Nitin Sangwan

BCom (Hons.)
Section B
Roll No.: 1327

HARSHAD MEHTA SCAM

About Harshad Mehta

• Harshad Shantilal Mehta was born on 29 July in a Gujarati Jain family of modest means. Father:
Mr Shantilal Mehta, a small businessman
• Moved from small town Raipur to find his future in Mumbai First job as dispatch clerk in the
New India Assurance
• Worked with stock brokers and soon managed to get a brokers ‘card.
• Soon started his own venture: GrowMore Research and Asset Management Company Ltd.
Became a dream seller and a celebrity of the financial world.
• People know this personality as “The Big Bull” of Indian stock exchange
• After recommendations of the Big Bull demand for the stocks used to exponentially rise!!!
Propounded the “Replacement Price Theory”
• The theory basically argues that old companies should be valued on the basis of the amount
of money which would be required to create another such company
• He was alleged to have engineered the rise in the BSE stock exchange in the year 1992
• On April 23, 1992, journalist Sucheta Dalal in a column in The Times of India, exposed the
dubious ways of Harshad Mehta
• He was later charged with 72 criminal offenses and more than 600 civil action suits were filed
against him
• He died in 2002 of a massive heart attack in a jail in Thane, with many litigations still pending
against him.
OVERVIEW OF THE SCAM

This scam can be categorized as a Capital Market scam in which it is done by manipulating the facts in
order to attain enormous profits. There were 4 different aspects of this scam:

• Diversion of funds - Diversion of funds from the banking system to brokers for financing their
operations in the stock market
• Intra-day trading – The modus operandi mainly included investing heavily in certain shares at
the start of the day which led to a sharp increase in the price of the stock and then cashing in
at the end of the day to reap huge benefits
• Following two aspects shall be explained in detail later. Use of Ready Forward (RF) to maintain
SLR
• Fake Bank receipts (BR)

Taking advantages of the loopholes in the banking system, Harshad and his associates triggered a
securities scam diverting funds to the tune of Rs 4000 Cr. from the banks to stockbrokers from
April 1991 to May 1992. He caused the steep rise in the Stock market index in the year 1992 by
bidding at a premium for many shares.

Some of the stocks which were highly invested in by Harshad Mehta were:

• ACC
• Apollo Tyres
• Reliance
• Tata Iron and Steel Co. (TISCO)
• BPL
• Sterlite
• Videocon
The above graph shows the rise in the Sensex during the period when Harshad Mehta was operational
and putting in loads of money in the stock exchange increasing the liquidity and thus arbitrary increase
in the prices of some shares.
READY FORWARD (RF) – MODUS OPERANDI

Ready forward is actually a sort of a short-term loan (typically 15 days or less) usually from one
bank to another. Unlike other loans, it is actually a secured loan with Government securities
backing it up. In essence, it’s like one bank selling its securities to another with a promise of buying
it back at a pre-determined price.
In early 1990s, Banks in India had to maintain a fixed ratio of their deposits in the form of Government
securities/bonds which was governed by the statutory liquidity ratio (SLR). This obligation on the part
of the banks required them to show a detailed sheet of its stock of Government bonds at the end of
every day. Soon after the rule changed and the banks were not required to show these details at end
of everyday rather, they were allowed to show in once in a week i.e. Friday.

This allowed the banks to sell their bonds in the earlier part of their week and then buy it back in the
later part. This helped them make some profits as they could invest the money that they got by selling
the bonds. The whole process of buying and selling the bonds was taken care of by brokers and only
they knew the two parties which were involved. Individual banks did not have any idea as to who the
other party in the whole transaction was.

The whole process can be described in 3 phases:

1. Settlement Process
2. Payment cheques
3. Dispensing of securities

SETTLEMENT PROCESS
The normal settlement process usually involved the two banks exchanging the money and the
securities at the same time. This was very beautifully manipulated by the brokers so that the money
first gets into the hands of the brokers and then they paid off the banks.

PAYMENT CHEQUES
The brokers asked the banks to give the cheques in their own name claiming that they will pay to the
other party on their own. The practice thus emerged was that the broker would obtain a cheque drawn
on the RBI favouring not himself but his bank and the bank would get the money and transfer it to the
broker account on the same day. This helped the brokers to get the money as soon as the transaction
is made which could further be used to be channelled into the stock market.

DISPENSING THE SECURITY

Here the brokers used their credibility to persuade the banks to part with the cheques without actually
receiving the securities with the promise that they will get the securities the next day with a 15%
interest for one day. Bank officials were bribed to accomplish this task as this was illegal on the part
of the banks to let go of their money without any assurance. This was Harshad Mehta and his
associates were able to use the money of the banks which was eventually used for speculating in the
stock market.

BANK RECEIPT

Another instrument used in this scam was the bank receipt (BR). In an RF deal, securities were not
moved back and forth in actuality. Instead, the borrower, who is the seller of securities, gave the buyer
of the securities a BR.

