Harshad Mehta Scam Soft Copy

8/8/2019 Harshad Mehta Scam Soft Copy

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The Harshad Mehta Scam - Presentation Transcript

1. The Securities SCAM2. SCAMSo Va

rious scam

s, scandal

sand

stigma

s hav

e surface

di

nthe rece

nt ye

ars.

Thesema

ynot

allbe

attribut

ab

le to the

antics

andbu

ng

li

ng of

politicians, but they have been facilitated largely because of the vitiatedatmosphere that the politicians and the political system have

created in the country.

o Some of the most famous SCAMS that have surfacedduring the time are: The 1200 crores fodder scam relating to the procurement ofnon -existent fodder on payments from the state exchequer. The Scam in printing & selling of stamp papers, which is used for recording documents for registration purpose. This scam is

ofabout Rs. 2200 crores & involves fraudulent printing & sale of stamp papers in the various parts of the country.

There is the famous Bofors scam, which was about the purchase of important defense equipment from foreignmarketso The list goes on & on & moreover there are continuous additions to the same.

3. Introduction to the Securities SCAMo But we are here to talkabout one of the most infamous scams that has been unearthed The Securities SCAM. o The Securities Scam refers to adiversion of funds to the tune of Rs. 3,500 crores from the banking system to various stock brokers

ina series of transactions (primarily in Government securities) during the period April1991 to May 1992.

Harshad Mehta was anIndian Stockbrokerand is alleged to have engineered the rise in the BSE stock exchange in the year1992 . Exploiting

severalloopholes in the banking system, Harshad Mehtaand his associates siphoned off funds from inter bank transactions and bought

shares heavily at a premiumacross many segments, triggering a rise in the Sensex.

4. Briefo Before we go forward, I wouldlike to give an outline o f what the following slides contain.It is very essential to have a clear

understanding of the below points to get an idea of what exactly happened then.

Intro

ductio

n.

The Two Securities Market. Liberalization of the Economy. The Ready forward Deal. The Mechanics of the Scam & its explanation. Bank Receipt. Breakdown of the Control System Other Aspects of the Scam. Where has all the money gone ? Impact of the Scam

5. Introduction o In April1992, the first press report appeared indicating that there was a shor t f all in the Government Securities held by the State Bank

ofIndia.Inalittle overamonth, investigations revealed that this was just the tip ofan iceberg which came to be called the securities

scam, involving misappropriation of funds to the tune of o ver Rs. 3500 crores.


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o Inan ever expanding ambit, the scam has engulfed top executives oflarge nationalized banks, foreign banks and financialinstitutions, brokers, bureaucrats and politicians.

o The functioning of the money market and the stockmarket has been thrown indisarray. o A large number ofagencies, namely, the Reserve Bank ofIndia (RBI), the Central Bureau ofInvestigation (CBI), the Income Ta x

Department, the Directorate of Enforcement and the Joint Parliamentary Committee (JPC) are currently inv estigating various aspects

of the scam.

6. The Two Securities Marketo The scam was in essence adiversion of funds from the banking system (in particular the inter -bankmarket in government securities)

to brokers for financing their operations in the stockmar ket. A clear understanding of the government securities market and the stock

(Corporate securities) markets is a prerequisite for understanding the scam.

7. Liberalization of the Indian Economy8. Liberalization of the Economyo Afterassuming office in June 1991, the new government accelerated the process of economic liberalization under the auspices of the

International Monetary Fund (IMF). The opening up of the Indian economy as a result of these measures promisedan unprecedent ed

growth and prosperity for the p rivate corporate sectoras new sectors of the economy were being allowed private participationand

various administrative impediments were being removed.

o Anticipating the good tidings for the private sector, the stockmarket started booming - the Bombay Stock Exchange Sensitive Index(Sensex) rose tremendously.

o Heavy margins imposed by the Bombay Stock Exchange on settlement trading added to the funds requirement. Even the PSUs wereunder pressure to perform including the nationalized banks.

o This was the ti me Harshad Mehtaand his associates decided to strike. 9. The Ready Forward Deal (RF)o The Ready Forward Deal (RF) is in essence a secured short term (typically 15 day) loan from one bank to another bank. The len ding

is done against Government Securities exact ly the way a pawnbrokerlends against jewelry.

o Inf

act o

ne c

ans

ay th

at the borrowi

ng b

ank

actu

ally se

lls the securities to the

le

ndi

ng b

ank

andbuys the

mb

ack

at the e

ndo f the

period of the loanat (typically) a slightly higher price.

