A guide to the JPC Report

The stock market scam and the UTI imbroglio.

STOCK markets around India crashed during March-April 2001. They are yet to recover from the sensex level of around 3000 where the index has been stagnating since the crash. At the height of the 1999-2000 boom, the sensex had crossed the high watermark of 6000. By April 12, 2001, the sensex had tumbled to 800 points below its early March level and a huge number of skeletons had started tumbling out of the cupboard: Ketan Parekh's malfeasance; swindles in urban cooperative banks like Madhavpura in the Deputy Prime Minister's constituency and City Cooperative Bank in the Prime Minister's constituency; the payments crisis on the Calcutta Stock Exchange; misuse of the Mauritius route for investment in our stock markets; and the involvement of a bewildering number of banks, brokers and corporates in exploiting every available loophole left gaping open by the government and its regulators. The hardest hit, of course, was the innocent individual investor who had put his trust in the government and its regulators and other agencies to ensure the integrity of the market.

Thus, the government was left with no alternative but to concede the Opposition demand for a JPC when Parliament resumed its budget session in the second half of April 2001.

It was evident that both the artificial boom and the inevitable bust involved a variety of malpractices. These went unchecked because the Ministry of Finance and its regulators, in particular the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI), grievously failed in the performance of their duties. The government and its regulators were more concerned with stoking the "feel good factor" than with ensuring the integrity of the market when the market was spiralling dizzily upwards. They got concerned only when the market collapsed. As the JPC report remarks:

"When stock markets were rising, there was general lack of concern to see that such a rise should be in consonance with the integrity of the market and not the consequence of manipulation or other malpractice. On the other hand, when the markets went into a steep fall, there was concern all over." (para 2.12, page 8)

The small investor enters the market in the expectation that the government and its regulators will ensure the integrity of the market, so that whether the market rises or falls, market behaviour is not the consequence of rigging or other malpractices and irregularities. Of course, no one can stop fraudsters from attempting to deceive ordinary investors. But if there is persistent malpractice, and this is known or should be known to the government and its regulators, and yet little or nothing is done quickly to restore integrity to the market, then repeated fraud, accompanied by persistent failure on the part of the authorities to close the loopholes, becomes a scam. The JPC explains the scam in the following terms:

"The scam does not lie in the rise and fall of prices in the stock market but in large scale manipulations like the diversion of funds, fraudulent use of bank funds, use of public funds by institutions like the Unit Trust of India (UTI), violation of the risk norms on the stock exchanges and banks, and use of funds coming through overseas corporate bodies to transfer stock holdings and stock market profits out of the country." (para 2.20, page 10)

The JPC then goes on to say:

"These activities went largely unnoticed." (para 2.20, page 10)

And this at a time when stock market turnover exponentially increased from a daily average of some Rs.300 crores to Rs.12,000 crores a day, sometimes reaching even Rs.15,000 crores!

The JPC says:

"While the stock market was rising, there was inadequate attempt to ensure that this was not due to manipulations and malpractices. In contrast, during the precipitous fall in March 2001, the regulators showed greater concern." (para 2.20, page 10)

The Opposition in Parliament had frequently drawn the attention of government to their apprehension of malpractices in the stock market when the market was booming, in particular to the glaring contrast between inactivity in the primary stock market, where fresh investment is mobilised, and frenetic activity in the secondary market, where existing stock holdings are traded. The Opposition had also contrasted the stagnation in the real economy - low growth rates in agriculture, industry, infrastructure, exports, foreign direct investment, etc. - with the runaway boom in the stock market. The government paid scant attention to these Cassandra warnings.

Therefore, as soon as it became public knowledge that SEBI had instituted on March 2, 2001, its inquiry into the fall of the market, where no similar inquiry had been made in regard to the rise of the market, the Opposition in Parliament began agitating for a Joint Parliamentary Committee (JPC) to inquire into the scam. The government initially refused to concede the demand for a JPC, arguing, as Finance Minister Yashwant Sinha did in the Rajya Sabha on March 13, 2001, that there was "no big scam" and the regulators were doing a good job of ensuring the safety and integrity of the stock markets.

