Saturday, January 12, 2008

How Harshad Mehta was caught

Nepali capital market and banking system can learn from how Harshad Mehta pulled off one of the most audacious scams in the history of the Indian stock market.
Harshad Mehta first started working as a dispatch clerk in the New India Assurance Company. Over the years, he got interested in the stock markets and along with brother Ashwin started investing heavily in the stock market.
As they learnt the ropes of the trade, they went from boom to bust a couple of times and survived. Mehta gradually rose to become a stock broker on the Bombay Stock Exchange, who did very well for himself. At his peak, he lived almost like a movie star in a 15,000-sq-feet house, which had a swimming pool as well as a golf patch. He also had a taste for flashy cars, which ultimately led to his downfall.
The year was 1990. Years had gone by and the driving ambitions of a young man in the faceless crowd had been realised. Harshad Mehta was making waves in the stock market. He had been buying shares heavily since the beginning of 1990. The shares which attracted attention were those of Associated Cement Company (ACC). The price of ACC was bid up to Rs 10,000. For those who asked, Mehta had the replacement cost theory as an explanation.
Through the second half of 1991, Mehta was the darling of the business media and earned the sobriquet of the 'Big Bull', who was said to have started the bull run. But, where was Mehta getting his endless supply of money from? Nobody had a clue.
On April 23, 1992, journalist Sucheta Dalal in a column in The Times of India, exposed the dubious ways of Harshad Metha. The broker was dipping illegally into the banking system to finance his buying.
The crucial mechanism through which the scam was effected was the ready forward (RF) deal. The RF is in essence a secured short-term (typically 15-day) loan from one bank to another.
Crudely put, the bank lends against government securities just as a pawnbroker lends against jewellery. The borrowing bank actually sells the securities to the lending bank and buys them back at the end of the period of the loan, typically at a slightly higher price.
It was this ready forward deal that Harshad Mehta and his cronies used with great success to channel money from the banking system.
A typical ready forward deal involved two banks brought together by a broker in lieu of a commission. The broker handles neither the cash nor the securities, though that wasn't the case in the lead-up
to the scam. In this settlement process, deliveries of securities and payments were made through the broker. That is, the seller handed over the securities to the broker, who passed them to the buyer, while the buyer gave the cheque to the broker, who then made the payment to the seller. In the process, the buyer and the seller might not even know whom they had traded with, either being know only to the broker.
This the brokers could manage primarily because by now they had become market makers and had started trading on their account. To keep up a semblance of legality, they pretended to be undertaking the transactions on behalf of a bank.
Another instrument used in a big way was the bank receipt (BR). In a ready forward deal, securities were not moved back and forth in actuality. Instead, the borrower or the seller of securities, gave the
buyer of the securities a BR, that '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 mean time, the seller holds the securities in trust of the buyer.
Having figured this out, Metha needed banks, which could issue fake BRs, or BRs not backed by any government securities. Two small and little known banks — the Bank of Karad and the Metorpolitan Co-operative Bank — came in handy for this purpose. These banks were willing to issue BRs as and when required, for a fee. Once these fake BRs were issued, they were passed on to other banks and the banks in turn gave money to Mehta, obviously assuming that they were lending against government securities when this was not really the case. This money was used to drive up the prices of stocks in the stock market. When time came to return the money, the shares were sold for a profit and the BR was retired. The money due to the bank was returned.
The game went on as long as the stock prices kept going up and no one had a clue about Mehta's modus operandi. Once the scam was exposed, though, a lot of banks were left holding BRs that did not have any value — the banking system had been swindled of a whopping Rs 4,000 crore Indian currency.
Interestingly however, by the time he died in a jail in December 2001, Mehta had been convicted in only one of the many cases filed against him.
(Source — The Great Indian Scam: Story of the missing Rs 4,000 crore by Samir K Barua and Jayanth R Varma)

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