NSEL scam Take 2

The scam exposes the rot that runs deep into several aspects of the financial market

Harshad Mehta, in the early ’90s, and Ketan Parekh, at the start of the millennium, became the ‘formidable villains’ of small investors in India’s stock market. In the next decade, when the National Spot Exchange (NSEL) scandal came to light in 2013, market participants were quick to declare another conspicuous market person as the ‘sole’ anti-hero. But even five years after the NSEL payment crisis broke out, the question of who masterminded India’s first commodity market scam still baffles investigators and seasoned market watchers, as skeletons tumble out of the closet and new facts keep emerging.

Contours of the scam

The now defunct NSEL was India’s first electronic commodity exchange for ‘spot delivery’ of contracts, including agricultural products. The exchange lengthened its settlement cycles for some contracts to 25 or even 35 days; much beyond the stipulated 11-day settlement cycle, which now is under adjudication by the Bombay High Court (HC). Short-selling, too, was allowed despite regulations disallowing it. This made the Forward Market Commission (FMC) crack the whip to wind down existing contracts, which ended in payment default.

The reason for many NSEL investors now staring at losses is paired contracts that the exchange traded in. Few commodity stockholders sold warehouse receipts (WRs) on NSEL for immediate payment and entered into subsequent buyback for the same WRs, 25 or 35 days later for a fixed return of 12-14 per cent. The system degenerated to an extent where WRs were not backed by any physical commodity. This quasi-ponzi scheme was revealed after trading was suspended on the NSEL. When investors demanded commodity worth their money, the borrowers could not deliver them, as goods were woefully short in warehouses, and the new scam was born.

NSEL and its board were clearly to be blamed for the regulatory lapse and failure of checks and balances. But what at first appeared as an open-and-shut case of fraud and fund siphoning by an overambitious exchange promoter and key employees, has now encompassed large brokers and financiers, who introduced clients to this intricate trading ring.

The NSEL scam, when seen through investigation reports of various government agencies and court filings, exposes a wide net of money laundering, skullduggery and rot that runs deep into several aspects of India’s financial market. It is a lesson for small investors on how to spot the warning signs.

Games brokers played

‘Fiduciary duty,’ the highest possible standard of care in American law for financial market brokers, stems from Investment Advisers Act, 1940, and describes their responsibilities towards clients in a highly technical and notoriously complex industry. In India, SEBI picked up the US Act to form ‘code of conduct’ rules for brokers. Small investors have no choice but to trust brokers due to market complexities. Yet, the probe by Serious Fraud Investigation Office (SFIO) shows brokers failed in their fiduciary duty by marketing spurious schemes and may have gamed the system to bump up profits.

Of the 12,735 clients who lost money in the NSEL crisis, SFIO says it got responses from 7,217 and nearly 84 per cent of them were found to have never traded in commodities before their brokers introduced them to the NSEL. It has also come to the fore that paired contracts were marketed as investment products with ‘fixed return’. Messages like “13% (return) in raw wool February” were sent out by brokers to entice clients.

“This was very serious as a person who does not trade in commodities as a regular business would naturally believe his broker, who held fiduciary relationship with the clients and had a position of trust. Investigations reveal this position was compromised by brokers, and clients were betrayed on false promises,” the SFIO report says.

The SFIO report makes remarks against commodity arms of top five brokers — Anand Rathi, IIFL, Motilal Oswal, Geofin Comtrade and Phillip Capital — among others. The top five to seven brokers churned most volumes on the NSEL and are generating high volumes in equity and commodity futures on other exchanges too.

Ketan Shah, the most active aggrieved NSEL investor, was summoned by SFIO on March 1 and 5, 2018. He revealed under oath that Motilal Oswal and Phillip Commodities obtained his ‘power of attorney’ and controlled all aspects of NSEL trading. On the most important question in the scam — regarding missing goods — Shah told SFIO that his brokers had informed him, “that they visited the designated warehouses, and goods were available.”

