How Scams are instrumental in improving the corporate governance?

There exists a link between the reliability of the financial reporting system and the quality of
governance mechanisms by investigating improvements in these mechanisms following fraud
detection and the corresponding economic consequences of such improvements.
Fraud firms and, perhaps more importantly, institutional investors and the market, view
improving the quality of governance mechanisms as a way of restoring trust after fraud. After
fraud detection, fraud firms increase board independence and audit committee activity.
More importantly, there is a positive and economically important relation between
improvements in outside director percentage and long-run abnormal returns, suggesting that the
market views this change as a means of restoring the reliability of the financial reporting system.
Firms most likely increase their governance quality following the detection of financial reporting
fraud. With that regard, we can say how good governance holds importance for improving the
organization.
Harshad Mehta Scam 1992
The 1992 Indian stock market scam was a market manipulation carried out by Harshad shantilal
Mehta and other bankers and politicians on the Bombay Stock Exchange. The scam caused
significant disruption to the stock market of India, with over one billion USD defrauded.
Techniques used by Mehta involved having corrupt officials signing fake cheques,
market loopholes, and lies to drive the prices of stocks up to 40 times their original price. Stock
traders making good returns as a result of the scam were able to fraudulently obtain unsecured
loans from banks. When the scam was discovered in April 1992, the Indian stock
market collapsed, and the same banks suddenly found themselves holding millions of INR in
now useless debt.
The 1992 scam was the biggest money market scam ever committed in India. The main
perpetrator of the scam was stock & money market broker Harshad Mehta. It was a systematic
stock fraud using bank receipts and stamp paper which caused the Indian Stock market to crash.
The scam exposed the inherent loopholes of the Indian financial systems and resulted in a
completely reformed system of stock transactions and an introduction of online security systems.
Security frauds refer to the idea of diversion of funds from the banking system to various
stockholders or brokers. The 1992 scam was a systematic fraud committed by Mehta in the
Indian stock market which made the entire securities system collapse. He committed a fraud of
over 1 billion from the banking system to buy stocks on the Bombay Stock Exchange. This
impacted the entire exchange system as the security system collapsed and investors lost
thousands of rupees in the exchange system. The scope of the scam was so large that the net
value of the stocks was higher than the health budget and education budget of India. The scam
was orchestrated in such a way that Mehta secured securities from the State Bank of
India against forged cheques signed by corrupt officials and failed to deliver the securities.
Mehta made the prices of the stocks soar high through fictitious practices and sell the stocks that
he owned in these companies. The impact of the scam had many consequences, which included
the loss of money to lakhs of families and the immediate crash of the stock market. The index
fell from 4500 to 2500 representing a loss of Rs.1000 billion in market capitalisation. This rapid
fall was the largest the stock market had ever seen. The 1992 scam raises many questions
involving bank officials responsible for being in collusion with Mehta. An interview
with Montek Singh Ahluwalia (Secretary, economic affairs at the Ministry of Finance) revealed
that many top bank officials were involved.

Changes after the scam

The first reform was the formation of the National Stock Exchange of India (NSE). It was
followed by the development of the CII Code for Desirable Corporate Governance by Rahul
Bajaj. The CII Code commanded the formation of two major committees headed by Kumar
Mangalam Birla and N. R. Narayana Murthy, and overseen by the Securities and Exchange
Board of India (SEBI). The objective was to monitor corporate governance and prevent future
scams. The SEBI were to monitor the NSE and the National Securities Depository. For the
equity market, the government introduced ten acts of parliament and one constitutional
amendment based upon the principles of economic reform and legislative changes. The
introduction of online trading by NSE changed the dynamics of stock buying and selling. The
financial market opened up nationally rather than being confined to Bombay (now, Mumbai).
Changes in the financial structure of India
The 1992 scam collapsed the Indian stock market; around 40% of the market value or
₹1,000 billion was wiped out. It led the authorities to reconsider existing financial systems and
restructure it. The first structural change was to record payments made for purchasing
investments in reconciliated Bank Receipts and Subsidiary General Ledgers to prevent
fraudulent transactions. On the advisory of the Janakiraman Committee, a committee was
established to oversee the Securities and Exchange Board of India. The primary recommendation
of the committee was limit ready forward and double ready forward deals to government
securities only. All banks were made custodians than principals in transactions. Banks were to
have a separate audit system for portfolios, and it were to be monitored by the Reserve Bank of
India (RBI).

