Harshad Mehta Scam

Harshad Mehta scam: Harshad Mehta  was an Indian stockbroker and is alleged to have engineered the rise in the BSE stock exchange in the year 1992. Exploiting several loopholes in the banking system, Harshad and his associates siphoned off funds from inter-bank transactions and bought shares heavily at a premium across many segments, triggering a rise in the Sensex. When the scheme was exposed, the banks started demanding the money back, causing the collapse. He was later charged with 72 criminal offenses and more than 600 civil action suits were filed against him.He died in 2002 with many litigations still pending against him. 3. 1 Ready Forward Deal (RF): †¢ The crucial mechanism through which the scam was effected was the Ready Forward deal. †¢ The Ready Forward Deal (RF) is in essence a secured short term (typically 15 day) loan from one bank to another bank. The lending is done against Government Securities exactly the way a pawnbroker lends against jewelry. †¢ In fact one can say that the borrowing bank actually sells the securities to the lending bank and buys them back at the end of the period of the loan at (typically) a slightly higher price. It was this RF deal that Harshad Mehta and his associates used with great success to channel money from banking system. 3. 2 The Mechanics of the Scam: As explained above, a ready forward deal is, in substance, a secured loan 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 unsecured loan to broker. This was wonderfully engineered by the brokers. To give a better understanding of the mechanism, the whole process has been segregated into 3 different parts. . The settlement process 2. Payment cheques 3. Dispensing the security 1. The settlement Process: ? The normal settlement process in government securities is that the transacting banks make payments and deliver the securities directly to each other. ? Dur ing the scam, however, the banks or at least some banks adopted an alternative settlement process which was similar to the process used for settling transactions in the stock market. ? In this settlement process, deliveries of securities and payments are made through the broker.That is, the seller hands over the securities to the broker who passes them on to the buyer, while the buyer gives the cheque to the broker who then makes the payment to the seller. ? In this settlement process, the buyer and the seller may not even know whom they have traded with, both being known only to the broker. ? There were two important reasons why the broker intermediated settlement began to be used in the government securities markets. ? The brokers instead of merely bringing buyers and sellers together started taking positions in the market.In other words, they started trading on their own account, and in a sense became market makers in some securities thereby imparting greater liquidity to the mar kets. ? When a bank wanted to conceal the fact that it was doing an RF deal, the broker came in handy. The broker provided contract notes for this purpose with fictitious counter parties, but arranged for the actual settlement to take place with the correct counter party. 2. Payment Cheques: ? A broker intermediated settlement allowed the broker to lay his hands on the cheque as it went from one bank to another through him.The hurdle now was to find a way of crediting the cheque to his account though it was drawn in favor of a bank and was crossed account payee. ? As it happens, it is purely a matter of banking custom that an account payee cheque is paid only to the payee mentioned on the cheque. In fact, exceptions were being made to this norm, well before the scam came to light. ? Privileged (corporate) customers were routinely allowed to credit account payee cheques in favour of a bank into their own accounts to avoid clearing delays, thereby reducing the interest lost on the amo unt. Normally, if a customer obtains a cheque in his own favour and deposits it into his own account, it may take a day or two for the cheque to be cleared and for the funds to become available to the customer. At 15% interest, the interest loss on a clearing delay of two days for a Rs. 100 crores cheque is about Rs. 8 lakhs. ? On the other hand, when banks make payments to each other by writing cheques on their account with the RBI, these cheques are cleared on the same day. ? The practice which thus emerged was that a customer would obtain a cheque drawn on the RBI favoring not himself but his bank.The bank would get the money and credit his account the same day. ? This was the practice which the brokers in the money market exploited to their benefit. 3. Dispensing the security: ? The brokers thus found a way of getting hold of the cheques as they went from one bank to another and crediting the amounts to their accounts. This effectively transformed an RF into a loan to a broker r ather than to a bank. ? But this, by itself, would not have led to the scam because the RF after all is a secured loan, and a secured loan to a broker is still secured. What was necessary now was to find a way of eliminating the security itself! There are three routes adopted for this purpose: 1. Some banks (or rather their officials) were persuaded to part with cheques without actually receiving securities in return. A simple explanation of this is that the officials concerned were bribed and/or negligent. A more intriguing possibility is that the banks' senior/top management were aware of this and turned a Nelson's eye to it to benefit from higher returns the brokers could offer by diverting the funds to the stock market. One must recognize that as long as the scam lasted, the banks benefited from such an arrangement.The management of banks might have been sorely tempted to adopt this route to higher profitability. 