Author: Karuna Soni
College: K.G shah Law School, SNDT University
LinkedIn Profile: https://www.linkedin.com/in/karuna-soni-047b15268?utm_source=share_via&utm_content=profile&utm_medium=member_ios
To the Point
The 2001 Securities Scam was masterminded by Ketan Parekh, a chartered accountant and stock broker, who is infamously known as the “Pentafour Bull”. Nineteen years later, we still hear of Ketan Parekh in relation to how he managed the Capital Market by using a systematic approach to create a payment crisis in India that led to the collapse of the Calcutta Stock Exchange and put many cooperative banks into financial distress.
The 2001 Securities Scam was primarily about Parekh creating an illegal route to transfer capital. Parekh was able to receive over ₹40,000 Crores of capital from both public and corporate entities to corner and inflate the price of ten illiquid low-cap equity stocks primarily from the Technology, Media, and Telecommunications (TMT) sectors known as “K-10 Stocks” (such as Zee Telefilms, Silverline, Pentamedia Graphics, Himachal Futuristic Communications Ltd).
Parekh was able to artificially create an uptrend in these stocks through the use of circular trades, matched order entry, and the use of Offshore Corporate Bodies (OCB) to layer and transfer funds. When the technology market worldwide declined due to a general correction in technology stocks in 2001, Parekh was considered to be solvent; however, he was highly leveraged. His collapse in leveraged credit therefore caused a massive crash in the market as well as resulted in the vast majority of retail investors losing an estimated ₹1,15,000 Crores to the market crash, the Cooperative Bank of Madhavpura Mercantile Bank ceased operations and the Unit Trust of India was suspended from operation.
Use Of Legal Jargon
When analyzing this case through the more sophisticated framework of economic law, one must evaluate the specific legal doctrines and statutory terminology used by enforcement agencies during prosecutions. In particular, one must consider:
– Circular Trading is used in a fraudulent way to manipulate the market by having a small group of brokers and shell corporations continually purchase and sell the same block of stock at increasing prices to each other. This gives the appearance of active public trading in a market where there is no actual activity, thus presenting an illusion of added depth within the market.
– Synchronized Trading / Pre-arranged Trading is used as a means of manipulation through the input of matching buy and sell orders into electronic stock exchange trading terminals at the same time, down to the millisecond, price and volume, thus ensuring these trades occur only against each other and not at “true” market prices.
The market is being manipulated by intermediaries and through false reports of share activity because of the ability to inflate the price of a security. Once the intermediary has pumped the stock, it looks to sell off its over-valued investments at the highest price points to take advantage of unsuspecting investors. When these investors try to sell their holdings after the price collapses, the intermediary has already made its gain.
The Urban Cooperative Bank (UCB) is regulated by two separate agencies; state governments and the Reserve Bank of India (RBI). The overlap of regulations creates concerns for oversight and management as there is no one agency responsible for oversight of UCBs. As such, no accountability exists for improperly operated UCBs as neither state officials nor the RBI has the complete oversight of UCBs.
‘Piercing the corporate veil’ refers to an act of judicial determination where a court will disregard the separate identity of a corporation to identify, hold and punish an individual involved in the corporation’s wrongdoing. This doctrine was applied against Ketan Parekh for corporate actions executed through a series of closely held corporate proxies.
Nemo Dat Quod Non Habet: This legal principle establishes that no one is able to give something that they do not possess. This maxim was invoked in the recovery actions concerning the billions of rupees worth of fraudulently executed pay orders that were discounted at various commercial banks without there being any real capital backing those transactions.
De Facto vs. De Jure: This concept has been used to determine if someone has committed a crime or not, in this instance, Parekh was not a de jure (legal) director on the boards of the many different cooperative banks or the Calcutta Stock Exchange brokerage firms, but instead had de facto (in reality) total control over their financial activities through economic coercion and institutional bribery.
Vires (Ultra Vires): A doctrine concerning actions that fall outside the legal scope of an institution’s statutory authority. The credit exposures, amounting to many crores, that cooperative bank officials granted to Parekh were deemed to be ultra vires under both the Banking Regulation Act and the directives from the central bank.
To Proof
The investigation by securities regulators and others into the conspiracy led to the discovery of the following:
1. TheMMC Pay Order Fraud Trail
Initially, the payments made to Parekh were through an irregular bank note issued by the Madhupura Mercantile Co-op Bank, Ahmedabad. The conduct of the Bank Manager / Chairman of the Bank was shown through ledger records (Annexure “O”) to have issued illegal Pay Orders on a single day in March 2001 of 10 Pay Orders containing a total value of ₹ 137 crores directly to the shell trading companies – Panther Fincap, Classical Share & Stock Brokers and Luminant Investments which were controlled by Parekh.
