Red flags in the Capital Market - India perspective

The red flags in the capital market may be grouped into following classes:

A. Based on type of intermediary

1. Stock Exchanges

2. Brokers

3. Depository Participants

4. Mutual Funds

5. Others

B. General 

1. Financial and Business Red Flags

2. Investment and Fraud-Related Red Flags 

Some examples of above are given for familiarizing the kind of red flags in the capital market activities for the uninitiated:

A.1. Stock Exchanges

Client Identification & Behavioural Red Flags

 

These indicators typically relate to unusual client behavior, transaction patterns, and the nature of the funds involved. 

 

Reluctance or refusal to provide complete Know Your Customer (KYC) details, or providing vague/changing explanations when asked about the purpose of transactions.

Frequent changes in contact details or an unusual level of nervousness/aggression during routine verification.

Use of nominee or proxy shareholders and complex structures (e.g., shell companies, offshore entities) to obscure the true beneficial owner.

Maintaining multiple accounts with no apparent business purpose, especially with a large number of unexplained inter-account or third-party transfers. 

Transaction & Activity Red Flags

 Transaction red flags include any transaction that raises suspicion of involving criminal proceeds, or that appears overly complex or lacks a clear economic reason. Cash transactions over ₹10 lakhs or a series of smaller transactions summing to this amount within a month also trigger red flags. 

Other indicators involve potential market manipulation like "pump and dump" or insider trading, as well as suspicious off-market transactions. Transactions structured to stay below reporting limits (smurfing), unexpected activity in dormant accounts, or activity inconsistent with a client's profile are also red flags. Suspicious third-party funding or transfers and transactions involving forged documents are also causes for concern. 

Stock exchanges and their intermediaries use these red flags to monitor client activities, escalate issues to a Principal Officer, and report suspicious transactions to the Financial Intelligence Unit (FIU-IND) as required by PMLA regulations. 

Examples

 

Transactions lacking a clear economic rationale or legitimate purpose.

Sudden, unexplained activity in dormant accounts.

Inflows of funds or assets well beyond a client's known income or financial standing.

Large cash deposits or transfers, especially those structured into smaller amounts just below regulatory reporting thresholds (currently ₹10 lakh) to avoid scrutiny.

Excessive journal entries between unrelated accounts without a clear business purpose.

Transferring investment proceeds to unrelated third parties.

Transactions involving certain types of securities (e.g., Z group and T group stocks) which, while legitimate, have historically been associated with fraudulent schemes and market manipulation.

Suspicious off-market transactions, circular trading, or activities indicative of insider trading or market manipulation. 

A.2 Brokers

Broking companies are required to have robust PMLA policies in place to identify these red flags, conduct enhanced due diligence for high-risk clients, and report suspicious transactions to the FIU-IND

Customer Behavior & Identity

Unusual concern for compliance: A customer showing excessive anxiety about government reporting requirements or the company's anti-money laundering (AML) policies.

Reluctance to provide information: Refusing to reveal details about business activities, source of funds, or providing false/misleading information.

Questionable background: The customer (or associated persons) having a dubious reputation or links with known criminals as per public information.

Lack of concern for costs: Little interest in investment performance, risks, commissions, or other transaction costs, focusing instead on early termination or movement of funds.

Non-face-to-face clients: Higher scrutiny is needed for clients where initial identification and verification did not involve physical presence.

Politically Exposed Persons (PEPs): Establishing business relationships with PEPs without senior management approval and enhanced due diligence on the source of funds and wealth. 

Account Activity & Transactions

Inconsistent activity: Transaction patterns that are unusual compared to past behavior or inconsistent with the client's declared business or financial standing.

Sudden activity in dormant accounts: Unexplained, sudden high-volume trading in an account that was previously inactive.

Multiple accounts with common parameters: A large number of accounts sharing the same introducer, authorized signatory, or address without a clear business rationale.

Circular trading: Using an account for circular transactions, which involves moving funds or securities repeatedly between accounts to disguise their origin. 

Nature & Value of Transactions

Lack of economic rationale: Transactions that lack a clear business sense, apparent investment strategy, or bonafide purpose.

Third-party transfers: Investment proceeds or funds transferred to apparently unrelated third parties.

Suspicious off-market transactions: Off-market deals (outside the exchange platform) that are not at market price or appear artificially inflated/deflated.

Structuring/Smurfing: Transaction values just under the official reporting threshold in an attempt to avoid mandatory reporting to the Financial Intelligence Unit-India (FIU-IND).

Large overseas transfers: Receiving large sums of money from overseas locations or transferring investment proceeds abroad without justification.

Insider trading or market manipulation: Transactions that reflect likely insider trading or market manipulation activities. 

A.3. Depository Participants

Depository companies must establish internal policies to categorize clients by risk (low, medium, high), conduct due diligence, and report suspicious transactions to the Financial Intelligence Unit - India (FIU-IND). 

Client Identity and Behavior 

Unusual concern about compliance: A customer who is excessively worried about the company's reporting requirements or AML policies.

Reluctance to provide information: Refusing to disclose information about business activities, source of funds, or beneficial ownership.

Suspicious background: The client (or associated persons) has a questionable reputation or links to known criminals, as per public information or news reports.

False/Unverifiable identification: Using false identification documents or documents that cannot be verified within a reasonable time.

Non-face-to-face clients: Clients where identity verification is difficult, requiring enhanced due diligence (EDD).