Shah has submitted broker presentations, delivery allocation report, VAT invoices of goods, among other documents. Shah told SFIO that Phillip Capital had told him that it had used a company called “Amin Labs” to check quality and quantity of stocks at the NSEL.

When contacted by BL, Shah did not respond to queries.

The Economic Offence Wing (EOW) of Mumbai police say brokers traded without client permission, illegally changed unique client codes, engaged in market capturing activity, traded under names of employees, had nexus with defaulters, re-routed funds through multiple accounts, enrolled and financed low-income people as clients, misled submission to EOW about clearing and forwarding services, gave false assurances to investors and were involved in short-selling that was disallowed.

According to SFIO, investors like Achal Agarwal, Borosil Glass Works, Encore Natural Polymers, Vishvanidhi Dalmia and Moti Dadlani have complained against their brokers for fabricating documents, forging signatures and trading without authority. Agarwal told SFIO that he had discovered that ₹5 crore was invested in his name even though he gave only ₹97 lakh to his broker. Dadlani discovered ₹1.82 crore invested against the ₹50 lakh he had given.

Brokers cut high financing deals

Before it went bust, the NSEL was operational for four years, during which when the exchange claims that transactions worth over ₹7.67 lakh crore were executed on its platform and client obligations over ₹2.81 lakh crore were settled. Of course, not all of this was investor money, as a chunk came from broker-financed trades via their own NBFCs. Even if one considers an extremely conservative ₹50,000 crore worth leveraged trades in four years, mere interest earned on these funds by NBFCs could be thousands of crores. NBFCs charge 10-20 per cent annual interest on financing.

The EOW note says, for brokers and NBFCs, higher volumes on the NSEL meant higher commissions and interest. Rajvardhan Sinha, the then additional commissioner, EOW, submitted a confidential report to FMC on brokers’ benami trading operations and money transactions under investigation.

On July 31, 2013, Geojit Credits (an NBFC, which is a subsidiary of Geojit Financial Services) had an outstanding loan of about ₹136.60 crore to 117 clients. SFIO says Geojit Credits confirmed this to the court and even filed an affidavit stating that the amount, which was due from the NSEL to its clients, be ultimately paid to it. BL has the affidavit copy.

IIFL (the NBFC) financed ₹231.34 crore to 70 clients.

“IIFL Commodities was among the 300 brokers and enabled transactions as per the NSEL system. Findings clearly indicate fraud, misappropriation and default by the NSEL, its management and promoters. We have fully replied and clarified on all notices to authorities. Funding was part of the NBFC. The RBI verified and found no violation. Customers repaid loans in due course and there is no outstanding to the NBFC. No show cause notices (SCN) from SFIO,” IIFL clarifies when contacted by BL.

Geofin said, “We have replied to all agencies investigating the matter. Geofin did not fund clients.”

Motilal Oswal said, “We have our own group investment of ₹58.7 crore outstanding on the date of default. We have never misled our clients and informed them about risk involved in trading on the NSEL. Our group NBFC financed only one client. A SEBI-appointed auditor in 2016 did not find anything adverse against us. Auditors observed that Ketan Shah’s trades were not modified, and it was unlikely that his trades were carried without his authority. We never informed Shah that we visited the NSEL warehouse. An EOW report dated April 4, 2015, to FMC makes no allegations against us, but specifically against three other brokers.”

Anand Rathi said, “The only fraud in the NSEL is of missing commodities, perpetrated by the NSEL, FTIL and borrowers. The rest of the allegations are baseless.”

Phillip Capital has not responded to our queries.

Police reports show brokers visited NSEL-linked warehouses across India 54 times between May 2012 and July 2013 where commodities were supposed to be present. Also, government companies MMTC and PEC carried out warehouse visits on several occasions and confirmed stock and even traded on the NSEL as per CAG auditor.

Mystery shrouds investors

A figure of ₹5,600 crore and nearly 13,000 (12,735) investors is now synonymous with the NSEL scam. But only 7,217 investors responded to SFIO.

