Playing the game: Scams & Frauds
In school, the more you know about the subject the better you get in predicting the type of questions that will be asked in the exam. The same applies to industry or academics, once you understand the entire play-field upside down, it doesn’t require any magic potion to trigger the brain to layout the possible loopholes present in the system. Then it lies entirely on the individual’s ethics and greed fear balance to execute further actions.
In this article, lets go through three stock market scams in India and how the laws and policies evolved with them.
1. 1992 Scam
This fraud amounted to around 4000 Cr. and is considered the biggest scam in the history of securities market in India, which lead to complete structural change of banking and financial framework followed by the further insurgence of technology in the system.
Q. What was the financial scenario in 1990's?
Prior to concepts of dematerialization of physical share certificates, depository participants (DP), demat accounts and direct market access (DMA), everything was paper based i.e. in form of certificates and receipts, with brokerage houses being the sole intermediate between investor and the concerned exchange.
Apart from the differences between the money market and corporate markets in terms of their securities, participants, trading volumes & market capitalization etc., the cost of finance in corporate markets was about twice that of the formal markets. This prompted one to think in the direction of somehow diverting the funds from banking systems to brokers and further to stock market where yields seemed vastly better in comparison. Further, the economic liberalization (June, 1991) brought positive news for private sectors, but had simultaneously put pressure on public section, financially, to perform well. Also, introduction of portfolio management schemes (Shorn of a verbiage-a deposit without interest rate ceiling or reserve requirements)also encouraged competition among banks for PMS funds and to enhance on their own profitability.
Q. What was the system flaw and mechanics of the scam?
Banks in order to maintain their statutory liquidity ratio (SLR), had to increase or decrease their holdings in liquid assets like Gold and G-secs. Instead of physically buying or transferring holding of these securities through inefficient public debt office (PDO), banks preferred to enter ready forward deals, which are a secured short term loan (~15 days) from one bank to another. A ready forward deal (RFD) can be seen as lending money or borrowing of securities (Illustrated in figure provided below). However, the transaction were done using bank receipts (BR), issued by the borrower. Basically making it unsecured and solely built on trust that seller holds the securities.
Lack of proper control systems in place like credit or counterparty limit further widened the loophole. These flaws were exploited by the broker, who instead of just being an intermediate, also started to engage in their settlement process i.e. the cheques and receipts were now routed through broker. The broker then credited the money to his account even though it was account payee cheque. How?
During that time, when banks made payments to each other, those cheques were cleared on same day. Thus, in order to reduce the clearing time and to save the interest lost for that delay (e.g. 50 Cr. cheques->2 days delay in clearing->Loss of 4 Lakhs @ 15%) certain corporate clients were allowed to clear the account payee cheques in favour of the banks into their own accounts.
Further, the broker persuaded certain small banks to issue counterfeit bank receipts and enter RFD with other banks. Hence with BR with RFD became a pathway for getting unsecured loan from banks to broker to stock market.
Q. How did it come under scanner?
Eventually, the huge difference in the amount represented by BR’s in circulation and the government bonds actually held by the banks led to the discovery of the scam. This lead to a sharp fall in the share prices. Further, one may analyse that technically 4000 Cr impact on a market of size 250,000 Cr. may not too significant. The prices plummeted largely due to the knee jerk response it received afterwards, like declaring all transactions routed through the accused individuals (like brokers) as void leaving several shares worthless as they could not be delivered in the market.
Q. What were the reforms that followed?
The broken financial system of 1990’s underwent dramatic structural changes following the scam. To improve transparency, online trading came into light in 1992 which expanded the boundaries of capital market nationally. The satellite communications systems were in place which eliminated the geographical barriers. Regulatory bodies were given more powers. RBI was made the primary agency for banking system regulation in November 22, 1993. Securities and Exchange Board of India though founded in April 1988, was (through SEBI Act 1992) conferred statutory powers to it. Vigilance towards defaulted paper work was increased with audits and laws in line to deter future offenders.
Lets look into our next story which came into light in early 2000's.
2. Supervisory Lapse (1998-2001 )
This 1000 Cr. financial con was an assemble of multiple illegal manipulation practices namely circular trading, pump and dump and synchronized trading. Focusing on micro and small cap shares certain cartels, consisting of named brokers, traders and big institutions came under investigation light. Further, even after the 1992 scam, in this case, the illegal divergence of money from banks to stock market was carried out in form of pay orders with the help of some co-operative banks.
