Indian Institute of Management Kozhikode

BUSINESS ETHICS

HARSHAD MEHTA SCAM

SUBMITTED TO: Dr. ANANDA DAS GUPTA

SUBMITTED BY:

GROUP IV PGP/14/260 NITESH KUMAR GUPTA PGP/14/274 HEERAL BHATIA PGP/14/280 MAHTAAB KAJLA PGP/14/287 PRACHI CHAWLA PGP/14/290 RAHUL MITTAL PGP/14/313 VINNY ARYA PGP/14/315 VISHAD DUBEY

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TABLE OF CONTENTS
ABOUT HARSHAD MEHTA ............................................................................................................................... 2 OVERVIEW OF THE SCAM ................................................................................................................................ 2 READY FORWARD (RF) MODUS OPERANDI .................................................................................................. 3 SETTLEMENT PROCESS ................................................................................................................................ 4 PAYMENT CHEQUES .................................................................................................................................... 4 DISPENSING THE SECURITY ......................................................................................................................... 4 BANK RECEIPT ................................................................................................................................................ 5 CONTROL SYSTEMS..................................................................................................................................... 5 DISAPPEARANCE OF MONEY ........................................................................................................................... 6 AFTER THE SCANDAL....................................................................................................................................... 7 IMMEDIATE IMPACT: ................................................................................................................................... 7 IMPACT ON THE INDIAN ECONOMY ............................................................................................................. 7 IMPACT ON THE BANKS ............................................................................................................................... 7 RESPONSE OF THE GOVERNMENT ................................................................................................................ 8 POLICY MEASURES .......................................................................................................................................... 8 ACTIONS TAKEN BY THE GOVERNMENT: ........................................................................................ 8
ETHICAL ISSUES ............................................................................................................................................... 9

ETHICAL MISSHAP ...................................................................................................................................... 9 AVOIDANCE OF SUCH SCAMS....................................................................................................................... 9

CONCLUSION ............................................................................................................................................. 10

REFERENCES ................................................................................................................................................. 11

December 9, 2010

Group IV | Indian Institute of Management, Kozhikode

ABOUT HARSHAD MEHTA

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 brokerscard 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

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)

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December 9, 2010

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

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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

December 9, 2010

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, its like one bank selling its securities to another with a promise of buying it back at a pre-determined price.

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READY FORWARD (RF) MODUS OPERANDI

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 byying 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

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December 9, 2010

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.

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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 doesnt 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 its dealing with a secured loan but in reality its 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 bank s 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

December 9, 2010

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

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DISAPPEARANCE OF MONEY

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.
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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

December 9, 2010

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).

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POLICY MEASURES

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 didnt 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 Mehtas 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:

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December 9, 2010

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

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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 : Individuals 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, its 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 CAs a. Bringing transparency b. Bringing accountability
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December 9, 2010

ETHICAL ISSUES

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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? Thats relative.Business ethics is relative-Prof Anand Dasgupta

Group IV | Indian Institute of Management, Kozhikode

December 9, 2010

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REFERENCES

http://en.wikipedia.org/wiki/Harshad_Mehta http://www.bullrider.in/harshad-mehta-stock-scam/ http://investmentpark.blogspot.com/2007/02/harshad-mehta-scam-1992.html http://www.scribd.com/doc/17227215/Harshad-Mehta-Scam http://wiki.answers.com/Q/Can_you_give_the_details_about_the_Harshad_Mehta_scam http://www.authorstream.com/Presentation/pratm_18-486267-harshad-mehta-and-ketanparekh-scam/ http://www.slideserve.com/PPTFiles/insights_investing_jul08_29542_32424.ppt

December 9, 2010

Group IV | Indian Institute of Management, Kozhikode