The Beginning Of The End? Will The NSEL Fiasco Pull Down Jignesh Shah’s Empire?

While the NSEL payments crisis threatens to bring one of the classic young business stories in the country to an inglorious fate, it has also cast a shadow of doubt on the regulatory framework for the commodities market in India. Shailendra Lotlikar gives you a lowdown of the events as they unfolded.

Systemic failures triggered by avarice have always been among the worst of banes for the markets. In 1992 came the first scourge – Harshad Mehta. The dream run of the stock markets set in motion by this smart operator ended in a miserable manner. This was India’s introduction to the world of financial crime perpetrated by a host of inter-linked market participants. A few years down the line, Ketan Parekh stepped into the infamous boots of Mehta to send the market into a second round of scam-tainted tailspin. Almost 12 years since then, the markets are again staring at what is emerging as another scam –this time in a different asset class.

The commodity markets are just about beginning to take root in India. Truth be told, they have come a long way from where they started within a very short period of time. As good as this sounds, the speed at which the commodity markets have set themselves up in the overall financial market ecosystem also calls for caution. The first brush of these markets with what so far has been alleged to be a scam proves our counterpoint of caution raised above.

What has unfolded over the past nearly a month following the suspension of trading by the National Spot Exchange Limited (NSEL) and the subsequent payout crisis points toward the systemic weakness of certain quarters of the financial market ecosystem. The developments assume a larger significance, particularly considering the most inappropriate time that they have come to light at. The Indian economy is presently going through a lot of pain. Matters for the financial markets are getting worse, thanks not only to domestic macro worries but also developments abroad. The Indian currency is yet to find its bottom even after hitting its worst-ever lifetime levels.

With so already much happening, the NSEL crisis was surely the last thing that one would have expected to happen and disrupt the market. Its eruption has come as a real bolt to the confidence of the markets. How deep is the crisis? How did it all happen? What does it mean to the lay investor on the street? And most importantly, what does it mean for the future of the promoters of the company – Financial Technologies and its Group companies?

Without getting into market jargon and technicalities, we intend taking you through the entire drama that has unfolded until now. The main take-away, of course, will be what is to come in the future. Is this the beginning of the end for one of the most ambitious first generation entrepreneurs of our times? Read on...
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What Exactly Happened?

To cut a long story short, NSEL was launched as a platform for spot trading of commodities way back in 2008. It was formed under a notification issued by the Ministry of Consumer Affairs, Food and Public Distribution division of the Government of India. After obtaining license from various state governments under the APMC Act, NSEL started launching farmers’ contracts.

According to some large investors with whom DSIJ has constantly been in touch with ever since the crisis erupted, representatives of stock brokers started aggressively canvassing the products launched by the exchange to investors by making presentations and representations about ‘100 per cent risk-free investments in spot trading’ through the NSEL. The pitch for the sale of the products was that the exchange was a government-regulated trading platform. Believing in these representations, investors began investing in commodities.

Transactions were three-pronged in nature – with sellers of commodities on one side, forward buyers on the other and the investors in between who were actually funding the transaction. On settlement, the buyers would pay the differential (which usually came at a premium to the spot price) and settle the contracts. The eventual payout would ensure that the financiers or investors got their money. What the investors made was more than a decent amount of interest on the transaction they actually financed.

All was well until at the end of July 2013, when matters got out of hand, and the Exchange under the directions of the Ministry of Consumer Affairs, suspended trading and launch of new contracts indefinitely. The amount involved in unsettled payouts as on July 29, stood at around Rs 5400 crore. The staggering amount sent shockwaves throughout the market circles.

These matters evinced even more interest in light of the fact that NSEL is an entity owned by the mighty Financial Technologies promoted by Jignesh Shah.