2. The second route was to replace the actual securities by a wort hless piece of paper – a fake Bank Receipt (BR). This is discussed in greater detail in the next section. 3. The third method was simply to forge the securities themselves. In many cases, PSU bonds were represented only by allotment letters rather than certificates on security paper. And it is easier to forge an allotment letter for Rs. 100 crores worth of securities than it is to forge a 100 rupee note!Outright forgery of this kind however accounted for only a very small part of the total funds misappropriated 3. Bank Receipt: ? In an RF deal, as we have discussed it so far, the borrowing bank delivers the actual securities to the lender and 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 functions: ? The BR confirms the sale of securities. ? It acts as a receipt for the money received 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 trust for the buyer. ? In short, a BR is something like an IOU (I owe you securities! ), and the use of the BR de facto converts an RF deal into an unsecured loan. The lending bank no longer has the securities; it has only the borrower's assurance that the borrower has the securities which can/will be delivered if/when the need arises. BRs issued without Backing of Securities: ? As stated earlier, a BR is supposed to imply that the issuer actually has the securities and holds them in trust for the buyer.But in reality the issuer may not have the securities at all. ? There are two reasons why a bank may issue a BR, which is not backed by actual securities: 1. A bank may short sell securities, that is, it sells securities it does not have. This would be done if the bank thinks that the prices of these securities would decrease. Since this would be an outright sale (not an RF! ), the ban k issues a BR. When the securities do fall in value, the bank buys them at lower prices and discharges the BR by delivering the securities sold. Short selling in some form is an integral part of most bond markets in the world.It can be argued that some amount of shortselling subject to some degree of regulation is a desirable feature of a bond market. In our opinion, an outright sale using a BR, which is not backed by securities, is not harmful per se though it violates the RBI guidelines. 2. The second reason is that the bank may simply want an unsecured loan. It may then do an RF deal issuing a â€Å"fake† BR which is a BR without any securities to back them. The lending bank would be under a mistaken impression that it is making a secured loan when it is actually advancing an unsecured loan.Obviously, lenders should have taken measures to protect themselves from such a possibility During the scam, the brokers perfected the art of using fake BRs to obtain unsecured loans fr om the banking system. They persuaded some small and little known 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' accounts. In effect, several arge banks made huge unsecured loans to the BOK/MCB which in turn made the money available to the brokers. 4. Breakdown of the Control system in scam: ? The scam was made possible by a complete breakdown of the control system both within the commercial banks as well as the control system of the RBI itself. ? We shall examine these control systems to understand how these failed to function effectively and what lessons can be learnt to prevent failure of control systems in the future. ? The internal control system of the commercial banks involves the following features: 1. Separation of Functions:The different aspects of securities tr ansactions of a bank, namely dealing, custody and accounting are carried out by different persons. 2. Counterparty Limits: The moment an RF deal is done on the basis of a BR rather than actual securities, the lending bank has to contend with the possibility that the BR received may not be backed by any/adequate securities. In effect, therefore, it may be making an unsecured loan, and it must do the RF only if it is prepared to make an unsecured loan. This requires assessing the creditworthiness of the borrower and assigning him a â€Å"credit limit† up to which the bank is prepared to lend.Technically, this is known as a counterparty limit. 5. Other Aspects of the scam: ? There are several aspects of the scam which are closely related to the securities markets, but which are different from the operational aspect of the markets. ? These pertain to information that can cause significant changes in the prices of securities as well as the information supplied by the commercial ba nks on their financial performance. ? On each occasion the coupon rate was increased by 1/2%, thereby raising the coupon rate from 11. 5% to 13% during this ten month period.The major implication of raising interest rate on new borrowings is that it would trigger a fall in the market prices of the old loans which are pegged at the old (lower) interest rates. The price of the 11. 