Far from there being "no big scam", the JPC have uncovered "a practice of non-accountability in our financial system":

"The effectiveness of the regulations and their implementation, the role of the regulatory bodies and the continuing decline in the banking system have been critically examined, for which the regulators, financial institutions, banks, Registrars of Cooperative Societies, perhaps corporate entities and their promoters and managements, brokers, auditors and stock exchanges are responsible in varying degrees." (para 2.20, page 10)

Moreover, says the JPC (para 2.20, psge 10), "the parameters of governmental responsibility have also been taken into account". What are these parameters? In establishing these parameters, this JPC has simply reverted to the report of the previous JPC. It cites, at para 13.2, page 309, the previous JPC's examination of the distinction sought to be made then by the Minister of Finance between his "direct responsibility" for "broad policy decisions" and "administrative failures or management deficiencies" for which, he had said, the Finance Minister "cannot be held responsible". The 1992 JPC had held that "such a distinction cannot be sustained by the constitutional jurisprudence under which the parliamentary system works".

That JPC also held that "the principle of constructive ministerial responsibility is equally applicable to other Departments and Ministries". This JPC says:

"The Committee are agreed that ministerial responsibility in regard to this Report flows from these principles." (para 13.3, page 310)

The JPC have faulted the Ministry of Finance in at least 52 paragraphs of the report!

Also faulted is the Department of Company Affairs, which is the regulator for corporate entities. At the time of the scam, the Department was under the charge of Arun Jaitley. Besides, the government's investigative agencies, such as the Central Bureau of Investigation (CBI) and the Enforcement Directorate, which fall directly under the purview of the Prime Minister, have also been indicted by the JPC.

Specifically faulted is the slow action investigating and proceeding against three entities - City Cooperative Bank, Cyberspace Infosys and Century Consultants - located in the Prime Minister's constituency of Lucknow. This group enjoyed such close relations with the U.P. government (then run by the BJP) and the local political establishment that the Prime Minister was persuaded to inaugurate Cyberspace Infosys.

Yet, owing to the inadequate and even misleading briefing given by the chairman of the JPC, media headlines on the presentation of the JPC report described Ketan Parekh as the "root cause" of the scam. The JPC report (para 2.15, page 9) describes Ketan Parekh as a "key player", not as the "root cause". Of course, Ketan Parekh and others manipulated the market but they got away with this for as long as they did because the regulators and the government left the loopholes gaping wide. Moreover, as set out in para 2.21 page 11 of the report, "the lack of progress in implementing the recommendations of the last JPC", and the special cell set up then to go into the broker-bankers-corporates nexus "having gone defunct", have led the Committee to "express their concern at the way the supervisory authorities have been performing their role and the regulators have been exercising their regulatory responsibilities". It is "the Committee's view" that "no financial system can work efficiently even if innumerable regulations are put in place unless there is a system of accountability, cohesion and close cooperation in the working of the different agencies of the government and the regulators." For ensuring such "cohesion and close cooperation", Dr. Manmohan Singh had in 1992 constituted a High Level Committee on Capital Markets (HLCC) under the chairmanship of Governor, RBI, comprising the heads of the regulatory agencies and the senior-most officers of the Ministry of Finance, serviced by the capital markets division of the Ministry. The JPC have found (para 13.50, page 321) that the HLCC "has not carried out its mandate to regularly review the position regarding financial/capital market". The JPC have also found that: "The Ministry of Finance, on its part and in relation to the assurance given by it to Parliament in the revised Action Taken Report, has not referred such crucial issues to the HLCC." It then concludes:

"Had these issues been taken up by the HLCC periodically, it would have definitely helped in minimising, if not averting altogether, the irregularities which have surfaced in the present scam." (para 13.50, page 321)

It is such negligence on the part of government and its regulators that lies at the root of the scam.

It is, therefore, necessary to examine the role of the Ministry in regard to the regulators to establish the nature of ministerial responsibility for the scam.

WHAT control is to the command economy, regulation is to the market economy. Effective regulation is the key to market integrity. The regulator is not there to see whether the market is going up or down but to ensure that the rise or fall of the market reflects market sentiment, not market manipulation or other irregularities. The regulator must also assume that at all times there are fraudsters looking for opportunities to exploit any weaknesses in regulation. The regulator must, therefore, ensure that existing regulations are being strictly observed; more important still, the regulator must be alert to any signal of regulations being subverted or bypassed so that corrective action is taken as quickly as possible. A regulator that waits for the horse to flee before bolting the stable door is not doing its duty.