The Blame Game

NSEL is not a lending institution, but is a platform for buying and selling of commodities. A person selling a commodity would be paid by the exchange upon taking delivery of the commodity to the NSEL-designated warehouse. Simultaneously, another purchaser undertakes to buy that commodity after paying a certain margin to the exchange, whereby the delivery of the goods and payment thereof happens at a later date at a slightly higher rate to the spot sale price. Thus, each transaction is in effect a buying and selling transaction.

According to aggrieved investors, NSEL’s claim that all the monies are with the ‘borrowers’ is a grossly erroneous statement. There are no borrowers, but only buyers and sellers in the said transactions. If the subsequent buyer fails or refuses to take delivery of the commodity contracted, the exchange would be able to sell the contracted quantity to another buyer and at the same time forfeit the margin money deposit of the failed buyer.

This sounds logically correct. But remember, there are not just buyers and sellers, but also a third category of players involved in these transactions – the so-called ‘investors’ or actually the financiers of these margin buying transactions. These are the very people who are today fighting to get their “hard earned” money back. So much for the interest that these financing propositions brought in for the investors!

NSEL’s Flip-Flop: Spilling The Beans

While the aggrieved investors have been crying hoarse for their money to be paid back, NSEL or rather the Financial Technologies Group as a whole has been getting into a mess created by its own flip-flops. This obviously suggests that all isn’t really well, as it is being made out to be.

From the amount lying in the Settlement Guarantee Fund (SGF), which drastically came down from an initial claim of around Rs 839.53 crore to just Rs 65 crore between the day the crisis erupted and August 5, 2013, there has been absolutely nothing that can lend credence to what the NSEL officials have been reporting in public.

Another most important point about this whole episode is the collateral in the form of physical commodity stocks as contracted. A look at the table will tell you exactly why the collaterals look suspect. Overwhelming quantities of sugar and metals as well as other commodities including rice and paddy have been found on record. The practical feasibility of the quantity held is completely out of sync with the reality.

We, at Dalal Street Investment Journal, visited two of the warehouses located off Mumbai, but met with little success in getting a physical verification done on account of security reasons. Statistics about the location of other warehouses and their capacities to hold quantities mentioned have also been found to be off the normal range of possibility. Another factor to be considered is the quality of the collateral held.
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Hopes, Promises, Schedules & Reschedules

The most important point here is the repayment of the monies due to the concerned investors. The NSEL management has given a schedule of repayment, according to which every Tuesday (commencing August 20, 2013) would see a payout of Rs 174.72 crore for the first 20 weeks and Rs 86.2 crore for the next 10 weeks. But as expected, the exchange has failed in the very first payout, having distributed just around Rs 92 crore against a commitment of Rs 174.72 crore.

As the calendar flipped between July 29 and August 20, each passing day has only added to the worries of the NSEL, and in turn of the Jignesh Shah-led Financial Technologies Group.

The Missing Money Trail

A case which would have been very easy to understand and resolve has taken an inordinately long time in settling down. The basic worry is about the missing trail of the money involved. Investors have paid the money they had contracted to pay at the time of taking positions. This money has obviously found its way out of the custody of the exchange into the hands of the parties which are today being asked to pay.

Exchange officials whom DSIJ spoke to have been stressing on the fact that sale of collateral is the only way out and that it would yield the desired result. But this contention too has fallen flat on its face, particularly after the failure of the first payout.

Moreover, NSEL’s own attitude towards the whole thing has been rather shoddy. The Financial Technologies Group has always been media savvy when it comes to corporate communications and interactions with the media. But this time has been different – a distinct deviation from its usual self. Our constant effort of trying to touch base with Anjani Sinha was met with stiff resistance – until he was unceremoniously sacked by the Group from the position of MD and CEO of NSEL.

On our part, we have been reading through the entire fiasco very carefully, and have desisted from getting into heresay and chatter. In a bid to get to the bottom of the problem and to provide an objective view of the matter, we have spoken to members of every stakeholding quarter in this drama.
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The Regulator

One of the most surprising elements of the entire NSEL saga was the deafening silence of the Forward Markets Commission (FMC) until the last minute. It was only after the failure of the first payout that the FMC actually reprimanded the NSEL management, raising questions on the “fit and proper” grounds.

