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Harshad Mehta Securities Scam

After a three-year stint as Under Secretary in the Central Board of Direct Taxes, New Delhi, I was promoted to the rank of Deputy Commissioner in May 1992 and transferred to Mumbai. I was posted to a Range comprising of banks (both Indian and foreign), financial institutions, an RBI subsidiary, public sector companies, and other big corporates. There were four other such Ranges, each headed by a Deputy Commissioner. The tax department’s bread and butter essentially came from banks who paid most of the advance tax which were critical in Bombay Region’s budget target. Any less-than-expected payment would lead to panic with bells ringing as far as North Block. So, they had to be carefully nurtured, lines of communication with them needed to be operative throughout, their advance tax provisions for the year analyzed and discussed, and actual quarterly payments monitored. Any downward variation would entail discussions with their top brass , understanding the reasons , urging the bank to make up in the next quarter , and looking for  systemic solutions at our end – such as fast tracking appeals so that stuck up tax demand could be recovered ( provided we won).

The contentious issues in the assessment of banks were unremarkable. These were fairly routine in nature and it would not have been an exaggeration to state that the annual assessment orders conformed to a template. With control and supervision exercised by RBI over banks, with government audits , with well-established processes and procedures , the issues were purely legal in nature , arising out of differing interpretations of law; which was absolutely normal and standard in the life of any corporate. You differed over an issue, the tax department made additions to your taxable income, you went in appeal, you won some, you lost some.

So, what were these issues? Besides issues common to other  industries , the issues exclusive to the banks were broken period interest paid; interest accrued on securities and debentures; diminution in the value of investments; interest on sticky advances; bad debts; discount on permanent investments. For foreign banks, there were some additional issues such as Head Office expenses; expenses for soliciting NRI deposits; claim for full expenses (without disallowance) relating to the Indian branches as per the banks’ interpretation of the Indo-US Tax Treaty.

Before I joined in Mumbai, Harshad Mehta, THE securities broker, was the flavor of the season. He was the Emperor of Dalal Street and had a fanatic fan following across the country. His was a rags-to-riches story. As a son of a peon, born in abject poverty, he had migrated to Mumbai with a mere Rs 40 in his pocket. He was now the poster boy of every retail investor in the country. His flats, fleet of cars, his exploits in the market, made newspaper headlines and magazine covers and subject of every TV news show.  As he pumped in money, the share market achieved new highs. Retail investors took cues from what Mehta was buying and followed in the footsteps of the ‘Big Bull’.  In the period between April 1991 and April 1992, the Sensex went into a frenzy and returned 274 percent, moving from 1,194 points to 4,467. It was all his doing. The growth story of India was playing out in the stock market, was the prevailing opinion. The tax department was happy. A rising turnover in the stock marker meant more profits to the brokers, hence more taxes. A rising index meant more capital gains for investors (when they sold), hence more taxes. The atmosphere was feel-good, and it was good to be going to Mumbai – with the Aayakar Bhawan just a kilometer (as the crow flies) from the iconic Phiroze Jeejeebhoy Towers housing the Bombay Stock Exchange.

In April 1992, the State Bank of India reported a shortfall in government securities. That led to an investigation that later showed that Mehta had manipulated around Rs 3,500 crore in the system. The functioning of the money market and the stock market was thrown in disarray. The tainted shares were worthless as they could not be sold. This created a panic among investors and brokers and led to a prolonged closure of the stock exchanges along with a precipitous drop in the price of shares. On August 6, 1992, the markets crashed by 72 percent leading to one of the biggest falls and a bearish phase that lasted for two years. The Scam engulfed top executives of large nationalised banks, foreign banks and financial institutions, brokers, bureaucrats and politicians. The Scam was in essence a diversion of funds from the banking system (in particular, the inter-bank market in government securities) to brokers for financing their operations in the stock market.

Since most of the tax officers had no domain knowledge of capital markets and the headline- capturing mayhem that was taking place, our dynamic Chief Commissioner organized a seminar in the tax office. The head honchos of big brokerages, financial companies, big corporates and some blue-blooded industrialists addressed us. They filled us in with their assessment of what, why and how the Scam took place.

So how did the scam work?

India had two very different but parallel markets in operation. One market was for corporate securities conducted through the stock exchange.  There were a large number of brokers in this market.

The other market was for government securities.  Less than a dozen brokers operated here. These brokers had to be licensed by the RBI because the market for government securities was an interbank market - the buyers and sellers in this market were usually banks. The turnover in this market was three to four 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 the tenuous, and poorly supervised, partition between the two markets would be bridged. Harshad Mehta did that. His job became easier because of the avarice of the banks.

