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September 7, 2006 September 7, 2006 S. K. Barua S. K. Barua 1 1

Securities Scam 92 Securities Scam 92 ± ± Some Governance Issues Some Governance Issues

�� What was the scam about?What was the scam about?

�� Why did the scam occur?Why did the scam occur?

�� How was the scam perpetrated? How was the scam perpetrated?

��

How was the scam discovered? How was the scam discovered?�� What was the response to the scam?What was the response to the scam?

�� Governance at the national level Governance at the national level

�� Governance at the regulatory level Governance at the regulatory level

�� Governance at the organizational level Governance at the organizational level �� Conceptualization of issues in governanceConceptualization of issues in governance

�� Other issuesOther issues




What was the scam about?What was the scam about?

The scam was about diversion of funds on aThe scam was about diversion of funds on a

very large scale from the banking system tovery large scale from the banking system to

stock market.stock market.

The exposure of the banking system was put The exposure of the banking system was put at over Rs. 4000 croresat over Rs. 4000 crores ± ± the most reliable of the most reliable of

the various estimates. To get a perspective onthe various estimates. To get a perspective on

the size of the exposure, the daily turnover inthe size of the exposure, the daily turnover inthe stock market in those days was about Rs.the stock market in those days was about Rs.

100100 -- 250 crores.250 crores.




Why did the scam occur?Why did the scam occur? ± ± the larger context the larger context

T T he few years leading up to the scam were a period of great he few years leading up to the scam were a period of great instabilityinstability

-- VP Singh was ousted due to Mandal,VP Singh was ousted due to Mandal,

-- Advani undertook his Rath yatra Advani undertook his Rath yatra

-- August 2, 1990 Iraq annexed Kuwait and was ousted and August 2, 1990 Iraq annexed Kuwait and was ousted and

subdued subsequentlysubdued subsequently-- In September ¶90, crude crossed $30 per barrel from $14 In September ¶90, crude crossed $30 per barrel from $14

-- In early 1991, Chandrashekhar government fell after just 4 In early 1991, Chandrashekhar government fell after just 4months in office « congress pulled the rug months in office « congress pulled the rug

-- Rajiv Gandhi was assassinated Rajiv Gandhi was assassinated

-- In May 1991, Congress came to power, Man Mohan Singh In May 1991, Congress came to power, Man Mohan Singhbecame the FM and Narasimha Rao the PM.became the FM and Narasimha Rao the PM.

-- By mid 1991, India¶s FX reserve position became By mid 1991, India¶s FX reserve position became precarious precarious





The New Government « induction by fireThe New Government « induction by fire

To avoid defaulting on its international financial To avoid defaulting on its international financial commitments, oncommitments, on July 6, 1991, 20 tons of gold from the July 6, 1991, 20 tons of gold from the

vaults of RBI were air vaults of RBI were air--lifted to vaults of Bank of England for lifted to vaults of Bank of England for Bank of Japan to extend loan of $400 million to India. Bank of Japan to extend loan of $400 million to India.

Rupee was depreciated by over 20% overnight to give a push Rupee was depreciated by over 20% overnight to give a pushto exports and discourage imports. The PSUs were asked byto exports and discourage imports. The PSUs were asked by

the government to borrow in foreign currency to bolster the government to borrow in foreign currency to bolster reserves. Government approached IMF for bailout. IMF put reserves. Government approached IMF for bailout. IMF put conditionsconditions ± ± economic reformseconomic reforms -- for helping out. At the time, for helping out. At the time, SENSEX was hovering below 1000. SENSEX was hovering below 1000.





PSUs were flush with funds that they did not PSUs were flush with funds that they did not

need for their business. They approached theneed for their business. They approached the

government to allow them to park these funds government to allow them to park these funds

with banks to earn returns. The PMS waswith banks to earn returns. The PMS wasdesigned precisely for thisdesigned precisely for this ± ± special depositsspecial deposits

exempt from investment restrictions onexempt from investment restrictions on

normal deposit with banks. Competing for normal deposit with banks. Competing for

these funds, banks offered higher returns that these funds, banks offered higher returns that

could be earned only through help fromcould be earned only through help from

operators like Harshad Mehta.operators like Harshad Mehta.




Why did the scam occur?Why did the scam occur? ± ± the market practicesthe market practices

Degeneration of processes: Degeneration of processes:-- Cheques in a bank¶s name credited to client Cheques in a bank¶s name credited to client account (to overcome clearance delays)account (to overcome clearance delays)

-- Bank Receipts (BRs) rather than exchange of Bank Receipts (BRs) rather than exchange of

securities used for transactions (to deal withsecurities used for transactions (to deal withinefficiency of the PDO)inefficiency of the PDO)

-- Broker intermediated spurious transactions Broker intermediated spurious transactionsbecame rampant for µwindow dressing¶ of accountsbecame rampant for µwindow dressing¶ of accountsof banksof banks

-- Large scale inside information based punting Large scale inside information based punting started occurring on the basis of change in thestarted occurring on the basis of change in theadministered interest ratesadministered interest rates




Why did the scam occur?Why did the scam occur? ± ± the opportunitythe opportunity

Cost of funds in formal money market was 18Cost of funds in formal money market was 18--20%,20%,

while cost of funds in the informal money market while cost of funds in the informal money market was 36%.was 36%.