10. The Mechanics of the Scamo As explainedabove, a ready forwarddeal is, in substance, a securedloan from one bank to another. To make the scam possible , the

RF had to undergo a complete change.In other words it practically had to become an unsecuredloan to a broker.

o This was wonderfully engineered by the Brokers. To give a better understanding of the mechanism, the whole process has beensegregated into three different parts viz.

The settlement process. Payment Cheques. Dispensing the security.

o Let me take you through these process one by one. 11. The Settlement Processo The normal settlement process in government securities is that the transacting banks make payments anddeliver the securities

directly to each other.

o During the scam, however, the banks orat least some banks a doptedanalternative settlement process which was similar to theprocess used for settling transactions in the stockmarket.


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o In this settlement process, deliveries of securities and payments are made through the broker. That is, the seller hands over thesecurities to the broker who passes them on to the buyer, while the buyer gives the cheque to the broker who the nmakes the p ayment

to the seller.

o In this settlement process, the buyerand the sellermay not even know whom they have traded with, both being known only to thebroker.

12.

The Settle

me

nt Process

o There were two important reasons why the broker intermediated settlement began to be used in the government securities market s: The brokers instead ofmerely bringing buyers and sellers together started tak ing positions in the market.In other words, they

started trading on their ownaccount, and ina sense became market makers in some securities thereby imparting greater

liquidity to the markets.

Whena bank wanted to conceal the fact that it was doing an R F deal, the broker came in handy. The broker provided contractnotes for this purpose with fictitious counter parties, but arranged for the actual settlement to take place with the correct

counter party.

13. Payment Chequeso A broker intermediated settlement al lowed the broker to lay his hands on the cheque as it went from one bank to another through him.

The hurdle now was to finda way of crediting the cheque to his account though it was drawn in favor ofa bankand was crosse daccount payee.

o As it happens, it is purely amatter of banking custom that anaccount payee cheque is paid only to the payee mentioned on thecheque.In fact, exceptions were being made to this norm, well before the scam came to light.

o Privileged (corporate) customers were routinely allo wed to credit account payee cheques in favour ofa bank into their ownaccountsto avoid clearing delays, thereby reducing the interest lost on the amount.

o Normally, ifa customer obtains a cheque in his own favouranddeposits it into his ownaccount, it may take aday or two for thecheque to be clearedand for the funds to become available to the customer. At 15% interest, the interest loss ona clearing delay of

two days fora Rs.100 crores cheque is about Rs. 8 lakhs.

14. Payment Chequeso On the other hand, when banks make payments to each other by writing cheques on theiraccount with the RBI, these cheques are

cleared on the same day.

o The practice which thus emerged was that a customer would obtaina cheque drawn on the RBI favoring not himself but hi s bank.The bank would get the money and credit his account the same day.

o This was the practice which the brokers in the money market exploited to their benefit. 15. Dispensing the Securityo The brokers thus founda way of getting hold of the cheques as they we nt from one bank to anotherand crediting the amounts to their

accounts. This effectively transformedan RF into aloan to a broker rather than to a bank.

o But this, by itself, wouldnot have led to the scam because the RF afterall is a securedloan, anda securedloan to a broker is stillsecured.What was necessary now was to finda way of eliminating the security itself!

o There are three routes adopted for this purpose:16. Dispensing the Security 1. Some banks (or rather their officials) were persuaded to pa rt with cheques without actually receiving securities in

return. A simple explanation of this is that the officials concerned were bribedand/ornegligent. A more intriguing possibil ity is that the

banks' senior/top management were aware of this and turned aNelson's eye to it to benefit from higher returns the brokers could offer by

diverting the funds to the stockmarket.One must recognize that as long as the scamlasted, the banks benefited from such an arrangement.

