Decoding the Deception: A Case Study of the Harshad Mehta Scam and its Repercussions in the Indian Stock Market
Abstract
The 1992 Harshad Mehta scam stands as a pivotal moment in India’s financial history, shaking the trust in its nascent stock market and exposing vulnerabilities in its regulatory framework. This paper delves into the intricate details of this intricate financial manipulation, analyzing the modus operandi employed by Mehta and his accomplices. Leveraging techniques such as “ready forward” deals, fabricated bank receipts, and political connections, the scam siphoned billions from the banking system, devastating countless investors. The paper will reveal how Mehta capitalized on weaknesses in the Bombay Stock Exchange’s settlement process, enabling him to create fictitious bank receipts and inflate stock prices artificially. By drawing lessons from the Harshad Mehta case, the paper aims to contribute to a deeper understanding of market manipulation, the importance of robust regulations, and the need for ethical conduct within the financial system. It serves as a cautionary tale for policymakers, market participants, and investors, urging them to remain vigilant against potential malpractices and advocate for a more transparent and accountable financial environment.
Keywords: Harshad Mehta, Stock market scam, Market manipulation, Regulatory failure, Socioeconomic impact, Media role, Financial reforms, India.
Introduction
The meteoric rise and fall of Harshad Mehta, the “Big Bull” of the Indian stock market, is a cautionary tale of greed, deceit, and the fragility of financial systems. In 1992, Mehta, a seemingly ordinary broker, orchestrated a series of fraudulent transactions that inflated stock prices and defrauded investors to the tune of billions of rupees. The scam was one of the greatest financial frauds in Indian history, and it exposed major flaws in the Indian financial system’s regulation and supervisory processes.
This paper delves deep into the anatomy of the scam, examining the techniques employed, the regulatory loopholes exploited, and the devastating consequences for the Indian financial landscape.
Modus Operandi and exploited Vulnerabilities
Mehta exploited various loopholes in the banking and securities regulations of the time. His primary modus operandi involved:
Diversion of Funds:
Harshad Mehta collected enormous sums of money from government securities and invested it in his stock market in a short period. He subsequently invested the funds in a few carefully selected assets, causing their values to skyrocket. He cheated banks by asking them to pay directly to his account while posing as a broker.
Intra- Day Trading:
Between April 1991 and May 1992, Harshad and his investors used flaws in the banking system to create a securities scheme that transferred Rs. 4000 crores from banks to stock traders. By investing at a premium for a significant number of shares, he was responsible for the huge growth in the stock market price in 1992. Mehta extensively invested in ACC, Apollo Tyres, Reliance, Tata Iron & Steel Co, BPL, Sterlite, and Videocon.
Manipulation of Ready Forward (RF) Deals:
Harshad Mehta was the person in control of the RF transactions. He was successful in convincing banks to write checks in his name. He’d then be able to invest the funds in the stock markets that had been deposited into his account. He instantly exploited the flaw in the system and rapidly expanded the con. A standard RF transaction can only involve two banks. In exchange for cash, securities would be obtained from a bank. When a bank required security or restitution, Harshad Mehta would seek the assistance of a third bank. There will eventually be a fourth bank, and so forth. Instead of simply two banks, there were now a slew of them, all linked by an RF network.
Settlement Process:
Harshad Mehta was familiar with these procedures: transactional banks make payments and transfer securities directly to one another. He then works as a bank broker, distributing securities and making payments to the appropriate institutions. The seller’s (bank’s) securities are delivered to Harshad, a broker, who subsequently transfers them to the buyer’s (bank’s) account. Harshad refunds the money to the seller once the buyer has paid the bank. This is the technique for reaching an agreement. After establishing trust with both institutions, he began to deceive them by depositing monies into his account without securities, which he gradually used to invest in the stock market. The banks involved were unaware of the ruse. These were middle-class dollars. He took use of it for his benefit.
Payment Cheques:
Harshad Mehta, gradually demanded that cheques be issued in his name. He further indicated that he would pay the other party (the bank) immediately. The following day, he pulled a cheque from the RBI in the name of his bank, received funds, and deposited them into his account. This allowed him to withdraw money as soon as the deal was completed and deposit it in his stock market.
Dispensing of securities:
Harshad Mehta used his reputation to persuade banks to issue cheques without first collecting the securities in exchange for the promise of obtaining them the next day. This was a bribe paid to banks for them to release funds with no collateral. As a result, Harshad Mehta and his associates were able to use bank funds to engage in the stock market.
Forged Bank Receipts:
Mehta fraudulently obtained fake BRs from two prominent banks, the Bank of Karad and the Metropolitan Co-operative Bank Limited, essentially acting as promissory notes for government securities. He used these BRs as collateral to secure massive loans from other banks, bypassing standard margin requirements.1
Impact on the Stock Market
The scam’s immediate impact was a devastating market crash, eroding investor confidence and causing widespread financial losses. The Sensex plummeted by nearly 40%, wiping out billions of rupees from the market. However, the repercussions extended far beyond:
• Market Crash: The scam led to a massive crash in the stock market. In April 1992, the stock market experienced a sharp decline, causing panic among investors.
• Loss of Investor Confidence: The scam resulted in a loss of confidence among investors. Many small investors suffered substantial financial losses, leading to a decline in trust in the stock market.
