Do you think that stock market brokers only scam people in the U.S.? You are wrong. In 1992, India had just opened up its markets to the world, and a well-known stockbroker named Harshad Mehta, along with his partners, managed to carry on an even more impudent scam, which came to be known as the securities scam, by manipulating the Bombay Stock Exchange (BSE). They exploited the loopholes in the Indian banking system.
What Was The Securities Scam?
Led by Harshad Mehta, the securities scam of 1991–92 basically refers to the divergence of bank funds worth US$465 Million to a group of stockbrokers or brokers. Subsequently, these funds were selectively then put into the stock market by Harshad Mehta, leading to an upsurge of over 4,500 points. Basically, his modus operandi was fraudulently taking out funds from banks with worthless Bank Receipts (BRs) and subsequently using this liquidity to buy huge amounts of shares at a premium across many industrial sectors or businesses.
Mehta then put this amount into the stock market, making the prices of the stocks soar high – up to an astounding 4,400 percent at one point in time, through fictitious practices. This was followed by him selling the stocks that he owned in these companies, thereby earning a significant profit.
How Did It Start?
During the early 1990s, banks were not permitted to trade in the stock market, and thus they used to buy stocks and bonds from other stockholders or brokers and banks. Also, during that time as per the RBI, the minimum threshold of government securities or bond holdings that banks needed to keep was about thirty-eight percent.
So if some banks were falling short of government securities, then Ready Forward Deal (RFDs) were allowed through, in which a bank was permitted to take fifteen days of short-term loans from another bank, using government bonds as security. So instead of transferring actual bonds, bank receipts were created for such transactions. Noteworthy, in RFD transactions, brokers used to act as mediators between banks, with the task of searching buyers and sellers. Moreover, these brokers ensured that the banks would not know other dealing parties. And Harshad Mehta was one such broker that took advantage of this loophole in the system and allegedly conspired with some corrupt bank officials to get fake Bank Receipts (BRs) issued. These were then used to borrow money from other banks under the notion that they were lending against government securities.
He used these funds to buy stocks while also making the prices of the stocks surge high through malpractice; he then went on to sell the stocks that he owned in these companies. Some well-known stocks soared high in a short period, including Associated Cement Company (ACC), TISCO, Reliance, Hero Honda, Videocon, and Apollo Tyres to name a few. Regarding ACC, it is noteworthy that the company’s stocks went from $3 USD a share to $120 USD a share in three years, witnessing a 4,400 percent rise.
Further, estimations have it that Mehta defrauded the banks of nearly US$535 million. Afterward, when his mode of operation in the stock market was discovered and exposed, banks realized that they were in possession of fake BRs holding no value. The table given below depicts the extent of money certain banks lost.
The Aftermath
The Harshad Mehta scam was finally discovered in April 1992, after this scam was exposed by journalist Sucheta Dalal, and subsequently, attention was paid to the money missing from the government securities market. Harshad Mehta was later arrested by the Central Bureau of Investigation (CBI) in November 1992, along with his brothers Ashwin and Sudhir, who executed this scam together.
Further, several foreign banks, like Standard Chartered and ANZ Grindlays, were charged in the scam for their alleged involvement. While Standard Chartered was accused of the bank receipt scam for issuing receipts to Harshad Mehta, on the other hand, ANZ Grindlays was charged with injecting money into Mehta’s personal account.
As the scam broke out, the valuations in the Bombay Stock Exchange collapsed, witnessing a sharp fall in share prices. The index came down from 4,500 to 2,500, signifying a drop in stock prices of almost 40%, wiping out market value by a whopping US$13,333 million. To date, this rapid fall has been the largest the stock market has ever seen.
Many investors and other people lost their savings in the exchange system owing to this. Since the majority of the stock market is based on emotions rather than quantitative analysis, and the fallout from this scam made many investors taking their capital out of the market. This caused a major demand and supply crumpling of prices and quantity. This, in turn, affected the entire system, all because of the scam.
Further, following the scam, the Reserve Bank of India (RBI) appointed the Janakiraman Committee to investigate it. In its first report, the committee calculated the scam amount to be around $575 million USD, which stands to be a massive $3.2 billion USD today if we consider the inflation factor over the years.
Nonetheless, it would not be wrong to say that the scam was an eye-opener impacting the entire exchange system while opening a Pandora’s box of inbuilt issues within the security system of India. It indeed caused the collapse of the control system, both within the RBI as well as commercial banks triggering many changes in India’s financial regulatory system. First and foremost, it made the government realize that one of the basic problems with the financial structure of the stock market was the lack of computerized systems, which impacted the whole stock market, and later on, steps were taken to make it computerized.
The government also came out with many structural changes, the first being the formation of the National Stock Exchange of India (NSE) to keep the stock market under surveillance and control. Further, a new regulatory board known as the Securities and Exchange Board of India (SEBI) was formed to monitor the National Stock Exchange and the National Securities Depository. Also, the Securities Laws (Amendments) Act was passed in 1995, expanding SEBI’s jurisdiction and authorizing it to regulate depositories, credit-rating agencies, venture capital funds, and FIIs.
There have been several incidents where the global stock market witnessed major downfalls owing to scams or corrupt practices. Notwithstanding, the 1992 Harshad Mehta scam still tops the stock market crashes in the history of the stock market, especially that of India. The events that Harshad Mehta orchestrated have and will continue to serve as a reminder to both investors and regulators to remain observant and attentive at all times.