The management of banks might have be en sorely tempted to adopt this route to higher profitability. 2. The second route was to replace the

actual securities by a worthless piece of pa per a fake Bank Receipt (BR). This is discussed in greaterdetail in the next section. 3. The third

method was simply to forge the securities themselves.Inmany cases, PSU bonds were represented only by allotment letters rather than


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certificates on security paper. And it is easier to forge anallotment letter for Rs.100 crores worth of securities than it is to forge a100 rupee

note! Outright forgery of this kind howeveraccounted for only avery small part of the total funds misappropriated

17. Bank Receipto Inan RF deal, as we have discussed it so far, the borrowing bankdelivers the actual securities to the lend erand takes them back on

repayment of the loan.In practice, however, this is not usually done.Instead, the borrower gives a Bank Receipt (BR) which serves

three functio

ns:

The BR confirms the sale of securities. It acts as a receipt for the money receiv ed by the selling bank. Hence the name bank receipt. It promises to deliver the securities to the buyer.It also states that in the meantime the seller holds the securities in tr ust for

the buyer.

o In short, a BR is something like anIOU (I owe you securi ties!), and the use of the BRde facto converts an RF deal into an unsecuredloan. The lending bankno longer has the securities; it has only the borrower's assurance that the borrower has the securitie s which

can/will be delivered if/when the needarises.

18. BRs Issued without Backing of Securitieso As stated earlier, a BR is supposed to imply that the issueractually has the securities and holds them in trust for the buye r. But in

reality the issuermay not have the securities at all. There are two reasons wh y a bankmay issue a BR, which is not backed by actual

securities:

o 1. A bankmay short sell securities, that is, it sells securities it does not have. This would be done if the bank thinks tha t the prices ofthese securities woulddecrease. Since this woul d be an outright sale (not an RF!), the bank issues a BR.When the securities do fall

invalue, the bank buys themat lower prices anddischarges the BR by delivering the securities sold. Short selling in some f or m is an

integral part ofmost bondmarkets in the world.It can be argued that some amount of shortselling subject to some degree of

regulation is adesirable feature ofa bondmarket.In our opinion, an outright sale using a BR, which is not backed by secur ities, is

not harmful per se though it vi olates the RBI guidelines.

Contd..19. BRs Issued without Backing of Securities 2. The second reason is that the bankmay simply want an unsecuredloan.It may then do an RF

deal issuing a "fake" BR which is a BR without any securities to back them. The lending bank would be underamistaken

impression that it is making a securedloan when it is actually advancing an unsecuredloan.Obviously, lenders should have t akenmeasures

to protect themselves from such a possibility (This aspect will be examine dlater when we discuss the banks' control system in generaland

counterparty limits in particular.) During the scam, the brokers perfected the art of using fake BRs to obtain unsecuredloan s from the

banking system. They persuaded some smallandlittle kn own banks the Bank of Karad (BOK) and the Metropolitan Cooperative Bank

(MCB) - to issue BRs as and when required. These BRs could then be used to do RF deals with other banks. The cheques in favour of BOK

were, of course, credited into the brokers' acco unts.In effect, severallarge banks made huge unsecuredloans to the BOK/MCB which in

turnmade the money available to the brokers.

20. Breakdown of the Control System o The scam was made possible by a complete breakdown of the control system both within the co mmercial banks as wellas the control

system of the RBI itself.

o We shall examine these control systems to understand how these failed to function effectively and what lessons can be learnt toprevent failure of control systems in the future.

o The internal control system of the commercial banks involves the following features: Separation of Functions: The different aspects of securities transactions ofa bank, namely dealing, custody andaccounting

are carried out by different persons.

Counterparty Limits: The moment an RF deal is done on the basis ofa BR rather thanactual securities, the lending bank hasto contend with the possibility that the BR receivedmay not be backed by any/adequate securities.In effect, therefore, it m ay

be making an unsecuredloa n, and it must do the RF only if it is prepared to make an unsecuredloan. This requires assessing


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the creditworthiness of the borrowerandassigning hima "credit limit" up to which the bank is prepared to lend.

Technically, this is knownas a c ounterparty limit.

21. Other Aspects of the Scam o There are severalaspects of the scam which are closely related to the securities markets, but which are different from the o per ational

aspect of the markets.

o These pertain to information that can cause signific ant changes in the prices of securities as wellas the information supplied by thecommercial banks on their financial performance.

o On each occasion the coupon rate was increased by 1/2%, thereby raising the coupon rate from11.5% to 13% during this tenmo nthperiod. The major implication of raising interest rate onnew borrowings is that it would triggera fall in the market prices of the old

loans which are peggedat the old (lower) interest rates. The price of the 11.5% Government Loan 2010 dropped by 3% to 5% with

each coupon rate hike.Ifanyone has advance informationabout these changes in the coupon rates, he couldmake enormous amou nts

of riskless profit by short selling the old securities just before the announcement of rate hike and buying back (c overing his position)

after the prices have fallen.