Also, various investigation reports and committees have not yet been able to verify the claims of ₹5,600 crore made by brokers (including broker IBMA, an NSEL group company). The high-powered VC Daga Committee, appointed by the HC to look into the NSEL scam, confirmed claims worth only ₹650 crore from 4,697 entities. The Committee told the court in July 2018 that another ₹439 crore worth claims required further scrutiny.

Out of the 12,735 claimants registered with the NSEL, 67 per cent of the outstanding amount is represented by 781 traders (exposure of over ₹1 crore). Simply put, 6 per cent traders are claiming 67 per cent of ₹5,600 crore.

Small investors with less than ₹2 lakh exposure to the NSEL are 608, and 6,445 others with ₹2-10 lakh exposure. Out of the total investors stuck in the crisis, over 50 per cent are small investors, considering those less than ₹10 lakh invested, but accounting for only 6.32 per cent of the ₹5,600 crore claim amount.

According to the Daga Committee, of the 1,200 companies claiming ₹2,800 crore from the total outstanding, 32 were already declared as ‘shell companies’. Investigations have found that most of the large NSEL traders had transactions disproportionate to their known source of income.

Clues in money trail

The over 28,000-page police charge-sheet, a report by the Enforcement Directorate (ED), and a written statement by former Minister of State, Finance, Arjun Ram Meghwal to Parliament give details of the money trail that leads to 24 borrowers, who were declared defaulters, for investor dues. Bombay HC judge Abhay Thipsay, in his 2014 bail order, after studying the 8,000-page first police charge-sheet on Jignesh Shah said, “Though this is termed as ‘scam of ₹5,600 crore by the NSEL, it is not that monies have been received by the NSEL, but have gone from one bogus trader (investing) to another (borrower). There is no material to show any direct link between amount dishonestly earned by borrowers and the amount received by the applicant.”

ED’s first 23,000-page charge-sheet restricts the NSEL’s role to ‘aiding and abetting’. However, in the second charge-sheet, the ED has classified NSEL’s income of ₹1,112.03 crore from 2008-09 to 2013-14 as proceeds of crime. ED also says NSEL had a separate fund under ‘Settlement Guarantee Fund’ of ₹236.05 crore, which was meant to safeguard the interest of trading members but used to repay the overdraft facility of a private sector bank and thus it, too, was ‘proceeds of crime’.

Pritam Singh, Additional Secretary to Government of India, said in a Gazette notification, “ED has traced proceeds of crime amounting to ₹3,973 crore to all defaulters.” The court, too, has so far given a ‘decree’ on the amount of ₹3,365 crore, which has to be paid by borrowers. A similar decree on another ₹1,055 crore is expected soon, NSEL CEO Prakash Chaturvedi told BL.

In March 2018, government-appointed forensic expert, US Gandhi & Co., identified money trail to Astha Group, LOIL Group, Ark Imports, Lotus Refineries, Metkore Alloys, Namdhari Group, NCS Sugars, PD Agro, Shree Radhey Traing and MSR Food among others. Another forensic expert, Chetan Dalal Investigation & Management Services, traced funds to NK Protein.

SFIO got the nod to prosecute NSEL promoters, including Jignesh Shah and other board members, including Joseph Massey, for criminal conspiracy, cheating and fraud. It sought to prosecute NSEL auditors under sections of the Companies Act and borrowers for liability.

SFIO has asked SEBI to decided on ‘fit and proper’ status of the brokers. Assets of over ₹2,000 crore belonging to Financial Technologies, re-christened 63 Moons, its promoter and face of the company Jignesh Shah remain attached under the Maharashtra Protection of Depositors Act, awaiting further court orders. Total assets of around ₹8,000 crore (including defaulters’ assets) have been attached.

In October 2018, the HC stayed attachment of more assets of 63 Moons, and its key software product ODIN and investments.

Last month, the Supreme Court dismissed petition to intervene on thestay by the HC. The government had ordered merger of the NSEL and 63 Moons under section 396 of the Companies Act. The matter is now pending before the SC and the merger is stayed till the court decides.

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