Q. What was the system flaw and mechanics of the scam?
The system flaw that emerged with this large-value banking fraud was the lack or failure to enforce internal control systems (like credit worthiness etc.), internal audits of those mechanisms and corrective actions to identify conflict of interest raising potential for such reckless mismanagement. Further, at that time, the co-operative banks were under dual regulation with RBI (under Banking Regulation Act) being less rigorous than co-operative societies (under Co-operative Societies Act). As a result of this dual regulation framework, the RBI only used to lay down the guidelines for functioning but it was the state government which had power to regulate them, making the quality of supervision and regulation poor. Later in July, 2020 this seven decade old Banking Regulation Act was amended, and brought co-operative banks under the ambit of the Reserve Bank of India (RBI).Further, one cannot stress enough on the fact that the the regulatory systems lacked proper gathering of intelligence across the markets (formal & informal markets).
Going through the mechanics of the scam, the said broker had conducted most of his trading in Calcutta Stock Exchange where the regulation was not prudent and used to target those stock which had low market cap and were illiquid, which helped him to pump up the prices easily and indulge in fictitious trading within his network of traders (i.e. circular trading), seeing enhanced activity in the stock lures average genuine investors would buy the stock raising its price even higher. Then the said broker would start liquidating his position and book his gains.
Further, as stated before, the said broker used to have access to unsecured loans from co-operative banks using pay orders, which he made possible by bribing the bank officials and such arrangement helped him to get the loan amount sanctioned while he would be depositing collateral after some days.
Q. How did it come under scanner?
When IT bubble burst occurred, the said broken found himself out of cash and while the discounting bank had already credited the amount to him, the pay orders were not cleared/honored. This lead to the revelation of the illegal arrangement within the system.
Q. What were the reforms that followed?
This fraud event lead to cut shorting the trading cycle from a week to one day, the carry forward system in stock trading was again banned after introduction of F&O.
3. Mishandling of client’s securities (2019)
This particular fraudulent heist took place in year 2019 and involved illegal diversion of funds amounting to around Rs. 2000 Cr. A particular stock broking company was found to be dealing in off-market transfer of client shares to their own beneficiary account and pledging them as collateral to raise funds from four banks for their own usage and not for meeting client’s requirement. But with swift action of able regulators and depositories the impact of the wrongdoing was minimized.
Q. What was the system flaw ?
The stock broking company was able to execute this money heist despite the depository act and regulatory circular (CIR/HO/MIRSD/DOP/CIR/P/2019/75 June 20, 2019) restricting such practices of unethical handling of client’s securities/collaterals.
If one asks me, the core flaw lies in the fact that the securities that was traded say today (T day) are being settled at T+2 days, giving ample amount of time in which misuse of securities may take place. However, this case specifically involved sheer misuse of power of attorney (PoA) by the broking company. It is an optional legal document that the client provides the broker they get registered with, in order to make the debit of shares from their demat account convenient. If not provided, the client can still sell the shares via electronic delivery instruction slip (e-DIS) which essentially is a TPIN to authorize to place or modify sell orders (this was introduced in June, 2020). PoA enabled the company to carry out the illegal diversion of client’s securities to their own account.
Further, banks involved in lending against the securities ideally would have referred to a brokerage’s balance sheet to confirm its financial position before extending the loan. But, they did not even verify brokerage’s title over the unauthorized pledged securities and only relied on the representations made by the brokerage firm.
Q. How did it come under scanner?
From the interim regulatory order, the fraud was detected by limited purpose inspection of the brokerage company by a leading exchange. It was found that for the period January 2019 onwards, the company had not provided details for one of its DP account categorized as beneficiary client and henceforth the illegal transactions were uncovered. Further forensic investigation revealed the course of transactions from the banks where the funds were raised against the client’s shares to the accounts where these funds were transferred.
Q. What were the reforms that followed?
The regulator had managed to control the damage and its the impact on investors registered with the brokerage with the combined efforts of depositories and exchanges. Reforms inspired from this episode were changes in the PoA clause and tighter norms in handling of client’s securities and lending against such securities. Norms on disclosure of related parties transactions apart from proprietary is still awaited.
With the sheer objective to maintain the confidence of market participants in stock market and to uphold its transparency and integrity, the surveillance measures are continuously advancing in order to detect the manipulation and gather evidences to prove the malicious intent behind them.
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Sources:
[1] Samir K. Barua Jayanth R. Varma, “Securities Scam: Genesis, Mechanics and Impact” 18, no. 1 (March 1993): 3–12.
[2] Saptarishi Ghosh Mahmood Bagheri, “The Ketan Parekh Fraud and Supervisory Lapses of the Reserve Bank of India (RBI): A Case Study,” Emerald Group Publishing Limited 13 (2006): 107–24.
[3]“Ex Parte Ad Interim Order in the Matter of Karvy Stock Broking Limited” (Securities and exchange board of India, November 22, 2019).
