Custodian Shortfall and Broker Request to Net Client Assets
A custodian for a foreign portfolio investor holds 4.2 million shares of a listed company in a demat account. On Monday the operations team finds the account short by 1.1 million shares. Investigation shows that a broker, acting for another client, used the FPI's permanent account number and a standing instruction to execute an early pay-in for a short sale; the shares were transferred to the clearing corporation. The broker asks the custodian to net off the shortfall against 900,000 shares of a different FPI client that are pending credit, and to keep the matter quiet until month-end. The custodian's reconciliation policy requires daily matching and immediate escalation of any shortfall above 0.5% of holdings. The shortfall is 26% of the account.
1. What immediate compliance actions should the custodian take, and why is netting impermissible?
Read the worked answer
The custodian must not net the shortfall against another client's pending credit. Client assets are segregated, and using one client's shares to cover another client's shortfall would create a fresh misappropriation and conceal the original loss. The immediate steps are to freeze the affected account and related instructions, reconstruct the transfer and audit trail, contact the broker and clearing corporation to recall or replace the shares, notify the affected FPI, preserve all records and escalate to senior compliance and the board. The 26% shortfall is far above the 0.5% escalation threshold, so daily reconciliation and immediate escalation have both failed. The broker's request to keep the matter quiet until month-end is itself a red flag and must not be accepted.
2. What reporting and client communication should follow?
Read the worked answer
Notify the affected FPI promptly with the facts known so far, the shares involved, the expected recovery plan and the steps being taken to protect the account. Report the incident to SEBI within the applicable timeline, and inform the broker and clearing corporation in writing. If the transfer involved unauthorised use of the FPI's PAN or standing instruction, consider a police complaint or fraud report and check whether other clients are affected. Do not wait for month-end or for the broker to resolve the matter informally. The compliance officer should also review whether the shortfall must be disclosed in the custodian's compliance report and whether the FPI's own regulators or custodial agreements require notification.
3. What control failures does this reveal, and what remediation is needed?
Read the worked answer
The incident shows failures in standing-instruction verification, PAN and account-authorisation controls, dual authorisation for transfers, daily reconciliation, and escalation of exceptions. A broker should not be able to use an FPI's PAN and standing instruction to transfer shares for another client's short sale. Remediation should include disabling third-party standing instructions, requiring client-specific authorisation for every pay-in, implementing dual controls and independent review of transfers, restoring daily reconciliation with automated alerts above the 0.5% threshold, and training operations staff. The custodian should also test whether other accounts have similar exposures, document the root-cause analysis, and report the remedial action to SEBI and the board.