Why there should have been such a delay in taking up the matter head on at the regulator’s level is something that truly baffles us. Was it the continuous assurances coming in from the NSEL management or for that matter the Financial Technologies Group that kept the lid from blowing? Or is there something larger at play?

Finance Ministry

Ditto as for the regulator, the Finance Ministry too has maintained an eerie quiet over the entire issue. It is only after the failure of the first payout that talks of merging the FMC and the SEBI surfaced. Till the time of writing this story, that piece of information too seemed to be unofficial.

However, the move seems to be too little, too late. The entire episode has already shattered the confidence of the market players.
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As we mentioned earlier, DSIJ has been watching the NSEL drama very closely from all quarters. In order to sidestep speculations around this issue, we have been speaking to people directly connected with the matter. Our communication with the MD & CEO of NSEL asking for specific answers on questions surrounding the issue was replied to by the Corporate Communications team of the company. Here is what they had to say:

What, according to you, is the real problem and why have there been such inordinate delays in addressing it?

NSEL’s Response: No delay, it is a process, as borrowers have to pay-in.

DSIJ View: Nearly a month after the crisis erupted, there have been various flip-flops and different versions of how things are being worked out. This is certainly not expected of a company which is a part of a group known to run exchanges not just in India but throughout the world (See illustration).

Does the NSEL fall under the regulatory framework of the FMC or not? 

NSEL’s Response: As mentioned above.

DSIJ View: Our straightforward question was not explicitly answered. According to the company, NSEL was offering one-day forward contracts with a delivery and settlement cycle of T+10 days as per exemption granted under the Forward Contracts (Regulation) Act, 1952 by the Central Government via a gazette notification dated June 5, 2007.

We learn that there have been proper contract notes issued for all the transactions that have been entered into. Which part of the system has triggered a default?

NSEL’s Response:

DSIJ View: The company did not answer this query. According to the discussions and deliberations that we have had with other stakeholders, the contract notes that have been issued by the NSEL include all statutory levies such as ‘VAT, Godown Charges, Sales Tax, CF Charges, Delivery Charges, Transaction Charges, service Tax, Stamp Duty etc.’ We assume that these (if genuine) have accrued to the government. The money trail hence becomes all the more easy to establish.

There have been various flip-flops on the quantity of collateral lying in the designated warehouses. Can you please throw some light on that

NSEL’s Response: …independent audit announced…

DSIJ View: The independent auditor has been appointed by the NSEL itself. Would it not be proper for either the regulator or the Finance Ministry to step in at this stage and ensure complete independence of the auditors? Also one important point here is that the promoters of NSEL (as already mentioned earlier) have always been very media savvy.  At a very minimal level, what the exchange could have done is to organise a visit to some of the warehouses on a test check basis for the media and probably some large investors, which would have been very instrumental in instilling a sense of confidence in NSEL’s promises and claims.

There have been entities which have been termed as ‘borrowers’. Can you please throw some light on where ‘borrowers’ come into play in an exchange which is purely supposed to be a platform for spot trading in commodities? 

NSEL’s Response: ... Borrowers are planters/processors…a list 24 already announced who have to pay in…

DSIJ View: These are the people who have contracted to buy and settle at a forward date. The money isn’t borrowed. Either it has flowed out to them or they aren’t honouring their commitment to settle a contract.
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Another area of concern has been the amount lying with the exchange as Settlement Guarantee Fund. From around Rs 800 crore, the amount that came up within a few days of the crisis was around Rs 65 crore. Why was there such a mismatch?

NSEL’s Response: … EXPLAINED…netted out against pay-outs with commodity receipts kept as assets.

