Harshad Mehta Scam

Topics: Stock market, Bond, Bank Pages: 8 (2428 words) Published: November 4, 2012
Case 3: Harshad Mehta scam:

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 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. When the scheme was exposed, the banks started demanding the money back, causing the collapse. He was later charged with 72 criminal offenses and more than 600 civil action suits were filed against him. He died in 2002 with many litigations still pending against him.

3.1 Ready Forward Deal (RF):

• The crucial mechanism through which the scam was effected was the Ready Forward deal. • The Ready Forward Deal (RF) is in essence a secured short term (typically 15 day) loan from one bank to another bank. The lending is done against Government Securities exactly the way a pawnbroker lends against jewelry. • In fact one can say that the borrowing bank actually sells the securities to the lending bank and buys them back at the end of the period of the loan at (typically) a slightly higher price. • It was this RF deal that Harshad Mehta and his associates used with great success to channel money from banking system. 3.2 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 broker.

This was wonderfully engineered by the brokers. To give a better understanding of the mechanism, the whole process has been segregated into 3 different parts. 1. The settlement process
2. Payment cheques
3. Dispensing the security

1. 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.

▪ There were two important reasons why the broker intermediated settlement began to be used in the government securities markets.

▪ The brokers instead of merely bringing buyers and sellers together started taking positions in the market. In other words, they started trading on their own account, and in a sense became market makers in some securities thereby imparting greater liquidity to the markets.

▪ When a bank wanted to conceal the fact that it was doing an RF deal, the broker came in handy. The broker provided contract notes for this purpose with fictitious counter parties, but arranged for the actual settlement to take place with the correct counter party.

2. Payment Cheques:
▪ A broker intermediated settlement allowed the broker to lay his hands on the cheque as it went from one bank to another through him. The hurdle now was to find a way of crediting the cheque to his account though it was drawn in favor of a bank and was crossed account payee.

▪ As it happens, it is purely a matter of banking custom that an account payee cheque is paid only to the payee mentioned on the cheque. In fact, exceptions were being made to this norm, well before the scam came to light.

▪ Privileged (corporate) customers were routinely allowed to credit account payee cheques in favour of a...
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