22. Other Aspects of the Scam o Somebody who tooka short position of Rs. 500 crores before the coupon hike of September1991 could have made a profit of Rs. 15

crores, practically overnight! Since several pers ons in the Finance Ministry and the RBIare likely to be aware of the impending hike

in the coupon rate, the chance ofleakage of this all important information is always there.

o There have been severalallegations in this regard. However, it will probably be very difficult to prove with any degree of certaintythat there was insider trading based on informationabout coupon rate changes, because of the size of the market.

o With adaily trading volume of Rs. 3000 - 4000 crores, it would have beenvery easy fo ranyone to take a position (based on insideinformation) of Rs. 500 or even Rs.1000 crores without anyone suspecting anything untoward.

23. The Bull Run24. Where has all the money gone?o It is becoming increasingly clear that despite the intensive efforts by sev eral investigating agencies, it would be impossible to trace

all the money swindled from the banks. At this stage we can only conjecture about where the money has gone and what part of t he

misappropriatedamount would be recovered. Based on the result of i nvestigations and reporting so far, the following appear to be

the possibilities:

A large amount of the money was perhaps invested in shares. However, since the share prices have dropped steeply from thepeak they reached towards end of March 1992, the important question is what are the shares worth today? Till February 1992,

the Bombay Sensitive Index was below 2000; thereafter, it rose sharply to peakat 4500 by end of March 1992.In the

aftermath of the scam it fell to about 2500 before recovering to aro und 3000 by August 1992. Going by newspaper reports, it

appears likely that the bulk of Harshad Mehta's purchases were made at low prices, so that the average cost of his portfolio

corresponds to an index well below 2500 or perhaps even below 2000. Therefo re, Mehta's claim that he can clearall his dues

if he were allowed to do so cannot be dismissed without a serious consideration.Whether these shares are in fact traceable i s

another question.

25. Where has all the money gone?o It is well known that while Hars had Mehta was the "big bull" in the stockmarket, there was an equally powerful

"bear cartel", represented by Hiten Dalal, A.D.Narottamand others, operating in the market with money cheated out of

the banks. Since the stock prices ros e steeply during the period of the scam, it is likely that a considerable part of the money

swindled by this group would have been spent on financing the losses in the stockmarkets.

o It is rumored that a part of the money was sent out ofIndia through the Havala racket, converted into dollars/pounds, and broughtbackas India Development Bonds. These bonds are redeemable indollars/pounds and the holders cannot be asked to disclose the

source of their holdings. Thus, this money is beyond the reach ofany of the investigating agencies.

o A part of the money must have been spent as bribes and kickbacks to the various accomplices in the banks and possibly in thebureaucracy and in the political system.


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o As stated earlier, a part of the money might have been used t o finance the losses taken by the brokers to window -dress various banks'balance sheets.In other words, part of the money that went out of the banking system came back to it.In sum, it appears tha t only a

small fraction of the funds swindled is recoverab le.

26. Impact of the Scam The immediate impact of the scam was a sharp fall in the share prices. The index fell from 4500 to 2500 re presenting aloss of Rs.100,000 crores inmarket capitalization. Since the accused were active brokers in the stockmarkets, t he number of shares which

had passed through their hands in the last one year was colossal. All these shares became "tainted" shares, and ove rnight they

became worthless pieces of paperas they couldnot be delivered in the market. Genuine invest ors who had bought these shares well before

the scam came to light and even got them registered in theirnames found themselves being robbed by the government. This resu lted ina

chaotic situation in the market since no one was certainas to which shares w ere taintedand which were not.

27. The government's liberalization policies came under severe criticismafter the scam, with Harshad Mehtaand others being describedas theproducts of these policies. Bowing to the political pressures and the bad press it receivedduring the scam, the liberalizati on policies were

put on hold fora while by the government. The Securities Exchange Board ofIndia (SEBI) postponed sanctioning of private sectormutual

funds. The much talkedabout entry of foreign pension funds andmutual funds became more remote than ever. The Euro -issues planned by

severalIndian companies were delayed since the ability of Indian companies to raise equity capital in worldmarkets was severely

compromised.Impact of the Scam

28. Thank You

Harshad Mehta Scam Soft Copy

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