose of Risk Disclosure Document:

• Highlights the risks involved in trading on stock exchanges.
• Explains the rights and obligations of brokers and their clients.
• Clients must understand the risks before trading derivatives.

3. Complexity of Derivative Products:

• Derivatives can vary in complexity, with options being more complex than futures.
• Additional safeguards may be required for complex derivatives.
• Evaluating the fairness of option premiums can be difficult.

4. Risks in Equity Derivatives Trading: a) Market risk: Unfavorable market or stock price movement can cause losses. b) Liquidity risk: Difficulty in liquidating a loss-making position, especially as contracts near expiry. c) Counterparty risk: Risk of default by the counterparty, but less applicable to exchange-traded equity derivatives.
5. Leveraged Nature of Derivative Contracts:

• Equity derivatives involve leverage, where a small initial capital outlay controls a larger contract.
• Clients may build up large positions beyond their risk tolerance, leading to potential significant losses.

6. Risks in Futures Contracts:

• Marked to market and settled daily.
• Unfavorable market movement requires depositing the notional loss amount.
• Failure to deposit may lead to position liquidation and resulting losses.
• Increased margin rates and decreased liquidity during volatility pose additional risks.

7. Risks for Option Buyers:

• Options are a wasting asset, and if the anticipated price change doesn’t occur, the option becomes worthless.
• Failure to close out the option position exposes the buyer to losing the entire premium.

8. Risks for Option Sellers:

• Unlimited risk for option sellers if the underlying price moves unfavorably.
• Sellers can lose many times the collected premium amount.

9. Volatility Risk:

• All derivative traders are exposed to the risk of higher volatility causing significant price swings.
• Thinly traded derivatives contracts are more prone to such swings.

10. Execution and System Risks:

• Orders may not be executed on time or may be only partially executed due to system glitches or communication failures.
• Delays or non-execution of orders can result in substantial losses.

11. Regulatory Focus and Sales Practices:

• Regulatory focus is necessary for broker-client relationships and derivatives sales practices.
• Unethical sales practices and unsuitable derivative contracts should be avoided.
• Brokers must ensure clients have the necessary understanding and financial capabilities.

12. Know Your Customer (KYC) Requirements:

• Brokers must obtain and verify specific customer information, including net worth, annual income, and investment experience.
• Detailed explanation of derivative characteristics and risks should be provided to investors.

13. Disclosure Document:

• Provides information on mechanics, risks, transaction costs, margin requirements, and tax consequences of derivatives trading.

By providing this Risk Disclosure Document, brokers aim to ensure clients are aware of the risks involved in derivatives trading and make informed investment decisions.

Anti Money Laundering Procedures

1. Definition and Legislation:

• Money-laundering offense: Acquiring, owning, possessing, or transferring proceeds of crime.
• Prevention of Money-Laundering Act, 2002 (PMLA): Aimed at preventing money laundering and confiscating property derived from such activities.

2. Written Procedures for Anti-Money Laundering:

• Registered intermediaries should adopt written procedures to implement anti-money laundering provisions.
• Procedures should cover client due diligence, policy for client acceptance, and transaction monitoring and reporting.

3. Customer Due Diligence (CDD):

• Obtain sufficient information to identify beneficial owners or controllers of securities accounts.
• Verify customer’s identity using reliable sources.
• Identify and verify beneficial ownership and control.
• Conduct ongoing due diligence and scrutiny of transactions.

4. Policy for Acceptance of Clients:

• Develop customer acceptance policies and procedures.
• Identify customers likely to pose a higher risk of money laundering.
• Apply customer due diligence on a risk-sensitive basis.
• Safeguards: No fictitious or anonymous accounts, define risk perception factors, collect required documentation and information, reject clients with non-genuine information.

5. Risk-Based Approach:

• Apply customer due diligence measures based on the risk category of the customer.
• Enhanced due diligence for higher-risk customers, simplified due diligence for lower-risk customers.

6. Clients of Special Categories (CSC):

• Non-resident clients, high net-worth clients, trusts, charities, NGOs, etc.
• Politically exposed persons (PEP), companies offering foreign exchange, clients in high-risk countries, non-face to face clients, clients with dubious reputation.

7. Client Identification Procedure:

• Know Your Client (KYC) policy should include client identification procedures.
• Use reliable sources and obtain adequate information to establish client identity and purpose of the relationship.
• Report failure to provide satisfactory evidence of identity.