Banks in India were struggling to make profits in the 1990s. 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 corporates. This competition and the desire to gain an advantage over competitors drove the banks into the cunning hands of Harshad Mehta.

Harshad Mehta’s scheme was brilliant in its simplicity. He would secretly embezzle huge sums of money from the government securities market, in connivance with crooked bank officials, for a short duration and invest this money in a few selected securities and drive their prices insanely high. His followers, who watched his every move, would follow suit and drive the prices even higher. Harshad Mehta would slowly liquidate his holdings at the higher price, pay off the embezzled money and pocket the huge difference. The scale at which Harshad Mehta was doing this was unimaginable.

Here’s how Harshad Mehta could pull it off.He 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 Harshad 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, Harshad 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.

Obviously, the bubble had to burst one day.When it did and the Scam came to light, the valuations in the Bombay Stock Exchange collapsed.  People lost their life savings in the Scam. Some investors were heavily leveraged and committed suicide. Lives were destroyed, families ruined, shares and government securities market were in turmoil, confidence lost, credibility of institutions in tatters. I was in Mumbai witnessing the carnage first-hand.

The Scam became a major national issue.

A Joint Parliamentary Committee (JPC) was appointed to look into the Scam. The JPC observed, “The Scam is basically a deliberate misuse of public funds through various types of securities transactions with the aim of illegal siphoning off funds of banks and PSUs to select brokers for speculative transactions”. The Committee found Harshad Mehta directly responsible for embezzling worth Rs 1439 crores and causing a scam that led to the loss of wealth to the tune of Rs 3542 crores.

The Janakiraman Committee of Reserve Bank of India (RBI) was set up to investigate. The CBI got into the act. A Special Court was set up.


By 1992, I had already spent ten years in the tax department. Though words like ‘evasion’, ‘concealment’, ‘avoidance’, ‘colorable devise’, were usual in our day to day work, the word ‘scam’ entered the tax lexicon for the first during those days. And the word would become part of our professional lives for the next four years.

Our Chief Commissioner, in the editorial he wrote for the departmental magazine—Aayakar Bharati —put the Scam in perspective. Noting that the JPC, in its concluding paragraph ,had stated that it had come across various instances of close nexus between prominent industrial houses, banks and brokers, he invoked Lewis Carroll’s The Walrus and the Carpenter and observed that the system had failed to notice certain connections, certain collaborations and connivance. Did the system eat up the beings as the Walrus and the Carpenter did to the poor Oysters?


To understand the Scam in its complete details , the five officers dealing with banks were tasked with getting a thorough knowledge of the working of the RBI , the stock exchanges , the capital market , and the government securities market. We were deputed to the concerned institutions. We went through the Janakiraman Report with a fine-tooth comb and the JPC Reports as and when they were released. We also studied the relevant laws on the matter as well as the various instructions, circulars and guidance issued by the relevant institutions.

Having thus equipped ourselves with both facts and law on the Scam and the relevant institutions, it was time to put the knowledge to use.

First, we had to establish whether, and to what extent, the banks were involved in the Scam. All the investigations thus far were unanimous about the banks’ role. But which were these banks and what was the nature of the involvement? The biggest issue was that even if the banks were involved, where there any tax implications? For the tax department, that was the only remit. But even if the banks were to, in violation of RBI directions, allow funds to be diverted, as was one of the findings, to the brokers, what could be the tax angle?

This was an exercise that we five officers had to wrap our heads around and come up with answers. We were actively supported and encouraged by our Commissioner and Chief Commissioner. This was an area never ever attempted. But a massive scam had taken place, with the active participation of the banks; surely there would be some issues of taxability which needed to be ferreted out from the labyrinth.

Our collective brainstorming paid off.

Two issues needed to be answered first.

  1. Whether RBI directives were binding on the banks

  2. Whether RBI directives constituted ‘law’

RBI is constituted under the RBI Act, 1934 and as a Central Bank, exercises powers of superintendence and control over banks in India. The Banking Regulation Act, 1949 applies to all banks. Under this Act, the RBI has the power to control advances, prohibit certain kinds of transactions, determine policy, issue directions, and many other powers. It was clear that RBI directives were binding on banks. Even RBI guidelines were binding in view of the restrictions contained in them.  The Courts had also held likewise. They held that when negative, prohibitory and exclusive words are used, the directions/ circulars/guidelines become binding.  Moreover, one of the terms of reference of the Janakiraman Committee was to enquire into the extent of the non-compliance of the banks with RBI guidelines. If such guidelines were only in the nature of recommendations, and not mandatory, there was no need for the Committee to be set up.

So that was the first hurdle cleared. But the bigger one was still left. Did these directions, even if mandatory, constitute ‘law’. Because if they did, then it could be held that the banks had acted illegally, and the tax consequences of illegal activities was already established law.