5% Government Loan 2010 dropped by 3% to 5% with each coupon rate hike. If anyone has advance information about these changes in the coupon rates, he could make enormous amounts of riskless profit by short selling the old securities just before the announcement of rate hike and buying back (covering his position) after the prices have fallen. ? Somebody who took a short position of Rs. 00 crores before the coupon hike of September 1991 could have made a profit of Rs. 15 crores, practically overnight! Since several persons in the Finance Ministry and the RBI are likely to be aware of the impending hike in the coupon rate, the chance of leakage of this all important information is always there. ? There have been several allegations in this regard. However, it will probably be very difficult to prove with any degree of certainty that there was insider trading based on information about coupon rate changes, because of the size of the market. With a daily trading volume of Rs. 3000 – 4000 crores, it would have been very easy for anyone to take a position (based on inside information) of Rs. 500 or even Rs. 1000 crores without anyone suspecting anything untoward. 6. 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 representing a loss of Rs. 100,000 crores in market capitalization. [pic] ? Since the accused were active brokers in the stock markets, the number of shares which had passed through their hands in the last one year was colossal.All these shares became â€Å"tainted† shares, and overnight they became worthless pieces of paper as they could not be delivered in the market. Genuine investors who had bought these shares well before the scam came to light and even got them registered in their names found themselves being robbed by the government. This resulted in a chaotic situation in the market since no one was certain as to which shares were tainted and which were not. ? The government's liberalization policies came under severe criticism after the scam, with Harshad Mehta and others being described as the products of these policies. Bowing to the political pressures and the bad press it received during the scam, the liberalization policies were put on hold for a while by the government. The Securities Exchange Board of India (SEBI) postponed sanctioning of private sector mutual funds. ? The much talked about entry of foreign pension funds and mutual funds became more remote than ever. The Euro-issues planned by several Indian companies were delayed since the ability of In dian companies to raise equity capital in world markets was severely compromised. Harshad Mehta Scam Harshad Mehta scam: Harshad Mehta  was an Indian stockbroker and is alleged to have engineered the rise in the BSE stock exchange in the year 1992. Exploiting several loopholes in the banking system, Harshad and his associates siphoned off funds from inter-bank transactions and bought shares heavily at a premium across many segments, triggering a rise in the Sensex. When the scheme was exposed, the banks started demanding the money back, causing the collapse. He was later charged with 72 criminal offenses and more than 600 civil action suits were filed against him.He died in 2002 with many litigations still pending against him. 3. 1 Ready Forward Deal (RF): †¢ The crucial mechanism through which the scam was effected was the Ready Forward deal. †¢ The Ready Forward Deal (RF) is in essence a secured short term (typically 15 day) loan from one bank to another bank. The lending is done against Government Securities exactly the way a pawnbroker lends against jewelry. †¢ In fact one can say that the borrowing bank actually sells the securities to the lending bank and buys them back at the end of the period of the loan at (typically) a slightly higher price. It was this RF deal that Harshad Mehta and his associates used with great success to channel money from banking system. 3. 2 The Mechanics of the Scam: As explained above, a ready forward deal is, in substance, a secured loan 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 unsecured loan to broker. This was wonderfully engineered by the brokers. To give a better understanding of the mechanism, the whole process has been segregated into 3 different parts. . The settlement process 2. Payment cheques 3. Dispensing the security 1. The settlement Process: ? The normal settlement process in government securities is that the transacting banks make payments and deliver the securities directly to each other. ? Dur ing the scam, however, the banks or at least some banks adopted an alternative settlement process which was similar to the process used for settling transactions in the stock market. ? In this settlement process, deliveries of securities and payments are made through the broker.That is, the seller hands over the securities to the broker who passes them on to the buyer, while the buyer gives the cheque to the broker who then makes the payment to the seller. ? In this settlement process, the buyer and the seller may not even know whom they have traded with, both being known only to the broker. ? There were two important reasons why the broker intermediated settlement began to be used in the government securities markets. ? The brokers instead of merely bringing buyers and sellers together started taking positions in the market.In other words, they started trading on their own account, and in a sense became market makers in some securities thereby imparting greater liquidity to the mar kets. ? When a bank wanted to conceal the fact that it was doing an RF deal, the broker came in handy. The broker provided contract notes for this purpose with fictitious counter parties, but arranged for the actual settlement to take place with the correct counter party. 