Securities Scam 92 – Some Governance Issues

• What was the scam about?

• Why did the scam occur?
• How was the scam perpetrated?
• How was the scam discovered?
• What was the response to the scam?
• Governance at the national level
• Governance at the regulatory level
• Governance at the organizational level
• Conceptualization of issues in governance
• Other issues

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 What was the scam about?

The scam was about diversion of funds on a

very large scale from the banking system to
stock market.
The exposure of the banking system was put
at over Rs. 4000 crores – the most reliable of
the various estimates. To get a perspective on
the size of the exposure, the daily turnover in
the stock market in those days was about Rs.
100 - 250 crores.

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 Why did the scam occur? – the larger context
The few years leading up to the scam were a period of great
instability
- VP Singh was ousted due to Mandal,
- Advani undertook his Rath yatra
- August 2, 1990 Iraq annexed Kuwait and was ousted and
subdued subsequently
- In September ’90, crude crossed $30 per barrel from $14
- In early 1991, Chandrashekhar government fell after just 4
months in office … congress pulled the rug
- Rajiv Gandhi was assassinated
- In May 1991, Congress came to power, Man Mohan Singh
became the FM and Narasimha Rao the PM.
- By mid 1991, India’s FX reserve position became
precarious

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 Why did the scam occur? – the larger context

The New Government … induction by fire

To avoid defaulting on its international financial

commitments, on July 6, 1991, 20 tons of gold from the
vaults of RBI were air-lifted to vaults of Bank of England for
Bank of Japan to extend loan of $400 million to India.

Rupee was depreciated by over 20% overnight to give a push

to exports and discourage imports. The PSUs were asked by
the government to borrow in foreign currency to bolster
reserves. Government approached IMF for bailout. IMF put
conditions – economic reforms - for helping out. At the time,
SENSEX was hovering below 1000.

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 Why did the scam occur? – the larger context

PSUs were flush with funds that they did not

need for their business. They approached the
government to allow them to park these funds
with banks to earn returns. The PMS was
designed precisely for this – special deposits
exempt from investment restrictions on
normal deposit with banks. Competing for
these funds, banks offered higher returns that
could be earned only through help from
operators like Harshad Mehta.
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Why did the scam occur? – the market practices

Degeneration of processes:
- Cheques in a bank’s name credited to client
account (to overcome clearance delays)
- Bank Receipts (BRs) rather than exchange of
securities used for transactions (to deal with
inefficiency of the PDO)
- Broker intermediated spurious transactions
became rampant for ‘window dressing’ of accounts
of banks
- Large scale inside information based punting
started occurring on the basis of change in the
administered interest rates

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 Why did the scam occur? – the opportunity
Cost of funds in formal money market was 18-20%,
while cost of funds in the informal money market
was 36%.
From below 1000 in mid-1991, by March 1992, the
stock index had risen to about 4500. The rise was
unprecedented – at a rate well above rate of
borrowing to finance stock market operations.
Financing at almost any cost was profitable.
Profits were there to be had if any one could find a
way of diverting funds from the formal money
market to the stock market.
Harshad Mehta and several others were well
positioned as they were present in both the markets.

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 How was the scam perpetrated?
– the ready-forward deal
Brings A & B together
The Broker
TheBroker
Borker

Gives Securities
Bank A: Bank B:
Borrower Lender
Receives Cash

Brokers got hold of the securities and cash

Brokers stole securities from the banks
Securities were replaced with BRs, without underlying securities

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 How was the scam discovered?
In March 92, RBI started investigating the
possibility of insider trading. Just before a rate
hike SBI had bought huge amount of 2010
securities from Harshad Mehta. In that context,
SBI discovered that Rs. 649 crores worth of
securities were due from Harshad Mehta. After
secret negotiations, between April 13 and April
22, Harshad Mehta paid SBI about Rs. 622
crores – misappropriated from NHB. Market was
agog with rumours. Finally, on April 23, 1992 the
story broke in ToI that Rs. 500 crores worth of
securities were missing from the vaults of SBI.
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 What was the response to the scam?