Tragically, the key statutory regulator for the stock exchanges, SEBI, fell flat on its face through both the boom and the bust. The JPC's recitation of the failings of SEBI stretch over nearly 25 pages of the report and SEBI is also faulted at several other places in the report relating virtually to every aspect of the scam. The JPC, at para 9.64, page 200, lists five key areas of concern where "SEBI appears to have done nothing particularly substantive": monitoring and regulating the massive inflow of some Rs.50,000 crores from abroad into the stock market; the mismatch between the primary and secondary stock market; the mismatch between the huge number of listed scrips and the small number of actively traded scrips; the rise in private placements to the detriment of the primary market; and "negligence" in checking whether bull operators were overtly or covertly obtaining bank funding. Little wonder then that fraudsters had a field day deceiving investors while the government prided itself on the "feel good factor" which pervaded the stock market.

Moreover, SEBI did not act on alerts generated by the three main stock exchanges: Bombay Stock Exchange (BSE); National Stock Exchange (NSE); and Calcutta Stock Exchange (CSE).

"It was SEBI's job," says the JPC, "to ferret out the irregularities and defuse them before they blew up. This was the primary job of SEBI which they failed to do on time." (para 9.66, page 201). Thus, SEBI failed "to analyse why the BSE index reached a phenomenal high in February 2000":

"Absence of an investigation when the BSE index unusually rose contrary to the fundamentals of the stock markets represents the failure of the regulator. Had steps been taken by the regulator at the relevant time, perhaps the phenomenal rise could have been contained and the defaults avoided. The regulator should have known that regulation of the market could only be provided through constant vigil and in cooperation with other regulatory authorities." (para 9.69, page 201)

The fault, points out the JPC, does not lie with SEBI alone: "much that went wrong might have been forestalled" had "the Ministry of Finance been more insistent on SEBI measuring up." (para 9.68, page 201).

On the NSE, SEBI failed to act even after the NSE, on August 18, 2000, brought to the attention of the Regulator its concerns about "group companies and fund flows that supported the volumes of certain ICE (Information, Communications and Entertainment) scrips". The NSE's turnover averaged a phenomenal growth of 86 per cent per annum in the five years between 1995-96, when the exchange was established, and March 2001, when the scam broke. Indeed, in a single year, 2000-01, the NSE's turnover increased by Rs.6 lakh crores owing largely to the Automated Lending and Borrowing Mechanism (ALBM), a device for deferral operations, the single biggest user of which was Reliance Securities, its single largest client being another Reliance group company, Reliance Petroleum. Noting that "SEBI's handling of the issue relating to the revised ALBM leaves much to be desired", the JPC have remarked that the "funds deployed by one player" amounted to "as much as Rs.1,900 crores towards the end of February 2001". This large amount was not redeployed, "leading to adverse impact in the market" (para 6.137, p 141).Yet, SEBI did not see it fit to include Reliance Securities in its initial list of entities to be investigated for the post-Budget fall in the market.

Finance Minister Yashwant Sinha's own role in answering the Calling Attention Motion in the Rajya Sabha on March 13, 2001, on the payments crisis on the CSE is the key element to focus on in the JPC's recounting of the CSE tale.

The JPC note (paras 6.15 and 6.16, page 117) that the then Finance Minister told the Rajya Sabha that:

* "there has been no payment problem";

* "there was a delay of just one day because of the fact that some banks were closed, etc.";

* "there is no danger of a payment crisis";

* "the trade guarantee funds which are available with the stock exchanges are sufficient to be able to take care of any problem".

In fact, as the JPC's careful recitation of the facts on pages 115-117 of the Report establishes, there was a payment problem; the delay was not on account of banks being closed; a payment crisis did arise in subsequent settlements because of improprieties in effecting the initial settlement; and CSE had to eventually dip into its reserves because it did not have enough guarantee funds. The initial settlement, involving a default of Rs.32 crores the week before the Finance Minister spoke in Parliament, was effected largely by the UTI buying Rs.25 crores worth of dud DSQ Software shares to relieve the defaulting broker. It was none of UTI's business to come to the rescue of the CSE. There was no justification for the UTI chairman agreeing to his executive director's recommendation of loading the UTI investor with the problems of a defaulting broker. Indeed, even the contact between the CSE and the UTI in this regard was highly improper. Not only was this done, the news of the UTI bailing out the CSE was published in Business Standard on March 11, 2001, without provoking any rebuke to the UTI from the Finance Ministry or its Minister. The Minister made no mention of this when he assured the Rajya Sabha the next day that all was well.