2. Payment Cheques: ? A broker intermediated settlement allowed the broker to lay his hands on the cheque as it went from one bank to another through him.The hurdle now was to find a way of crediting the cheque to his account though it was drawn in favor of a bank and was crossed account payee. ? As it happens, it is purely a matter of banking custom that an account payee cheque is paid only to the payee mentioned on the cheque. In fact, exceptions were being made to this norm, well before the scam came to light. ? Privileged (corporate) customers were routinely allowed to credit account payee cheques in favour of a bank into their own accounts to avoid clearing delays, thereby reducing the interest lost on the amo unt. Normally, if a customer obtains a cheque in his own favour and deposits it into his own account, it may take a day or two for the cheque to be cleared and for the funds to become available to the customer. At 15% interest, the interest loss on a clearing delay of two days for a Rs. 100 crores cheque is about Rs. 8 lakhs. ? On the other hand, when banks make payments to each other by writing cheques on their account with the RBI, these cheques are cleared on the same day. ? The practice which thus emerged was that a customer would obtain a cheque drawn on the RBI favoring not himself but his bank.The bank would get the money and credit his account the same day. ? This was the practice which the brokers in the money market exploited to their benefit. 3. Dispensing the security: ? The brokers thus found a way of getting hold of the cheques as they went from one bank to another and crediting the amounts to their accounts. This effectively transformed an RF into a loan to a broker r ather than to a bank. ? But this, by itself, would not have led to the scam because the RF after all is a secured loan, and a secured loan to a broker is still secured. What was necessary now was to find a way of eliminating the security itself! There are three routes adopted for this purpose: 1. Some banks (or rather their officials) were persuaded to part with cheques without actually receiving securities in return. A simple explanation of this is that the officials concerned were bribed and/or negligent. A more intriguing possibility is that the banks' senior/top management were aware of this and turned a Nelson's eye to it to benefit from higher returns the brokers could offer by diverting the funds to the stock market. One must recognize that as long as the scam lasted, the banks benefited from such an arrangement.The management of banks might have been sorely tempted to adopt this route to higher profitability. 2. The second route was to replace the actual securities by a wort hless piece of paper – a fake Bank Receipt (BR). This is discussed in greater detail in the next section. 3. The third method was simply to forge the securities themselves. In many cases, PSU bonds were represented only by allotment letters rather than certificates on security paper. And it is easier to forge an allotment letter for Rs. 100 crores worth of securities than it is to forge a 100 rupee note!Outright forgery of this kind however accounted for only a very small part of the total funds misappropriated 3. Bank Receipt: ? In an RF deal, as we have discussed it so far, the borrowing bank delivers the actual securities to the lender and 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 functions: ? The BR confirms the sale of securities. ? It acts as a receipt for the money received 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 trust for the buyer. ? In short, a BR is something like an IOU (I owe you securities! ), and the use of the BR de facto converts an RF deal into an unsecured loan. The lending bank no longer has the securities; it has only the borrower's assurance that the borrower has the securities which can/will be delivered if/when the need arises. BRs issued without Backing of Securities: ? As stated earlier, a BR is supposed to imply that the issuer actually has the securities and holds them in trust for the buyer.But in reality the issuer may not have the securities at all. ? There are two reasons why a bank may issue a BR, which is not backed by actual securities: 1. A bank may short sell securities, that is, it sells securities it does not have. This would be done if the bank thinks that the prices of these securities would decrease. Since this would be an outright sale (not an RF! ), the ban k issues a BR. When the securities do fall in value, the bank buys them at lower prices and discharges the BR by delivering the securities sold. Short selling in some form is an integral part of most bond markets in the world.It can be argued that some amount of shortselling subject to some degree of regulation is a desirable feature of a bond market. In our opinion, an outright sale using a BR, which is not backed by securities, is not harmful per se though it violates the RBI guidelines. 