In practice, borrowing bank gives a Bank Receipt (BR) instead of delivering the actual securities to the
lender. Bank receipts serve three functions –

• it confirms the sale of securities

• promises to deliver the securities to the buyer. It states that the securities are held by the
seller in trust for the buyer.
• acts as a receipt for the received money by the selling bank

A BR means that the issuer holds the securities in trust for the buyer, but there is a possibility that the
issuer may not have the securities at all. Following are the reasons for a bank to issue a BR which is
not backed by actual securities –

• A bank may also short sell securities, i.e. bank will sell securities it doesn’t have. This will be
done if the bank anticipates fall in prices. Bank buys securities at lower prices when they fall
in value and discharges the BR.
• Bank may do an RF deal and issue a fake BR (not backed by securities) if banks simply want an
unsecured loan, where a lending bank would be under the impression that it’s dealing with a
secured loan but in reality it’s advancing an unsecured loan. Though, lenders should have
taken measures to protect themselves.

During the scam, brokers were so perfect in the art of using fake BRs and obtained unsecured loans
from various banks. They managed to persuade little known banks like the Bank of Karad (BOK) and
the metropolitan Cooperative Bank (MCB) to issue BRs and then these BRs were used to do RF deals
with other banks. This way several large banks made huge unsecured loans to these banks and thus it
created money for the brokers.

CONTROL SYSTEMS
There was a complete breakdown of the control system within the commercial banks and that of RBI.
Following features are involved in the internal control system:

• Whenever an RF deal is done by using BRs rather than actual securities, the lending bank has
to contend with the possibility that it may be making an unsecured loan. This requires
assigning credit limit to the borrower by assessing the creditworthiness of the borrower.
• The different aspects of securities transactions of a bank are carried out by different persons
DISAPPEARANCE OF MONEY

It is becoming increasingly clear that despite the intensive efforts by several 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 the misappropriated amount would be
recovered. Based on the result of investigations 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 the peak 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 peak at 4500 by end of March 1992. In the
aftermath of the scam it fell to about 2500 before recovering to around 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. Therefore, Mehta's claim that he can clear all his
dues if he were allowed to do so cannot be dismissed without a serious consideration.
• Whether these shares are in fact traceable is another question.
• It is well known that while Harshad Mehta was the "big bull" in the stock market, there was
an equally powerful "bear cartel", represented by Hiten Dalal, A.D. Narottam and others,
operating in the market with money cheated out of the banks. Since the stock prices rose
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 stock markets. It
is rumored that a part of the money was sent out of India through the Havala racket, converted
into dollars/pounds, and brought back as India Development Bonds. These bonds are
redeemable in dollars/pounds and the holders cannot be asked to disclose the source of their
holdings. Thus, this money is beyond the reach of any of the investigating agencies.
• A part of the money must have been spent as bribes and kickbacks to the various accomplices
in the banks and possibly in the bureaucracy and in the political system.
• A part of the money might have been used to 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 that only a small fraction of the funds
swindled is recoverable.
AFTER THE SCANDAL

IMMEDIATE IMPACT:
After the Harshad Mehta scandal was exposed, April, 1992, the situation in share market was that of
utter chaos. The first impact of the scam was a steep fall in the share prices. The index fell from 4500
to 2500 representing a loss of Rs. 100,000 crores in market capitalization. However, the major damage
to the stock market did not stop here. Since the accused were active brokers in the stock markets,
they had traded a large number of shares during the previous year. All these shares became tainted
and worthless and could not be used in the market. This was a great loss to the innocent investor who
had bought these shares much before the scandal was exposed.

IMPACT ON THE INDIAN ECONOMY

There was a lot of media coverage on the scam and the political parties left no opportunity in criticizing
the government for it. The government was under immense pressure and its liberalization policies
were severely criticized. It was also believed that Harshad Mehta and his accomplices were behind
framing of these policies. In the end the government had to put the liberalization plans on hold. SEBI
had to postpone the sanctioning of private sector mutual funds. Implementation of some aspects of
the Narasimham Committee recommendations on the banking system had to be delayed. 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 Indian companies
to raise equity capital in world markets was severely compromised.

IMPACT ON THE BANKS

Fake bank receipts (BR) which were an integral part of the execution of the whole scam landed the
banks involved in a tight spot. These BR were declared void and public money was at stake. At least
ten prominent banks were involved in this; some of them being SBI, Standard Chartered and a
subsidiary of RBI. The scam could have been checked in time with proper policies and verifications.
The government, the RBI and the commercial banks are as much accountable as the brokers for the
scam. The brokers were encouraged by the banks to divert funds from the banking system to the stock
market. The RBI too stood indicted because despite knowledge about banks over-stepping the
boundaries demarcating their arena of operations, it failed to check them. Some of the prominent
individuals who were penalized were K. M. Margabandhu, CMD of the UCO Bank (Arrested and sacked)
and V. Mahadevan, one of the MD the State Bank of India (Suspended).