• Regulatory Changes: The Harshad Mehta scam exposed weaknesses in the regulatory framework. In response, regulatory authorities implemented various reforms and measures to strengthen oversight and prevent such manipulations in the future.
• Banking Reforms: The scam also brought to light flaws in the banking system, particularly in the way banks handled securities transactions. This led to reforms in the banking sector to enhance transparency and prevent misuse of funds.
• Legal Actions: Harshad Mehta and several others involved in the scam faced legal actions. Mehta was banned from trading in the stock market and was later convicted for his role in the fraud.
• Impact on Financial Institutions: The scam had repercussions on financial institutions involved in the fraudulent transactions. Many banks and financial entities faced financial losses and damage to their reputation.
• Market Reforms: The securities scam prompted the government and regulatory bodies to introduce reforms aimed at improving transparency, accountability, and efficiency in the stock market. These reforms included the establishment of the Securities and Exchange Board of India (SEBI) to regulate the securities market.
• Increased Awareness: The scam increased awareness among investors, regulators, and the general public about the importance of ethical behavior, due diligence, and the need for a robust regulatory framework in the financial markets.2
While the Harshad Mehta scam harmed the stock market and the financial sector, it also triggered important reforms that aimed to strengthen the regulatory environment and prevent similar incidents in the future.
Reforms and Regulatory Changes
The Harshad Mehta scam of 1992 led to significant reforms and regulatory changes in the Indian financial system. The authorities recognized the need to strengthen the regulatory framework, enhance transparency, and prevent market manipulations. Some of the key reforms and regulatory changes implemented after the Harshad Mehta scam include:
Establishment of SEBI (Securities and Exchange Board of India):
One of the most significant outcomes of the scam was the establishment of SEBI in 1992. SEBI is the regulatory body for the securities market in India. Its role includes overseeing and regulating stock exchanges, protecting the interests of investors, and promoting the development of the securities market.
Introduction of Dematerialization (Demat) of Securities:
To reduce the risk of physical share certificates being manipulated or misused, the dematerialization of securities was introduced. This made it mandatory for investors to hold and trade securities in electronic form through demat accounts.
Know Your Customer (KYC) Norms:
Stricter KYC norms were introduced to ensure that financial intermediaries, including brokers and financial institutions, verify the identity of their clients. This measure was aimed at preventing unauthorized and fraudulent transactions.
Introduction of Rolling Settlements:
The settlement cycle for securities transactions was changed from a weekly basis to a rolling settlement system. This move helped reduce the scope for market manipulation by shortening the settlement period and enhancing the efficiency of the clearing and settlement process.
Risk Management Systems:
Stock exchanges and clearing corporations implemented robust risk management systems to monitor and control risks associated with trading activities. This included the imposition of margin requirements and other risk-mitigation measures.
Strengthening of Banking Regulations:
The scam exposed weaknesses in the banking system, particularly related to the issuance of bank receipts. Subsequent reforms aimed at strengthening banking regulations and improving oversight to prevent misuse of funds.
Enhanced Surveillance and Monitoring:
Regulatory authorities, including SEBI, increased their focus on surveillance and monitoring of market activities. Advanced technology and systems were deployed to detect and prevent market manipulation and insider trading.
Code of Conduct for Market Intermediaries:
A comprehensive code of conduct was formulated for market intermediaries, including brokers and financial institutions. This aimed at ensuring ethical behavior, preventing conflicts of interest, and promoting fair practices in the securities market.
Educational Initiatives:
Efforts were made to enhance investor education and awareness. Investors were educated about the risks associated with the market, the importance of due diligence, and their rights and responsibilities.
These reforms collectively aimed to create a more transparent, accountable, and resilient financial system in India. While the Harshad Mehta scam had negative consequences, the regulatory changes that followed contributed to the long-term development and stability of the Indian financial markets.
Conclusion
The Harshad Mehta scam stands as a stark reminder of the devastating consequences of greed and manipulation in the financial world. His elaborate schemes, fueled by a web of deceit and exploited vulnerabilities, not only defrauded countless investors but also fractured the trust in India’s fledgling stock market. However, the wreckage of this scandal also birthed a phoenix of reform.
The immediate repercussions of the scam were far-reaching. The market plummeted, eroding investor confidence and causing widespread financial hardship. Yet, the aftermath catalyzed significant changes. The establishment of SEBI as a dedicated regulator, coupled with stricter regulations, improved clearing systems, and technological advancements, aimed to plug the loopholes exploited by Mehta. These reforms, though not without their challenges, have undeniably strengthened the Indian financial system.
Beyond the regulatory landscape, the scam sparked a crucial dialogue about ethical conduct and the need for robust corporate governance within financial institutions. The lesson learned is clear: quick profits built on deception ultimately erode the foundation of a healthy market. Investor awareness and education, coupled with unwavering vigilance from regulators and market participants, are crucial to deterring future scams.
The Harshad Mehta saga is not just a financial crime story; it is a cautionary tale with lasting lessons. It underscores the fragility of trust in the financial system and the importance of constant vigilance against unethical practices. While the wounds inflicted by the scam may never fully heal, the reforms it triggered offer a path toward a more robust and transparent financial future for India. By embracing continuous improvement and upholding ethical standards, the Indian market can ensure that such a devastating deception never darkens its doorsteps again.
Author: Sharanya Agarwal, 3rd year student of Amity University, Lucknow.