2. The second reason is that the bank may simply want an unsecured loan. It may then do an RF deal issuing a â€Å"fake† BR which is a BR without any securities to back them. The lending bank would be under a mistaken impression that it is making a secured loan when it is actually advancing an unsecured loan.Obviously, lenders should have taken measures to protect themselves from such a possibility During the scam, the brokers perfected the art of using fake BRs to obtain unsecured loans fr om the banking system. They persuaded some small and little known 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' accounts. In effect, several arge banks made huge unsecured loans to the BOK/MCB which in turn made the money available to the brokers. 4. Breakdown of the Control system in scam: ? The scam was made possible by a complete breakdown of the control system both within the commercial banks as well as the control system of the RBI itself. ? We shall examine these control systems to understand how these failed to function effectively and what lessons can be learnt to prevent failure of control systems in the future. ? The internal control system of the commercial banks involves the following features: 1. Separation of Functions:The different aspects of securities tr ansactions of a bank, namely dealing, custody and accounting are carried out by different persons. 2. Counterparty Limits: The moment an RF deal is done on the basis of a BR rather than actual securities, the lending bank has to contend with the possibility that the BR received may not be backed by any/adequate securities. In effect, therefore, it may be making an unsecured loan, and it must do the RF only if it is prepared to make an unsecured loan. This requires assessing the creditworthiness of the borrower and assigning him a â€Å"credit limit† up to which the bank is prepared to lend.Technically, this is known as a counterparty limit. 5. Other Aspects of the scam: ? There are several aspects of the scam which are closely related to the securities markets, but which are different from the operational aspect of the markets. ? These pertain to information that can cause significant changes in the prices of securities as well as the information supplied by the commercial ba nks on their financial performance. ? On each occasion the coupon rate was increased by 1/2%, thereby raising the coupon rate from 11. 5% to 13% during this ten month period.The major implication of raising interest rate on new borrowings is that it would trigger a fall in the market prices of the old loans which are pegged at the old (lower) interest rates. The price of the 11. 5% Government Loan 2010 dropped by 3% to 5% with each coupon rate hike. If anyone has advance information about these changes in the coupon rates, he could make enormous amounts of riskless profit by short selling the old securities just before the announcement of rate hike and buying back (covering his position) after the prices have fallen. ? Somebody who took a short position of Rs. 00 crores before the coupon hike of September 1991 could have made a profit of Rs. 15 crores, practically overnight! Since several persons in the Finance Ministry and the RBI are likely to be aware of the impending hike in the coupon rate, the chance of leakage of this all important information is always there. ? There have been several allegations in this regard. However, it will probably be very difficult to prove with any degree of certainty that there was insider trading based on information about coupon rate changes, because of the size of the market. With a daily trading volume of Rs. 3000 – 4000 crores, it would have been very easy for anyone to take a position (based on inside information) of Rs. 500 or even Rs. 1000 crores without anyone suspecting anything untoward. 6. 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 representing a loss of Rs. 100,000 crores in market capitalization. [pic] ? Since the accused were active brokers in the stock markets, the number of shares which had passed through their hands in the last one year was colossal.All these shares became â€Å"tainted† shares, and overnight they became worthless pieces of paper as they could not be delivered in the market. Genuine investors who had bought these shares well before the scam came to light and even got them registered in their names found themselves being robbed by the government. This resulted in a chaotic situation in the market since no one was certain as to which shares were tainted and which were not. ? The government's liberalization policies came under severe criticism after the scam, with Harshad Mehta and others being described as the products of these policies. Bowing to the political pressures and the bad press it received during the scam, the liberalization policies were put on hold for a while by the government. The Securities Exchange Board of India (SEBI) postponed sanctioning of private sector mutual funds. ? The much talked about entry of foreign pension funds and mutual funds became more remote than ever. The Euro-issues planned by several Indian companies were delayed since the ability of In dian companies to raise equity capital in world markets was severely compromised.