From below 1000 in mid From below 1000 in mid--1991, by March 1992, the1991, by March 1992, thestock index had risen to about 4500. The rise wasstock index had risen to about 4500. The rise wasunprecedented unprecedented ± ± at a rate well above rate of at a rate well above rate of

borrowing to finance stock market operations.borrowing to finance stock market operations.Financing at almost any cost was profitable.Financing at almost any cost was profitable.

Profits were there to be had if any one could find a Profits were there to be had if any one could find away of diverting funds from the formal moneyway of diverting funds from the formal money

market to the stock market.market to the stock market. Harshad Mehta and several others were well Harshad Mehta and several others were well positioned as they were present in both the markets. positioned as they were present in both the markets.




How was the scam perpetrated? How was the scam perpetrated?

± ± the readythe ready--forward deal forward deal

Bank A:

Borrower

Bank B:

Lender

Gives Securities

Receives Cash

Broker

Brings A & B together

The BorkerThe Broker

Brokers got hold of the securities and cash

Brokers stole securities from the banks

Securities were replaced with BRs, without underlying securities




How was the scam discovered? How was the scam discovered?

In March 92, RBI started investigating the In March 92, RBI started investigating the

possibility of insider trading. Just before a rate possibility of insider trading. Just before a rate

hike SBI had bought huge amount of 2010hike SBI had bought huge amount of 2010

securities from Harshad Mehta. In that context,securities from Harshad Mehta. In that context,

SBI discovered that Rs. 649 crores worth of SBI discovered that Rs. 649 crores worth of

securities were due from Harshad Mehta. After securities were due from Harshad Mehta. After

secret negotiations, between April 13 and April secret negotiations, between April 13 and April

22, Harshad Mehta paid SBI about Rs. 62222, Harshad Mehta paid SBI about Rs. 622

crorescrores ± ± misappropriated from NHB. Market wasmisappropriated from NHB. Market wasagog with rumours. Finally, on April 23, 1992 theagog with rumours. Finally, on April 23, 1992 the

story broke in ToI that Rs. 500 crores worth of story broke in ToI that Rs. 500 crores worth of

securities were missing from the vaults of SBI.securities were missing from the vaults of SBI.




What was the response to the scam?What was the response to the scam?

-- RBI set up the Janakiraman Committee on RBI set up the Janakiraman Committee on

April 30 (first report by end of May) April 30 (first report by end of May)

-- Government ordered CBI enquiryGovernment ordered CBI enquiry

-- JPC set up by August 10 (submitted report JPC set up by August 10 (submitted report

on Dec 21, 1992)on Dec 21, 1992)

-- Government set up special court to deal withGovernment set up special court to deal with

scam related cases to expedite justice.scam related cases to expedite justice.




Governance at the National Level Governance at the National Level

³MUMBAI, APRIL 12, 2006: The Special Court hearing the³MUMBAI, APRIL 12, 2006: The Special Court hearing the

1992 security scam cases, on Wednesday sentenced Sudhir 1992 security scam cases, on Wednesday sentenced Sudhir

Mehta, brother of late Harshad Mehta, and six others, Mehta, brother of late Harshad Mehta, and six others,

including four bank officials, to rigorous imprisonment (RI)including four bank officials, to rigorous imprisonment (RI)

ranging from 1 year to 10 years on the charge of duping 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 State Bank of India to the tune of Rs 600 crore in connectionwith the securities scam that rocked the financial markets inwith the securities scam that rocked the financial markets in

1992.´ 1992.´

It took just It took just one week one week for Singapore to deal with for Singapore to deal with

failure of Barings plc in 1998. Nick Leeson was failure of Barings plc in 1998. Nick Leeson wastried and convicted tried and convicted within 6 monthswithin 6 months of the event.of the event.




Governance at the National Level Governance at the National Level

-- Multiplicity of investigating agencies created utter Multiplicity of investigating agencies created utter

chaoschaos

-- Despite special courts, 14 years after the scam Despite special courts, 14 years after the scam

occurred, scam related cases are still being heard occurred, scam related cases are still being heard

-- Innocent investors¶ interests were completely Innocent investors¶ interests were completelysubverted due to µtainted shares¶ subverted due to µtainted shares¶

-- Much needed reforms of the financial sector, Much needed reforms of the financial sector, particularly the debt market, were shelved particularly the debt market, were shelved

-- Over a dozen individuals connected with scamOver a dozen individuals connected with scam

(including Harshad Mehta) died (including Harshad Mehta) died ± ± several several prematurely prematurely

-- Reforms lost their momentum Reforms lost their momentum




Governance at the Regulatory Level Governance at the Regulatory Level

-- PDO¶s inefficiency led to fragile market practices PDO¶s inefficiency led to fragile market practices

