Besides the Harshad Mehta scam, there were numerous malpractices, essentially arbitrage between different instruments and markets
Many of the scams of the pre-reform era occurred because the peddlers were able to take advantage of the market's gaping regulatory holes. Some of these scams and dirty dealings also extended into the post-reform era. A good example is the Harshad Mehta-led securities scam, which is like the tip of the iceberg. Among that tip were a host of other malpractices, which were essentially arbitrage between different instruments and markets, financed in a way that circumvented existing rules and approved processes.
Many of these transactions and deals were outright illegal, while many of them were in the gray areas of legitimacy. An example of a 'grey zone' scam was trading in shares issued by the government-managed Unit Trust of India mutual fund, which was established by law. These units were colloquially referred to as US-64, after the year of their launch. The idea behind a government-owned mutual fund was to create another means of channeling household savings into the capital markets.
The fund's net asset value, or NAV, was never disclosed, but sales and redemption prices were announced at the start of the fund's financial year (June). The two prices could also change every month and a secondary market existed for these units, the price of which fluctuated within the sales-repurchase band.
The funny thing is that these prices were often unrelated to the real, net asset value of the fund, which ideally represents the NAV. The fund also paid a dividend every year, which continued to rise every year and helped create the illusion of assured returns, leading to greater inflows of household savings.
Smart traders always bought shares on the open market before the fund's annual dividend and redemption prices. These units, pregnant with dividends, would be available at a premium. Once the dividend was declared, the price would be adjusted downwards, at which point the trader would sell them at a lower price than the purchase price and make a loss. This trading strategy allowed traders to adjust their dividend-based taxable income against the capital loss resulting from their buy-sell trades. Moreover, the total capital loss also helped offset other tax liabilities incurred during the year.
Traders were essentially adjusting one type of income to another type of financial loss. While this was not strictly illegal, it was still poor accounting practice because it involved comparing apples and oranges. However, traders indulged in it because tax law did not explicitly prohibit avoidance. In fact, Manmohan Singh stopped this rampant practice in the historic 1991 Budget speech: 'The current provision for offsetting short-term capital losses with revenue leads to tax avoidance. I therefore propose that any loss on the transfer of one capital asset should be set off only against the gain from the transfer of another capital asset. This only makes sense. It should also put an end to the practice of buying up short-term capital losses that some unscrupulous taxpayers are resorting to.”
Cover of Slip, Stitch & Stumble: The Untold Story of India's Financial Sector Reforms, by Rajrishi Singhal, published by Penguin Random House India
But some other scams of the later years made this tax arbitrage business – which was otherwise legitimate – look like child's play. As illustrated in this chapter, the pre-reform Indian financial system was often the site of scams, fraud, misappropriation of funds and counterfeiting. The frequency and nature of these mishaps may have varied, but they are a regular feature of the Indian financial system.
It may be tempting to think that scams and crises are unique to the Indian financial system. It's not; All financial services sectors around the world, both in developed economies and emerging markets, have experienced scams and fraud. Here are two examples.
Former NASDAQ Chairman Bernie Madoff was considered an investment guru and his promises of high returns enticed investors – from individuals to even pension funds – to entrust their savings to him. In the aftermath of the 2008 financial crisis, when investors began asking for their money, Madoff was unable to repay. Ultimately, it turned out that the investments did not yield the outlandish returns he had promised and that he used new investors to pay back existing investors. It is estimated that Madoff lost approximately $20 billion in investor money and was sentenced to 150 years in prison in 2009. He died in April 2021.
The second example concerns the US-based bank Wells Fargo, which was known for its prudent management and emerged from the 2008 financial crisis unscathed, even after acquiring the failed bank Wachovia. In a complete turnaround, news emerged in 2016 that Wells Fargo had fraudulently opened millions of savings and checking accounts in the names of the bank's existing customers without asking their permission, secretly transferred money from existing accounts to the new ones, and sold credit cards. and other financial products to these fake accounts. The ostensible reason for this underhanded activity was to demonstrate growth in the bank's sales of financial products.
After complaints from some customers, regulators seized on the fraud in 2016 and fined the bank $165 million; the bank faces additional damages of $3 billion in civil and criminal proceedings. One of the enduring themes in all these Indian scam episodes is that of peddlers exploiting regulatory gaps or artificial barriers between different markets or instruments with varying returns. Money, like water from a higher level to a lower level, will flow from low-yield financial instruments to high-yield financial instruments. If artificial barriers stop this flow, the people who control this money will always find ways to circumvent or even outright break the rules.
Reprinted with permission from Slip, Stitch & Stumble: The Untold Story of India's Financial Sector Reformsby Rajrishi Singhal, published by Penguin Random House India, 326 pages, ₹599.