High-risk categories: Clients classified as Politically Exposed Persons (PEPs), High Net Worth Individuals (HNIs), non-governmental organizations (NGOs), or those from high-risk countries. 

Transaction Patterns and Activity

Transactions lacking business sense: Engaging in transactions that do not align with the client's stated business or investment strategy.

Lack of concern for costs: Showing indifference to risks, commissions, or other transaction costs.

Unusual activity in accounts:

Sudden, unexplained activity in a dormant account.

An unexplained high level of activity compared to past transactions.

Large numbers of accounts with a common holder or signatory with no clear reason.

Unexplained transfers between multiple accounts.

Complex or unusual transactions: Transactions that are unusually complex, have no apparent economic rationale, or seem designed to hide the source/destination of funds.

Disproportionate investment/activity: The value or volume of transactions is inconsistent with the client's apparent financial standing or declared income.

Structuring: Breaking large transactions into smaller ones just under the reporting threshold to avoid scrutiny.

Third-party involvement: Investment proceeds or funds are transferred to third parties without a legitimate reason.

Suspicious off-market deals: Block deals or off-market transactions at prices that appear artificially inflated or deflated. 

A.3. Mutual Funds

PMLA 2002 provides the legal base, with SEBI (Securities and Exchange Board of India) guidelines and AMFI recommendations guiding specific implementation for Mutual Funds, focusing on Customer Due Diligence (CDD), Enhanced Due Diligence (EDD), and robust transaction monitoring.

Behavioral Flags:

Reluctance to Provide Information: Hesitation or providing false details during KYC.

Unexplained Wealth: Sudden increase in investments inconsistent with known financial standing. 

Customer-Related Flags (Enhanced Due Diligence Needed):

      Politically exposed Persons (PEPs): Higher corruption risk.

High-Risk Jurisdictions: Clients from or investing in tax havens/secrecy jurisdictions.

Shell Companies/Complex Structures: Entities with opaque ownership or unknown beneficial owners (threshold now 10%).

Unusual Client Types: NRIs, HNIs, Trusts, NGOs with complex or non-transparent dealings.

Transaction-Related Flags:

      Structuring: Splitting large investments below reporting thresholds.

Inconsistent Transactions: Activity not matching client's financial profile or stated income.

Layering:  Complex, multi-layered transactions to obscure fund origins.

Sudden Large Inflows: Large overseas transfers for investments without clear economic purpose.

Artificially Priced Deals:  Block deals with prices significantly different from market rates.

B.1 Financial and Business red flags

These flags indicate potential instability or manipulation within a company. 

 

Declining Revenues or Profits: A consistent, multi-quarter decline in revenue or net profit suggests deeper issues like loss of market share or ineffective management.

High or Rising Debt Levels: Excessive debt (a high debt-to-equity ratio) makes a company vulnerable to economic downturns and high interest expenses, which can strain cash flow and increase the risk of default.

Poor Cash Flow Despite Profits: A significant, persistent discrepancy between reported profits and actual operating cash flow can signal aggressive accounting or overstated earnings.

Frequent Management/Auditor Changes: Unexplained resignations of CEOs, CFOs, or independent directors, or frequent changes in auditors, often hint at trouble or disagreements over financial reporting practices.

Opaque or Complex Structures: Business models that are hard to understand, or the presence of many shell-like subsidiaries or complex related-party transactions, may be used to hide inefficiencies or fraud.

Aggressive Accounting Practices: Sudden, unexplained changes in accounting policies (e.g., revenue recognition methods) can be an attempt to artificially inflate numbers.

High Promoter Pledging of Shares: While not illegal, if a large percentage of promoter shares are pledged as collateral for loans, a drop in share price could force a sale, causing a sharp decline in stock value. 

B.2. Investment and fraud related red flags

These red flags often relate to how an investment is sold or marketed, and signal potential scams. 

Guaranteed Returns/Low Risk Promises: All investments carry some risk. Promises of "guaranteed returns" or "risk-free" opportunities are almost always fraudulent.

Unlicensed Professionals/Unregistered Products: Ensure any investment professional or product is licensed and registered with relevant regulatory bodies like the SEC or a state regulator.

Pressure to Act Immediately: High-pressure sales tactics or "limited-time opportunities" are designed to rush you into a decision before you can conduct due diligence.

Unsolicited Pitches: Be wary of unexpected calls, emails, or social media messages offering "can't-miss" opportunities.

Requests for Unusual Payment Methods: Being asked to pay for investments using gift cards, wiring money abroad, or transferring funds to a personal account are major red flags. 

Anti-Money Laundering (AML) Red Flags 

For financial intermediaries, red flags often point to potential money laundering or terrorist financing activities. 

Transactions Inconsistent with Profile: Large or frequent transactions that do not match the customer's known business activities, age, or income level.

Unexplained Large Cash Amounts: The use of large amounts of cash (or numerous small cash deposits) in transactions where checks or wire transfers would be normal.

Reluctance to Provide Information: Customers who are overly secretive, provide minimal or false information, or use complex, unnecessary legal structures (like shell companies in high-risk jurisdictions).

Rapid Movement of Funds: Money that is deposited and immediately withdrawn or transferred across multiple accounts without a clear economic purpose

Those who read this, also read:

1. Capital Market & PMLA 2002

2. Red Flags in AML/CFT