Yashwant Sinha's fig-leaf is that he said what he said to Parliament because he was so assured by SEBI. But if SEBI did not ask the right questions of the CSE, clearly the Minister failed to ask the right questions of SEBI. Instead, he unquestioningly passed on to Parliament whatever was dished out to him by SEBI. Where circumspection was called for, the Finance Minister preferred to bail himself out with unverified assurances. It is for the Rajya Sabha to determine whether any question of privilege arises. As far as the JPC is concerned, their view is clear:

"Everyone concerned - the Ministry, the Regulator, CSE - ought to have seriously addressed themselves to the systemic deficiencies in CSE when its turnover was exponentially rising. They did not because, it would appear, no one was interested in intervening when the going was good."

(para 6.19, page 117)

"Everyone" includes Yashwant Sinha. He set the tone for no one intervening when the "going was good". Nor can he escape the responsibility for the Committee's "considered view":

"that, at bottom, the payments crisis on CSE arose because the SEBI in consultation with the Ministry of Finance (emphasis added) had permitted the resumption of badla without arranging for curbing or regulating rampant off-market `internal badla'."

The ethos in which SEBI functioned less as an independent statutory regulator than as a handmaiden of the Ministry of Finance is best illustrated by the manner in which SEBI swung into action when the market, after initially reacting favourably to the Finance Minister's Budget proposals for 2001-2002, reversed itself the following day and fell - a net fall of only a single sensex point. The JPC, on pages 199-200 of its Report, have analysed whether there was any objective basis to SEBI's perception of "unusual market behaviour in spite of a well-received Union Budget".

The JPC have found (para 9.57 page 199) that "market volatility in four months of the year 2000 (April, May, August, September) was higher than in February or March 2001". Yet such volatility did not awaken the sleeping Kumbakarnas of SEBI. The JPC have also found that "large falls had occurred at least 10 times in the previous year" and "the single day fall has been more on at least 125 days". Yet, none of this had occasioned in SEBI the concern that was felt when the market did not endorse the SEBI/Government of India view of "a well-received Union Budget". Indeed, for the market to fall the day after the presentation of the Budget is routine. It has done so, as the JPC says, "on most occasions in (the) decade of the nineties". And in actual fact "the biggest fall - of 520 points - was recorded the day after the Budget was presented in 2000". But as February 2000 was the peak of the boom with the sensex touching 6000, SEBI was not stirred into an investigation. It was only when the Finance Minister stood in danger of being discredited that SEBI woke from slumber.

Moreover, as the JPC have found at paras. 4.3 and 4.4 (page 19) of its Report, in selecting the entities to be investigated, SEBI proceeded "on the assumption of a deliberate bear-hammering" and "did not take into account other signals of what was going awry in the markets":

"including the trouble brewing in CSE, the over-extended position of the Ketan Parekh Group, the withdrawal of large investments by FIIs, the non-redeployment of substantial funds by the largest ALBM operators, and problems worldwide on stock exchanges owing to market sentiment being disillusioned with ICE stocks, and the declining trend in sensex that had set in before the presentation of the Budget."

That investigation was launched only when SEBI got caught up in the Finance Minister's disappointment at market sentiment not reflecting government sentiment. The "dissonance" in approach to regulation when the market was booming and when it was falling was clearly the consequence of a system of governance in which hands were kept off when the going was good and scapegoats were chased when things went from bad to worse. The RBI Governor admitted to the JPC (para 9.65, page 201):

"I would honestly say that may be that one likes the bull run and one does not like the bear run and, therefore, you always react to adversity and not to good fortune."

