the harshad mehta security scam

2. 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. The
“Securities Scam” refers to a diversion of funds to the tune of Rs. 4,000
crores from the banking system to various stockbrokers in a series of
transactions (primarily in Government securities) during the period April
1991 to May 1992.
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 Mehta 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.

3. ASPECTS OF THE 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.
 READY FORWARD (RF)
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.

4. 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.

5. 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 a broker.
 This was wonderfully engineered by the Brokers. To give a better
understanding of the mechanism, the whole process has been
segregated into three different parts viz.
– The settlement process.
– Payment Cheques.
– Dispensing the security.

6. 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.
 During 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.

7. 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.

8. 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.
 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
rather than to a bank.

9. 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 tothe 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 sellerin trust for the
buyer.
• acts as a receipt for the received money by the selling
bank

10. • 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 .

11. 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
Kanad (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.

12. 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.

13. Some of the stocks which were highly invested in by Harshad
Mehta were-
 ACC
 Apollo Tyres
 Reliance
 Tata Iron and Steel Co. (TISCO)
 BPL
 Videocon
The following 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.