The forensic audit further established that there was no cash deposits, margin allocation or collateral allocation to support these 10 Pay Orders which were immediately discounted for cash at the Bank of India, Stock Exchange Branch, Mumbai to meet his significant trading obligations on the stock exchanges. When Bank of India attempted to clear these Pay Orders with Madhupura Mercantile Co-op Bank, all 10 bounced, creating a systemic deficiency of cash of over ₹ 1,030 crores within Madhupura’s bank books.
2. A review of the electronic audit trails (logs) of the Calcutta Stock Exchange (CSE) has revealed how Parekh used a web of front brokers to circumvent SEBI’s exposure limits on the Bombay Stock Exchange (BSE), including well-known operators such as Dinesh Dalmia and Harish Bhasin. Analysis of the trade terminal server logs of CSE provides definitive evidence of circular and synchronised trading. A forensic examination of server timestamps demonstrates entered buy and sell orders for millions of HFCL and Zee Telefilms shares by brokers acting on behalf of Parekh, less than 500 milliseconds apart. Additionally, the logs demonstrate that the aforementioned shares were continuously traded back and forth between five brokerage accounts with only the intent to manipulate closing prices and create margin credits from the clearing house.
3. Evidence has been obtained by the CBI for the internal bank statements, and communications of top-level management of public listed companies in collusion with Parekh to artificially inflate their stock price. Evidence indicates that companies such as HFCL, Zee Telefilms, and Kopran Drugs transferred ₹2,700 crores of cooperative funds directly into Parekh’s accounts as “Corporate Loans” or “Advances for Investments.”
Abstract
This comprehensive study of legal research provides an in-depth analysis of the substantial structural, regulatory and institutional weaknesses that contributed to the failure of the Indian capital markets through the actions of stock trader Ketan Parekh to violate the integrity of Indian capital markets in 2001. Specifically, this study examines the ways in which operational loopholes in forward trading systems in India were exploited by Parekh to commit systemic financial crime by evaluating the content and statutory provisions of the Securities Contracts (Regulation) Act, 1956, the Banking Regulation Act, 1949 and the SEBI Act, 1992.
in examining in detail the inter-market arbitrage manipulation techniques employed by Parekh, such as the unlawful exploitation of the Urban Cooperative Banking System and the use of sham offshore accounts to disguise circular possession of shares, this study ultimately analyses the responses of legislators and regulators to the scam. The legislative and regulatory failures that resulted from the scam led to the legislative abolition of traditional Forward Trading Markets (Badla) in India, the mandatory establishment of Corporate Governance (Dematerialised Shares) in India; and legislative adoption of Internationally Accepted Electronic Rolling Settlement Cycles.
Case Laws
1. Ketan Parekh v. Securities and Exchange Board of India (2006, SAT – Appeal No. 2 of 2004)
This is the likely most crucial landmark judgment of the SAT in relation to the litigation of the Indian securities market as a whole. Parekh challenged SEBI’s omnibus order that completely barred Parekh and his corporate entities from buying, selling or dealing in the capital markets for a period of 14 years.
The defence was that “synchronised trading” was not prohibited by any statutory text when it was done, and was simply a conventional method to reduce the impact costs associated with large trades. The Tribunal rejected this defence and provided the important legal definition of market manipulation as follows:
“A transaction, which has been entered into with the intention of artificially affecting the price or volume of securities, in order to distort the natural forces of supply and demand, in the open market, constitutes a fraudulent and manipulative trading practice. Furthermore, if the trades executed through electronic means are of a premeditated nature, then the matching of the buy and sell orders, is a fraud upon the market, notwithstanding that there is evidence of the trades being executed electronically”.
This ruling confirmed that SEBI has the authority to impose large bans on the market based on circumstantial electronic evidence or trading patterns without having to provide direct evidence.
2. Bank of India v. Ketan Parekh & Others (2008) 8 SCC 148
This very important case concerned the civil and criminal enforcement action against Ketan Parekh (KP) and the directors of M/s M M C B (MMCB) before the Supreme Court of India as a result of KP’s failure to pay back some public money in the form of “Pay Orders” issued by Bank of India to MMCB. The Bank of India sought urgent recovery of its outstanding public money from KP and the directors of MMCB. In response KP’s lawyers argued that Bank of India should be treated as having accepted the risks of non-payment of Pay Orders as part of normal commercial banking activity, and therefore, this dispute was essentially a civil contractual dispute and should not be treated as a criminal breach of law.