Enron Scandal

The Enron scandal was an accounting scandal involving Enron Corporation, an American energy

company based in Houston, Texas. Upon being publicized in October 2001, the company
declared bankruptcy and its accounting firm, Arthur Andersen – then one of the five
largest audit and accountancy partnerships in the world – was effectively dissolved. In addition
to being the largest bankruptcy reorganization in U.S. history at that time, Enron was cited as the
biggest audit failure.
Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and Intermonth.
Several years later, when Jeffrey Skilling was hired, Lay developed a staff of executives that –
by the use of accounting loopholes, special purpose entities, and poor financial reporting – were
able to hide billions of dollars in debt from failed deals and projects. Chief Financial
Officer Andrew Fastow and other executives misled Enron's board of directors and audit
committee on high-risk accounting practices and pressured Arthur Andersen to ignore the issues.
Enron shareholders filed a $40 billion lawsuit after the company's stock price, which achieved a
high of US$90.75 per share in mid-2000, plummeted to less than $1 by the end of November
2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and rival
Houston competitor Dynegy offered to purchase the company at a very low price. The deal
failed, and on December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United
States Bankruptcy Code. Enron's $63.4 billion in assets made it the largest corporate bankruptcy
in U.S. history until the WorldCom scandal the following year.
Many executives at Enron were indicted for a variety of charges and some were later sentenced
to prison. Arthur Andersen was found guilty of illegally destroying documents relevant to the
SEC investigation, which voided its license to audit public companies and effectively closed the
firm. By the time the ruling was overturned at the U.S. Supreme Court, Arthur Andersen had lost
the majority of its customers and had ceased operating. Enron employees and shareholders
received limited returns in lawsuits, despite losing billions in pensions and stock prices.
As a consequence of the scandal, new regulations and legislation were enacted to expand the
accuracy of financial reporting for public companies. One piece of legislation, the Sarbanes–
Oxley Act, increased penalties for destroying, altering, or fabricating records in federal
investigations or for attempting to defraud shareholders. The act also increased the accountability
of auditing firms to remain unbiased and independent of their clients.

Changes after the Scam

While some employees, like John D. Arnold, received large bonuses in the final days of the
company, Enron's shareholders lost $74 billion in the four years before the company's
bankruptcy. As Enron had nearly $67 billion that it owed creditors, employees and shareholders
received limited, if any, assistance aside from severance from Enron. To pay its creditors, Enron
held auctions to sell assets including art, photographs, logo signs, and its pipelines.
A class action lawsuit on behalf of about 20,000 Enron employees who alleged mismanagement
of their 401(k) plans resulted in a July 2005 settlement of $356 million against Enron and 401(k)
manager Northern Trust. A year later the settlement was reduced to $37.5 million in an
agreement by Federal judge Melinda Harmon, with Northern Trust neither admitting or denying
wrongdoing.
In May 2004, more than 20,000 of Enron's former employees won a suit of $85 million for
compensation of $2 billion that was lost from their pensions. From the settlement, the employees
each received about $3,100. The next year, investors received another settlement from several
banks of $4.2 billion. In September 2008, a $7.2-billion settlement from a $40-billion lawsuit,
was reached on behalf of the shareholders. The settlement was distributed among the main
plaintiff, University of California (UC), and 1.5 million individuals and groups. UC's law
firm Coughlin Stoia Geller Rudman and Robbins, received $688 million in fees, the highest in a
U.S. securities fraud case. At the distribution, UC announced in a press release "We are
extremely pleased to be returning these funds to the members of the class. Getting here has
required a long, challenging effort, but the results for Enron investors are unprecedented.