That may be an honest confession but it is also the admission of a collapse of good governance. If regulators were behaving in this manner, it was for the Minister of Finance to have brought them back on track. For, as the JPC points out:

"It is evident that SEBI suspected something might be wrong but, for fear of being held responsible for pricking the balloon, decided to go along" (para 9.55, p 199)

THE RBI's performance as the regulator of the banking system was no better than SEBI's as the regulator of the stock market. The JPC have severely indicted the RBI for a whole host of deficiencies, including failure to "effectively supervise" urban cooperative banks notwithstanding "the huge increase in the number of UCBs, the huge size of their deposits and their increasing involvement, overtly and covertly, in stock market operations well before the scam" (para 10.58, page 239). The scam would not have occurred if SEBI or the RBI or both, or the High Level Coordination Committee chaired by the RBI Governor and serviced by the Ministry had been a little alert to what was going wrong when the going was apparently good. That the Finance Ministry did next to nothing to chivvy the regulators is testimony alike to the incompetence and impotence of the Ministry and the Minister who headed it.

The JPC comes down particularly heavily on the failure to implement legislative proposals from the regulators arising out of the previous JPC's recommendations (which Sinha, as a member of that JPC, had played a large part in drafting!) In fact, the most hilarious part of an otherwise dull and serious Report is Appendix III of Volume II, which sets out as many as 32 recommendations of this JPC which are analogous to the recommendations of the previous JPC, "starkly revealing the extent of non-implementation which characterises the system" (para 3.33 page 18). Typically, Sinha blames his officers for him not having been "told that any or many of the recommendations of the JPC were still to be implemented". Should a Minister wait to be told - should he go out and find out?

It is in leaving the Mauritius route entirely unregulated, despite Mauritius having emerged during Sinha's period as Finance Minister as the single most important source of foreign institutional investment in our capital markets, that the Minister and the Ministry he ran are most severely to be indicted. It is highly significant that the numerous companies registered in Mauritius by the Ketan Parekh group soon after Mauritius passed its Offshore Business Activities Act, 1992, did not become active in the Indian market until Yashwant Sinha made it abundantly clear during the 1999-2000 boom that he was deliberately looking the other way (page 174). The numerous improprieties perpetrated through the Mauritius route have been recounted in detail on pages 180 to 182 of the Report. These include: "several instances of violations of SEBI regulations" by Overseas Corporate Bodies (OCBs) and sub-accounts of Foreign Institutional Investors (FIIs), which have "aided, assisted and abetted in creation of artificial markets and volumes" resulting in "more outflow than inflow of funds"; no monitoring by RBI of "compliance of its guidelines regarding OCBs"; "purchase of shares of their own companies by Indian promoters" through the illegitimate if not illegal dodge of "Participatory Notes issued by sub-accounts of FIIs". Moreover, as SEBI reported to the Committee, "more than 80 per cent of OCBs are registered in Mauritius and some of them seem to act as front for promoters of certain Indian companies". Yet, as the Committee "note with concern":

"The Ministry of Finance did not adequately address itself to issues relating to the Mauritius route notwithstanding the growing impact of this Mauritius route on our capital market over several years." (para 8.79, page 181)

After detailing, on pages 182 to 186, the stark contrast between the hectic diplomatic interaction between the Governments of India and Mauritius in the period covering the prime ministerships of P.V. Narasimha Rao and H.D. Deve Gowda, the JPC note that "virtually no action was taken" after February 1997 "to raise and pursue these concerns" with the Mauritius authorities, concerns that included "money-laundering by Indian companies". Particularly damning is the JPC's observation that notwithstanding the offer made to the Indian Finance Minister by the Mauritius Minister in March 2000 to address "Indian concerns of recent origin", "little or nothing was done in the Ministry or by the Minister (emphasis added) to raise these issues with Mauritius".

"Indian concerns of recent origin" related to "misuse of the route (which) appears to have been significantly responsible for market manipulations during the boom of 1999-2000 which led to the bust of 2001." It was negligence of this order which failed to "prevent scams of the kind that occurred in 1999-2001 when due attention was not being paid to the dangers inherent in the virtually unregulated Mauritius route" (para 8.97, page 186).

It was a failure of both financial regulation and diplomacy. Yet, Yashwant Sinha has been rewarded for his failures in finance by being promoted as Minister for diplomacy!

Unit Trust of India/US-64

On July 2, 2001, a stunned nation learned that the Unit Trust of India's flagship mutual fund scheme, US-64, which had emerged since 1964 as the most trusted instrument for the investment of small household savings, had betrayed the trust of the people. For the first time in nearly four decades of its existence, the UTI failed to declare a dividend and froze all redemptions for six months. At least two crore and possibly up to three crore investors, affecting approximately 15 crore middle-class Indians, constituting over half of all those in the country who have the capacity to save, were robbed of their hard-won savings for no fault of their own.

