Genesis of the SEBI Act

The Big Bull releases on 23rd Oct. Scam 1992 premiered yesterday on Sony LIV.

The man behind this content, goes by the name of: Harshad Shantilal Mehta.

Here's a close look, at how a broker exploited the flaws in the processes, and made the entire securities exchange system in India collapse, like a pack of cards:

Up to the early 90s, banks in India were not allowed to invest directly in the equity markets.

However, they were expected to post profits, and to retain a certain ratio of their assets in government fixed interest bonds.

A bank had to go through a broker, to buy securities and forward bonds from other public sector banks.

The banks approached Mehta, who squeezed capital out of the banking system, to address this requirement of banks, and pumped this money into the share market instead of dealing with other banks.

He drove up the demand of certain shares dramatically, selling them off, passing on a part of the proceeds to the bank, and keeping the rest for himself.

This resulted in stocks like ACC, which was trading in 1991 for ?200, to jump to nearly ?9,000 in 3 months.

This is called the "stamp paper scam".

He went a step further, and devised the "bank receipt scam".

The RF (ready forward) deal is in essence a secured, short-term (typically 15-day) loan from one bank to another.

One bank sells the securities to the other, and buys them back at the end of the period of the loan, typically at a slightly higher price, as agreed initially.

E.g. Bank A sells 1 share of X Ltd. to Bank B for 100 (spot rate) with a forward rate of 110. Contract period is 15 days.

Bank A receives 100 on day zero.

On day 15, Bank A pays 110 for the share while buying it back.

On day 15, if market rate was 110, Bank A makes zero profit (market rate - forward rate), by selling it in the open market.

If the market rate is 120 on day 15, Bank A makes a profit of 10 (120 - 110), by selling it in the open market.

If the market rate is 90 on day 15, Bank A makes a loss of 20 (90 - 110), by selling it in the open market.

The seller gives the buyer of the securities a BR (bank receipt). The BR confirms the sale of securities. It acts as a receipt for the money, received by the selling bank. It promises to deliver the securities to the buyer.

A typical ready forward deal involved two banks, brought together by a broker, in lieu of a commission.

The seller handed over the securities to the broker, who transferred them to the buyer's portfolio. The buyer gave a cheque to the broker, who then made the payment to the seller.

In this settlement process, the buyer and the seller might not even know whom they had traded with, either being known only to the broker.

Mehta needed banks which issued fake BRs (Not backed by any government securities). Two small banks, the Bank of Karad (BOK) and the Metropolitan Co-operative Bank (MCB) – came in handy for this purpose.

Going back to the earlier example, Bank A (fake) sold (fake) shares to Bank B (real) and received 100 on day zero.

100 was invested in the market, and became, say 150 on day 15.

On day 15, Harshad sold the shares for 150, Bank A (Mehta) paid 110 to Bank B, making a profit of 40 (150 - 110).

This money was used to drive up the prices of stocks in the stock market. When time came to return the money, the shares were sold for a profit and the BR was retired.

Once the scam was exposed, a lot of banks were left holding BRs which did not have any value – the banking system had been swindled of a whopping??40 billion?(US$560?million).

Inflation adjusted value today would be over $1B.

This phenomenal catastrophe, that was planned and executed with surgical precision, necessitated a complete overhaul of secondary market reforms in the country.

As they say, the rest is history.