- RBI set up the Janakiraman Committee on

April 30 (first report by end of May)
- Government ordered CBI enquiry
- JPC set up by August 10 (submitted report
on Dec 21, 1992)
- Government set up special court to deal with
scam related cases to expedite justice.

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 Governance at the National Level
“MUMBAI, APRIL 12, 2006: The Special Court hearing the
1992 security scam cases, on Wednesday sentenced Sudhir
Mehta, brother of late Harshad Mehta, and six others,
including four bank officials, to rigorous imprisonment (RI)
ranging from 1 year to 10 years on the charge of duping
State Bank of India to the tune of Rs 600 crore in connection
with the securities scam that rocked the financial markets in
1992.”
It took just one week for Singapore to deal with
failure of Barings plc in 1998. Nick Leeson was
tried and convicted within 6 months of the event.

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 Governance at the National Level
- Multiplicity of investigating agencies created utter
chaos
- Despite special courts, 14 years after the scam
occurred, scam related cases are still being heard
- Innocent investors’ interests were completely
subverted due to ‘tainted shares’
- Much needed reforms of the financial sector,
particularly the debt market, were shelved
- Over a dozen individuals connected with scam
(including Harshad Mehta) died – several
prematurely
- Reforms lost their momentum

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 Governance at the Regulatory Level

- PDO’s inefficiency led to fragile market practices

- RBI’s poor oversight resulted in systematic
diversion of funds
- Segmented financial markets set the stage for the
scam
- Fragmented regulatory structure weakened
supervision

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 Governance at the Organizational Level

Internal control system:

- Separation between dealing and back office functions
was not observed
- Within the back office work, custody of securities was not
separated from accounting
- Principle of dual custody was not used or failed to
function
- Prudential counterparty limits were set aside

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 Conceptualization of issues in governance
• Good governance is contingent on sound operating procedures
• There is great merit in consulting those affected by the governance structure
• Periodic reality checks must be carried out to ensure that regulations are not
hindering legitimate operations
• The fault lines in the governance structures are revealed during crises
• Governance structures should therefore be ‘stress tested’ before implementation
• The impact on governance ought to be explicitly taken into account while making
exceptions
• Incentive structures often play havoc with observance of principles of good
governance
• The governance structure too requires maintenance and needs to evolve with time
– there is no scope for complacency
• Media can play constructive and key role in ensuring good governance
• Balanced whistle blower policy will help ensure quality of governance
• Importance of audit and audit trail can not be over-emphasized
• The audit committee needs to be particularly sensitive to quality of processes
within the organization
• It is useful to have vigilance cum compliance function in an organization

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 The Securities Scam

Larger implications …
The momentum of economic reforms was lost due to the
scam. Assessed cost to the economy may be of the order of 1-
1.5% in terms of growth rate. While several reforms were
carried out in the financial sector, several much needed
reforms were put on the back burner. Loss to investors was
about 100000 crores – and it took another six years for the
index to cross the level reached before the scam. The final
cost of investigations may add up to much more than the size
of the scam.

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 The Securities Scam

Many questions may never be answered …

“Many of the key figures in the 1992 stock scam — Harshad
Mehta, Khemani, a senior official of SBI, R.L. Kamat and
former SBI managing director P.V. Subba Rao — are no
more. The then chairman of SBI, M.N. Goiporia, was asked
by the Government to leave and he too had passed away
shortly thereafter. M.J. Pherwani, chairman of National
Housing Bank which figured in the scam, had also passed
away earlier, almost immediately after the scam.”

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 The Securities Scam

And yet we have come a long way …

When the then FM, Dr. Manmohan Singh was grilled in the
parliament on the scam, he had said “As Finance Minister, I
am not expected to lose my sleep if the markets were to go up
one day and come down the next” … we have come a long
way from such an apathy about markets expressed at the
highest quarters in the government. The government today
recognizes the importance of markets … though we have a
long way to go in terms of the reforms that we still need to
carry out!

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 The Securities Scam

Thank You

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