RESPONSE OF THE GOVERNMENT

As discussed, the government was under immense pressure from media and opposition to take
concrete steps to bring justice to the people and also to ensure that the loopholes in the system which
caused such scam were closed so that such scams would not recur. As a first step by the government,
the case was handed over to Central Bureau of Investigation and the Joint Parliamentary Committee
(JPC). Then a special court was set up to facilitate speedy trial. The special court declared an ordinance
for the attached the properties of all individuals accused in the scam. Further, all transactions done by
the accused after March 31, 1991 were considered void. To reform the system further, the
government banned RF deals and slowed down the liberalization process.
POLICY MEASURES

The government, the RBI and the commercial banks were as much accountable as the brokers for this
scam. The brokers were encouraged by the banks to invest their funds in the stock market in place of
investing in the banking system. The RBI was also responsible for this scam because despite knowledge
about banks over-stepping the boundaries demarcating their arena of operations, it failed to reign
them in. RBI didn’t take any action against the commercial banks. The looting was done with full
knowledge of the very individuals appointed by the government who were responsible to guard
against such a possibility. So the Harshad Mehta’s scam could have been detected earlier if either of
the above (commercial banks, RBI or government) parties not encourage the brokers to invest in the
stock market.

ACTIONS TAKEN BY THE GOVERNMENT:

• Discover the guilty: This task was assigned to the Central Bureau of Investigation (CBI) and to
the Joint Parliamentary Committee (JPC). A special court was set up to facilitate speedy trial.
• Transactions became void: The government set up a special court and promulgated an
ordinance with several draconian provisions to deal with the scam. Sections (3) and (4) of the
ordinance attached the properties of all individuals accused in the scam and also voided all
transactions that had at any stage been routed through them after March 31, 1991.
• Recover the money: Provisions of the Ordinance for attachment of property and voiding of
transactions with the consequent creation of "tainted" shares were attempts in this direction.
• Reform the system: The government's response so far, banning of RF deals and going slow on
liberalization

The main motive behind punishing the offenders is more to prevent future offenders to not to try this
type of scam. The government must ensure that not only the obviously guilty (the brokers) but also
the not so obviously guilty (the bank executives, the bureaucrats and perhaps the politicians) are
identified and brought to book. These types of investigations are not only very time consuming but
also very expensive.
ETHICAL ISSUES

ETHICAL MISSHAP
The ethical temperature of any business depends upon :

• Individual’s sense of values: If large sums of money are involved, a person is often dictated by
greed and hence tends to become unethical
• Social values accepted in the industry i.e. acceptance of unethical practices because they are
the prevailing norm. For example during the Harshad Mehta Scam, it was claimed that Bank
receipts were the prevailing norm and hence there was nothing unethical in using them
though they proved to be one of the main reasons causing the scam
• The third and the most important reason being that there is a lack of corporate governance
systems in India. Corporate Governance is the result of the above two points, and in addition,
it’s the result of public governance system. If the public governance is weak, we cannot have
good corporate governance

“Scam after scam - Harshad Mehta to Ketan Parekh, corporates get away scot free. Brokers & bankers
should be jailed. After all they pay the netas!” Sucheta Dalal , Journalist who exposed Harshad
Mehta.

So how to avoid such scams?

AVOIDANCE OF SUCH SCAMS

Strengthen the legal and administrative framework of public governance system

• It is necessary to have a strong public governance system, because even if there are companies
who follow honorable and ethical practices , if the general environment is such that everyone
is unethical because of the lack of a proper legally enforceable system, then people are
tempted to indulge in unethical practices. But at the same time it does not mean that the
money markets are overregulated, because then even legitimate deals will be disguised.
• Stricter norms for corporate governance to be set by bodies like Association of CA’s
a. Bringing transparency
b. Bringing accountability

It is necessary for every corporate to follow the highest standards of corporate governance.
The laws for corporate governance need to be enforced as brutally as the law for any other
crime. These markets control our economy and the money of many small investors. There
is no future for an economy where the markets are not subjected to the highest levels of
accountability.

• Wrong-doers to be punished severely to discourage others from committing the crime.

There was a research done in India according to which a sample of people were asked that if you are
walking on a road and if you find a 1000 rupee note, will you pick it up? 90% of the people said yes.
Then the question was modified slightly and the people were asked , what if there was a surveillance
camera on the road and if it worked only 10% of the times, will you pick up the note? This time 90%
of the people said no.

In India today, the violators feel that they will not be punished and even if they are punished they can
easily get away with the whole thing. These same people will follow world standards of transparency
while dealing with the Nasdaq or the NYSE but they violate laws in Mumbai without thinking a second
time. After the Harshad Mehta scam, very soon , there was this Ketan Parekh scam, who followed the
footsteps of Harshad Mehta just because no example was set by punishing Harshad Mehta to deter
future violators

Finally it is important to punish those directly involved (brokers) and also those indirectly involved (
politicians, bureaucrats) because these people are the facilitators.
CONCLUSION

• Corporate Governance is the value framework, ethical framework and moral framework
within which businesses make decisions
• Business must harness the power of ethics which is assuming a new level of importance and
power. (James Joseph - former US ambassador to SA)
• When large sums of money are involved, greed causes people to become unethical. How
large? That’s relative.Business ethics is relative-Prof Anand Dasgupta