The Supreme Court of India rejected this argument and established a powerful precedent regarding white-collar economic crime:
“Where there is a criminal conspiracy to defraud public banks by the intentional falsification of financial instruments, the corporate veils of both entities will be pierced, and any entity that participates in such a scheme will not be able to use the doctrine of normal commercial business risk to shield itself from the consequences of its criminal actions. White-collar economic crime strikes at the economic health of the foundation of any nation, and thus the state must take whatever action is necessary to recover from the assets of the offender, and those efforts will take absolute statutory priority.”
3. Ramesh Parekh and other Businessmen who broke the Law (908-25-2013)
Central Bureau of Investigation Vs Ramesh Parekh & Other Businessmen (Special CBI Court – Mumbai)
This is a case of criminal trials and cases of violation of investigation codes under the Indian Penal Code (IPC). The charges under this case include violations of sections 120B (conspiracy to commit an offence), 420 (cheating), 467 (forgery of a valuable security) and 471 (using a forged document as genuine).
In the defence argument, it was argued that the accused had already received penalties from SEBI as a result of their actions and had therefore been subjected to “double jeopardy” in violation of article 20(2) of the Constitution of India, as a result of both civil legal proceedings (by SEBI) and a separate and distinct criminal trial (under the IPC) for conduct violating the code. The special court dismissed the defence submission and decided that an administrative investigation of a market regulator that is done to ensure market integrity is a different type of legal proceeding than a criminal prosecution by the State of India for conduct that represents a breach of public property and public trust and criminal conduct, allowing the continued criminal conviction and imprisonment of Parekh.
Conclusion
The Ketan Parekh Securities Scam (2001) provided an excellent diagnostic exposure into the weaknesses of the financial markets in India after liberalisation. Although the capital markets had a regulatory body like SEBI, they were not providing real-time monitoring and clearing for trading that allowed the construction of large numbers of fraudulent loan-to-loan leveraging operations by perpetrators.
The legal and structural ramifications of the Ketan Parekh scam changed the way that Indian capital markets are structured and operated. It led to the complete elimination of the traditional Badla system (a form of forward trading) and created a new trading infrastructure; the creation of purely corporate, demutualized stock exchanges; and the development of a new electronic settlement cycle for Indian stock markets that allowed for much faster and more accurate settlements.
The scams have also resulted in a significant amount of reform and new legislation, particularly with regard to investor protection and regulation of the financial markets. The frauds that took place were very complicated and required extensive reform of the existing laws and systems for managing these complex processes.
All of these reforms and changes have made the Indian capital markets far more technologically advanced, transparent, and regulated than before the Ketan Parekh scam took place.
FAQ
1. Which stocks were included in the “K-10 Stocks,” and how were they operated?
The “K-10 Stocks” were a selection of 10 specific shares in technology, media, and telecoms chosen by Ketan Parekh because they had comparatively low free floats (i.e., limited publicly traded shares). Through the use of front companies, Parekh was able to corner 20-30% of the total volume of these limited free float shares and restrict supply while simultaneously utilizing circular trading techniques, thus creating huge price spikes for K-10 Stocks in the marketplace.
2. What did the scam reveal about flaws in the “Dual Control” aspect of the Indian Banking Regulation Laws?
Urban Cooperative Banks, like the Maharashtra Maharashtra Cooperative Bank (MMCB), utilized the dual enforcement strategy to circumvent the Reserve Bank of India (RBI) by asserting administrative privilege from comprehensive RBI inspection due to the dual jurisdiction of the State Registrar of Cooperative Societies. As a consequence, MMCB was able to divert billions of rupees of their total public depositor base to a single stock broker, in complete violation of RBI-mandated credit exposure limits, and without the ability of the appropriate regulatory body to assure enforcement/compliance with the credit exposure limits. This loophole was corrected through the amendment of the Banking Regulation Act to provide the RBI with supreme apex regulatory jurisdiction over all cooperative banking institutions.
3. How did JPC function in terms of making legislation according to law?
After the stock market collapse, the high-level JPC was legally established to review the entire regulatory failure. Its complete legislative report resulted directly in statutory amendments to the SEBI Act in late 2002, which very greatly expanded SEBI’s institutional powers by giving the regulator specific authority to issue search-take possession of (seize) warrants, obtain telecom call data record subpoenas, impose compounding multi-crore fines, and directly attach bank accounts belonging to suspected stock manipulators.
