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The Harshad Mehta Scam in India (1992)

Harshad Mehta was the son of a peon. He was born in abject poverty and when he
migrated to Mumbai, he had a mere Rs 40 i.e. less than $1 in his pocket. However,
over the years Harshad Mehta rose meteorically to become one of the most
influential and powerful brokers on the Bombay Stock Exchange. At the peak of
his prowess, his fleet of cars would rival that of the nations biggest industrialists
and he was the subject of almost every news show in the country.

Later, it was revealed that Harshad Mehta had used some unscrupulous means to
obtain his wealth. The man who had come to the city with $1 had close to $8
billion as his net worth!However, he was later convicted of defrauding the public
and died in prison. In this article, we will find out more about the securities scam
of 1992 for which Harshad Mehta was convicted and sent to prison:

The Two Markets

India had two very different but parallel markets in operation. One market was for
corporate securities i.e. the stock exchange. Here the required return on funds was
much higher. Also, there were a relatively large number of brokers that were
present in the market. Even in 1992, at least 50 brokers operated in the Bombay
Stock Exchange.

Compared to that, the market for government securities had less than a dozen
brokers that operated. These brokers had to be licensed by the Reserve Bank of
India. This is because the market for government securities was an interbank
market i.e. the buyers and sellers in this market were usually banks. Also, the
turnover in this market was close to $1 billion per day which was 3 to 4 times
larger than the stock exchange and at the same time the cost of funds here was half
of that on the stock exchange!
The existence of these two parallel markets created rife opportunities for arbitrage.
It was only a matter of time before someone ventured to break the glass partition
between the two markets and that someone was Harshad Mehta.

Desperation by the Banks

Banks in India were struggling to make substantial profits in the 1990s. This is
because there were other competing products like the money market funds and
portfolio management services which were offering better returns to the investors,
thus driving business away from the banks. There was thus a huge competition
amongst banks for the additional cash that was held by the Indian corporate sector
particularly the oil and gas public sector units. This competition and the desire to
gain an advantage over competitors drove the banks into the schemes of cunning
brokers like Harshad Mehta.

The Massive Diversion

Harshad Mehtas scheme was very simple in essence. He would secretly embezzle
huge sums of money from the government securities market for a short duration.
He would then invest this money in a few selected securities and drive their prices
insanely high. When people would get excited about a particular security, Harshad
Mehta would slowly liquidate his holdings, pay off the embezzled money and
pocket the huge difference caused by rising prices. The scale at which Harshad
Mehta was doing this was unimaginable. In one year, he had driven the Sensex i.e.
the index of the Bombay Stock Exchange from 1000 to 4500! It was an
unprecedented bull run, never seen in the history of a conservative Indian market.

The Modus Operendi

Harshad Mehtas method of embezzlement was a bit complicated. Mr Mehta had
colluded with the banks to change the very nature of the government securities
market. Earlier, the role of a broker was only to bring the parties together whereas
the banks would undertake the transaction of securities and lending of money
themselves. In the new market established by Mr Mehta, the broker was more of a
market maker. This meant that both the banks were dealing with the broker and
neither knew who the counterparty was. Therefore, Mr Mehta could get the banks
to deposit a check in his account and have the funds for himself for a short period
of time!

Also, there was a time lag in the disbursement of money and depositing of
collateral. Hence, for this short time duration, the money was essentially an
unsecured loan to the broker and could be used to rig the markets.

The Aftermath

The Harshad Mehta scam was discovered when attention was paid to the money
missing from the government securities market. As the scam broke loose, the
valuations in the Bombay Stock Exchange collapsed. The mega growth that had
been witnessed by the exchange in one year came crashing down in a matter of
days. People lost their life savings in the scam. Some investors were heavily
leveraged and as a result committed suicide as a result of the fallout.

The issue rose to national prominence. Institutions like Reserve Bank of India,
Central Bureau of Investigation and Parliamentary Committees had to be involved.
The matter became even more convoluted as Harshad Mehta coughed up the name
of Prime Minister of India , Shri P.V. Narsimha Rao as being a beneficiary from
the corruption and threatened to reveal many more names.
Finally, the committee found Harshad Mehta directly responsible for embezzling
worth Rs 1439 crores ($3 billion) and causing a scam that led to the loss of wealth
to the tune of Rs 3542 crores ($7 billion). To this day, the Harshad Mehta scam
brings up memories of unprecedented boom and bust which was never witnessed
earlier by the Bombay Stock Exchange.