-- RBI¶s poor oversight resulted in systematic RBI¶s poor oversight resulted in systematic

diversion of fundsdiversion of funds

-- Segmented financial markets set the stage for the Segmented financial markets set the stage for the

scamscam

-- Fragmented regulatory structure weakened Fragmented regulatory structure weakened

supervisionsupervision




Governance at the Organizational Level Governance at the Organizational Level

Internal control system: Internal control system:

-- Separation between dealing and back office Separation between dealing and back office

functions was not observed functions was not observed

-- Within the back office work, custody of Within the back office work, custody of securities was not separated from accounting securities was not separated from accounting

-- Principle of dual custody was not used or Principle of dual custody was not used or

failed to function failed to function-- Prudential counterparty limits were set aside Prudential counterparty limits were set aside




Conceptualization of issues in governanceConceptualization of issues in governance�� Good governance is contingent on sound operating proceduresGood governance is contingent on sound operating procedures

�� There is great merit in consulting those affected by the governance structureThere is great merit in consulting those affected by the governance structure

�� Periodic reality checks must be carried out to ensure that regulations are not Periodic reality checks must be carried out to ensure that regulations are not hindering legitimate operationshindering legitimate operations

�� The fault lines in the governance structures are revealed during crisesThe fault lines in the governance structures are revealed during crises

�� Governance structures should therefore be µstress tested¶ before implementationGovernance structures should therefore be µstress tested¶ before implementation

�� The impact on governance ought to be explicitly taken into account while making The impact on governance ought to be explicitly taken into account while making exceptionsexceptions

�� Incentive structures often play havoc with observance of principles of good Incentive structures often play havoc with observance of principles of good

governance governance�� The governance structure too requires maintenance and needs to evolve with timeThe governance structure too requires maintenance and needs to evolve with time

± ± there is no scope for complacencythere is no scope for complacency

�� Media can play constructive and key role in ensuring good governance Media can play constructive and key role in ensuring good governance

�� Balanced whistle blower policy will help ensure quality of governance Balanced whistle blower policy will help ensure quality of governance

�� Importance of audit and audit trail can not be over Importance of audit and audit trail can not be over--emphasized emphasized

�� The audit committee needs to be particularly sensitive to quality of processesThe audit committee needs to be particularly sensitive to quality of processeswithin the organizationwithin the organization

�� It is useful to have vigilance cum compliance function in an organization It is useful to have vigilance cum compliance function in an organization




The Securities ScamThe Securities Scam

Larger implications « Larger implications «

The momentum of economic reforms was lost due to theThe momentum of economic reforms was lost due to thescam. Assessed cost to the economy may be of the order of 1scam. Assessed cost to the economy may be of the order of 1--1.5% in terms of growth rate. While several reforms were1.5% in terms of growth rate. While several reforms werecarried out in the financial sector, several much needed carried out in the financial sector, several much needed reforms were put on the back burner. Loss to investors wasreforms were put on the back burner. Loss to investors wasabout 100000 croresabout 100000 crores ± ± and it took another six years for theand it took another six years for theindex to cross the level reached before the scam. The final index to cross the level reached before the scam. The final

cost of investigations may add up to much more than the sizecost of investigations may add up to much more than the sizeof the scam.of the scam.





Many questions may never be answered « Many questions may never be answered «

³ ³ Many of the key figures in the 1992 stock scam Many of the key figures in the 1992 stock scam ² ² Harshad Harshad

Mehta, Khemani, a senior official of SBI, R.L. Kamat and Mehta, Khemani, a senior official of SBI, R.L. Kamat and former SBI managing director P.V. Subba Rao former SBI managing director P.V. Subba Rao ² ² are noare nomore. The then chairman of SBI, M.N. Goiporia, was asked more. The then chairman of SBI, M.N. Goiporia, was asked by the Government to leave and he too had passed awayby the Government to leave and he too had passed awayshortly thereafter. M.J. Pherwani, chairman of National shortly thereafter. M.J. Pherwani, chairman of National

Housing Bank which figured in the scam, had also passed Housing Bank which figured in the scam, had also passed away earlier, almost immediately after the scam.´ away earlier, almost immediately after the scam.´





And yet we have come a long way « And yet we have come a long way «

When the then FM, Dr. Manmohan Singh was grilled in theWhen the then FM, Dr. Manmohan Singh was grilled in the parliament on the scam, he had said ³As Finance Minister, I parliament on the scam, he had said ³As Finance Minister, I am not expected to lose my sleep if the markets were to go upam not expected to lose my sleep if the markets were to go upone day and come down the next´ one day and come down the next´ « we have come a long « we have come a long way from such an apathy about markets expressed at theway from such an apathy about markets expressed at thehighest quarters in the government. The government todayhighest quarters in the government. The government todayrecognizes the importance of markets « though we have arecognizes the importance of markets « though we have a

long way to go in terms of the reforms that we still need tolong way to go in terms of the reforms that we still need tocarry out!carry out!





Thank YouThank You

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