In response to the public outcry, the government quickly agreed to add UTI to the mandate of the JPC, which had already started functioning.

Meanwhile, Yashwant Sinha dismissed the Chairman of the UTI, P.S. Subramanyam, for having kept everybody, including the Ministry and the Minister, "deliberately in the dark". Sinha told the Rajya Sabha that Subramanyam had "repeatedly" assured him through his Ministry that everything was "hunky-dory" at the UTI and its hugely popular US-64 scheme. Was Subramanyam alone to blame?

The JPC have regretted that:

"The culture of governance continues to be pervaded by attempts at transferring responsibilities elsewhere" (para 13.47, page 320)

* Far from having "repeatedly" interacted with Subramanyam, there was, in fact, only one written communication to the Ministry from the Chairman, a letter dated 18.5.2001. No attempt was made by the Ministry or the Minister through the months of May and June 2001 to speak to Subramanyam on the telephone or meet him in person. The Minister claimed before the JPC that he had "repeatedly" instructed his officers to contact chairman, UTI. His instructions were ignored or not in fact given. Either way, there is no basis for the calumny that the chairman "repeatedly" assured Sinha that all was "hunky-dory". * "No analysis," says the JPC, "was made in the Ministry of the Chairman's letter of 18.5.2001." The letter itself was treated as an FR (Fresh Receipt) "requiring no more than perusal without analysis or follow-up." (para 17.22, page 388). "There is no summary, assessment or analysis of that communication in the notes or correspondence section of the file." (para 17.21, page 385). The JPC goes on to say: "Chairman UTI's letter of 18.5.2001 was put up to FM as FR for information but FM's order were neither sought nor given" (emphasis added). Indeed, the treatment of this letter was so casual that the file itself was constituted only after the Chairman was dismissed. * As regards the contents of the letter of 18.5.2001, it says the US-64 scheme will be able to give a dividend and maintain a reasonable post-dividend net asset value only "if the sensex reaches around 4300 level" by June-end. (Two years after the crash, the sensex is still hovering around 3000!) The letter further says, "There is an expectation of about 20 to 25 per cent raise in the sensex by 30 June 2001." (There was, in fact, no rise at all). These were ridiculous assumptions, and, unsurprisingly, as the JPC notes: `the following notations were made in the margin against these two quotes respectively: "?" and "?!!"' * Yet, although the absurdity of the assumption was clear enough to the Ministry officials who made these notations, the Minister told the JPC: "When I looked at the assumptions in the letter, there was nothing fairly dramatically unusual about it." Extraordinary that what occasioned incredulity in the Ministry, as is evident from the notations, was not found "fairly dramatically unusual" by the Minister! Was it Subramanyam who was pretending that everything was "hunky dory" - or was it Yashwant Sinha hoping against hope that everything would indeed turn out "hunky-dory"? * No wonder the JPC concludes: "Even if Chairman, UTI, did indeed keep everybody in the dark, as FM told the Rajya Sabha, the Committee find that the Ministry did little to bring itself out of the darkness" (para 17.22, page 388) * Scoring the Ministry for not having "instituted any formal mechanism to keep itself informed about the health of the US-64 scheme," the JPC point out that: "Autonomy in day-to-day management of the UTI cannot absolve the Ministry of its statutory responsibilities and accountability to Parliament." It is not UTI Chairman or the officials of the Ministry but the Minister and none but the Minister who is responsible to and accountable to Parliament. As the JPC have stated in their Chapter on the Ministry of Finance: "accountability must go hand-in-hand with autonomy and the principles governing the responsibility of the Minister to Parliament in terms of the Constitutional jurisprudence under which the parliamentary system works." (para 13.46, page 320) Hence, Yashwant Sinha can just not escape his responsibility to Parliament and the country for all that went wrong with UTI and US-64, as detailed by the JPC over nearly 100 pages of its Report (339-426).

"The Ministry of Finance, being the financial custodian of the country, is duty bound to protect the interest of the small investors." (para 13.48, page 320)

Mani Shankar Aiyar is a Congress(I) Member of Parliament.