By studying Articles 13(3)(a) and 336(10) of the Indian Constitution , section 3(29) of the General Clauses Act , and a catena of court decisions , it was concluded that since RBI directives/guidelines laid down a general rule of conduct , indicated a future course of action and specified a policy , they amounted to ‘law’ and their violation constituted infraction of law.

The law stipulated that illegal business constituted a species of its own and net losses from illegal business could not be set off against the legal business income of the bank. Also, such illegal loss could not be carried forward.

The Special Court ( Trial of Offences relating to Transactions in Securities) headed by Justice S.N. Variava, in its order dated 14th December, 1993, held that banks were bound to follow directions, orders or prohibitions of the RBI , and held that Ready Forward transactions were illegal. The decision supported our stand in the matter. 

With the accounts being voluminous, specialized and complex, how were we to discover and quantify the illegalities committed by the banks? An obscure section – 142(2A) – hardly ever used those days (most tax officers spent their entire career never using it) came to our rescue. The job was entrusted to the big accounting firms of Bombay with a clear mandate to identify and quantify the various violations of RBI directives committed by the banks. The logistics of implementing the exercise, and the learnings from it, were used as a case study when I gave lectures at the tax training institutes. The Section, which had the reputation of being purely academic in nature, had finally found its place in the sun as an indispensable tool to nab the wrong doers!

The Reports were finally prepared, and the following illegal transactions were found to have been done by the banks:

  1. Buy-back arrangements in public sector bonds, corporate shares, debentures and units

  2. Buy -back arrangement with non-bank clients

  3. Securities transactions with brokers

  4. Loans to brokers

  5. Transactions with differences in contract rates and delivery rates

  6. Sales transactions without holding sufficient balance of the Security

  7. Same day transactions in non- approved securities

As per law, the net losses in all the above transactions were disallowed by the tax department. 

Violations were also done with respect to Portfolio Management Schemes. Various conditions laid down by RBI directives were violated  - such as the banks could not guarantee a pre-determined rate ,  the services were to be provided at the customer’s risk , the minimum period had to be one year.

Because of the infractions, we treated such deposits not as PMS but as long-term deposits. Only the maximum rate of interest applicable on such deposits was allowed and the excess interest paid was disallowed.

The Janakiraman Committee and the JPC made scathing comments about the flagrant violations indulged in by banks regarding PMS. The work done by us was taken note of by the JPC at paras 17.108 and 17.109 under the head ‘PMS Transactions of Foreign Banks’. The JPC recommended that the matter may be seriously pursued and the CBDT may examine the case of other banks who had made similar transactions under PMS. This was a huge boost to us. A Parliamentary Committee had approved our stand on treating the excess interest under PMS as income of the bank. RBI then stepped in to formulate a policy to penalize banks for violating their guidelines on securities transactions and PMS, and also that of the SEC and Glass Stegall Act (in case of American banks).

Naturally, the banks complained to the Government. A team of CBDT officers camped in Bombay to assess what we had done so far, and what we were proposing to do. Briefings were given to them about the factual and legal position. They went back, did their own research, and issued guidance on 28th February 1995. They agreed that transactions violative of RBI directives were illegal and that they should be treated as a separate class of business. The net losses arising therefrom should not be allowed to be set-off against legal profits. The excess rate paid under PMS, which was illegal, was to be disallowed. On unauthorized loans given to brokers without charging of interest, appropriate disallowances be made from the interest paid by the banks on their borrowings. 

The years 1992-96 were truly eventful and satisfying for us. The exposure we got , the collective work we did , the encouragement and help we received right up the food chain , the chance we got to think out of the box to come up with the tax aspects of the Scam , was an experience that very few officers get in their career. Of course, we lost some issues in appeal, we won some, but that is normal in the tax eco-system. The point is we made a sincere effort to penalize a wrongdoing so that it would act as a deterrence in the future. It gave us confidence to face similar challenges in the future.

The Scam had collateral benefits too. If the banks were penalized, it was not necessary that their in-house tax department was also similarly placed. When I was leaving for my next assignment, the tax head of a foreign bank came to my office with sweets. Even though, our dealings during the four years had been professional, some amount of tension and animus had creeped in. So, I was flabbergasted. I asked him the reason. He said he tell me but first I must partake the sweets, which I did. I offered him tea and he opened up. In 1992, his office was a small room, and he had one junior. The CEO did not know his name. His was a peripheral role and he was treated as such. But the Scam changed all that. He was given rapid promotions, his department increased manifold and the World Tax Head sitting in the US headquarters was directly in touch with him. When Senior Management from Headquarters came visiting, he was given the pride of place in briefing them. His entire life had changed. And he had come to thank me!


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