8. Compliance with SEBI Guidelines:

• Registered intermediaries should comply with minimum KYC requirements prescribed by SEBI.
• Frame internal guidelines based on experience, legal requirements, and established practices.
• Maintain continuous familiarity with clients and follow-up on inconsistencies in information.

Customer Identification Procedure under KYC Accounts of Individuals

1. Documents for Customer Identification Procedure under KYC:
   • Accounts of Individuals: PAN card, Passport, Voter’s Identity Card, Driving License, Aadhaar Card, Job Card issued by NREGA, UIDAI letter, or letter from a recognized public authority.
   • Accounts of Company: Certificate of incorporation, Memorandum & Articles of Association, Resolution of the Board of Directors, Power of Attorney, and PAN allotment letter.
   • Accounts of Partnership Firms: Registration certificate, Partnership deed, Power of Attorney, and documents identifying partners.
   • In-person Verification: Compulsory for trading or demat account opening, can be physical or online.
2. e-KYC Process:
   • KYC can be completed offline or online.
   • Investor fills the account opening form online, submits scanned proofs, completes video-based In-person verification, and digitally signs the document.
3. Unique Client Code (UCC):
   • Allotted by the broker after KYC completion.
   • Linked to the client’s PAN, serves as an exclusive identification.
   • UCC details are uploaded to stock exchanges/clearing corporation.
4. Mapping UCC with Demat Accounts:
   • Implemented to detect diversion of securities.
   • Clients’ UCC linked with their demat accounts for reconciliation purposes.
5. Suspicious Transaction Reporting:
   • Certain transactions required to be reported to FIU-IND.
   • Examples of suspicious transactions include difficult identity verification, unclear source of funds, substantial increases without apparent cause, large transfers to/from overseas locations, etc.
   • Suspicious transactions must be immediately notified to the Money Laundering Control Officer or designated officer.

Investors Grievance Mechanism:

1. Each Exchange has a process for grievance redressal.
2. Exchanges have dedicated departments to handle grievances of investors against Trading Members and Issuers.
3. General features of the grievance redressal process:
   1. Receipt of Complaints
   2. Scrutiny of Complaints
   3. Redressal of Complaints
   4. Nature of Complaints
   5. Arbitration

Receipt of Complaints:

1. Investors submit complaints in a prescribed complaint form against the trading member.
2. Complaint form includes details specified in the instructions along with supporting documents.
3. Exchanges scrutinize the complaint and adequacy of submitted documents.
4. If relevant documents are submitted, complaint is recorded, assigned a complaint number, and an acknowledgment is sent to the investor.
5. If documents are inadequate, investor is advised to rectify the deficiencies.

Redressal of Complaints:

1. Exchanges try to resolve the complaint by following up with the trading member and the complainant.
2. The complaint is analyzed, and the trading member is contacted for resolution/response within a set timeframe.
3. Responses from the trading member are reviewed.
4. Actions based on the responses:
   1. If the trading member agrees with the complaint, they are advised to settle the matter immediately.
   2. If the trading member states that the complaint has already been settled, proof of settlement is requested.
   3. If the trading member raises issues, the comments are analyzed and forwarded to the investor for their views.
   4. If differences persist, a meeting may be held with the parties for resolution.
   5. If differences still persist, the investor may opt for arbitration proceedings.
   6. If the trading member has justifiable reasons within the regulatory framework, the investor is informed accordingly.

Nature of Complaints:

1. Exchanges provide assistance for complaints falling within their purview and related to trades executed on the exchange platform.
2. Examples of complaint types:
   1. Non-receipt of corporate benefits
   2. Non-issuance of documents
   3. Non-receipt of funds/securities
   4. Excess brokerage charged
   5. Execution of trades without consent, and more.

Arbitration:

1. Arbitration is a quasi-judicial process for settling disputes.
2. Application for arbitration should be filed at the Regional Arbitration Centres (RAC) within three years from the date of dispute.
3. Parties select an arbitrator from the panel provided by the exchange.
4. The arbitrator conducts the proceeding and passes an award within four months from the date of the initial hearing.
5. The arbitration award is binding, but an aggrieved party can file an appeal to the arbitration tribunal within thirty days.
6. Appellate Bench consisting of three arbitrators re-hear the case and give a decision, which is binding.
7. The final award of the Bench is enforceable.
8. Dissatisfied parties may challenge the Appellate Bench Award in a Court of Law.