DSIJ View: This is one area which is also suspicious. Why are investors raising a question about this money, which they claim has kept on changing, having come down from Rs 800 crore odd to Rs 65 crore? Aren’t these investors aware of the netting off?

There still exist a lot of apprehensions among the many investors who have been worried about the exchange honouring its commitment of payout as placed before them. What would you say about this?

NSEL’s Response: ...EXCHANGE has given a pay-in pay-out schedule…any default will be treated as per exchange bye-laws.

DSIJ View: This was a peculiarly diplomatic answer considering that a default in payment has already happened (a day before we went to print).

From self-serving appointments to shady organisations allowed to operate in the system, there have been a whole lot of allegations doing the rounds. What would you say about these?

NSEL’s Response:…Allegations, we cannot comment.

DSIJ View: This is one area which needs larger examination and investigation. We would surely like to get to the bottom of this issue.

How soon do you think will we be able to get over the crisis? If not, what is the end result that you foresee?

NSEL’s Response:

DSIJ View: The silence of the company on this issue is self-explanatory.

Can you throw some light on what happened to Safal National Exchange of India (SNEX), which was set up for the purpose of spot trading in the products of horticulture, floriculture, dairy and other allied products. Are we not going the same way in the case of NSEL too? 

NSEL’s Response: ...Already settled and closed as mentioned in MCX IPO prospectus of March 2012.

DSIJ View: In one of the communications that we are in receipt of from an aggrieved investor, it is alleged that ‘the said Exchange was created with around 200 members who contributed a sum of Rs 250000 each.  Surprisingly, after collecting the money from the members, the exchange collapsed and the promoters have not returned the money to the members. It is surprising as to how the government and other regulatory authorities/agencies granted permission to the said failed promoters of SNEX to promote NSEL u/s 27 and have also been given an exemption’. Well, the government would be the best judge to answer this question which has been raised.
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Endgame For The Empire?

In the mid-90s, Shah was employed with the Bombay Stock Exchange. He quit his job at the BSE, starting his own software company ‘Financial Technologies’ somewhere in the early 2000s. The strong willed and astute businessman that he was, it wasn’t long before he met with success in a big way. By his mid-30s, Shah was running MCX, one of the top commodity exchanges in the world.

But as they rightly say, reaching the pinnacle is difficult, but what is even more arduous is to keep yourself positioned out there. The NSEL fiasco today has shaken up the foundations of the edifice that Shah built over these years. Credibility is the essence of the business in which Financial Technologies (as a parent company) is involved. MCX, which has been looked upon for years as the premiere commodity exchange of India, faces a stiff test of credibility and ethics today.

What will also be worrisome for the group is that regulators across the world will now watch it with a hawk’s eye. We have written to various regulators across the globe where Financial Technologies holds an interest in the local bourses (100 per cent in many of them). The regulators in countries like Tanzania, Zambia, Singapore and Bangladesh, among others, are the ones to whom we have written seeking their view and how they were watching the developments out here. They are yet to respond.

Investor confidence in the group companies, including the promoters (FT), is shattered beyond repair. From the day the mess was unearthed till August 19, 2013, the share price of FT and MCX have lost a whopping 73 per cent and 64 per cent respectively. For both put together, the shareholders have lost a humongous Rs 3756 crore in market capitalisation between then and now. Excluding promoters’ holdings, the loss to public shareholders is an eye-popping Rs 2423 crore.

The next question is, will shareholders be able to recoup their losses any time soon? Historically, it has been seen that it takes a lot of time to recover such losses, and in many cases the share prices never recover. This is particularly so in cases where there is a loss of confidence in management quality. The budding equity exchange business floated by the MCX will suffer more headwinds in convincing companies to list on it. As on date, there are only 50 companies listed on the MCX-SX.

The NSEL fiasco has opened up a can of worms in the empire’s closet. Are there more to come? More skeletons could tumble out. Until then, it would be prudent to not even think about bottom fishing in these counters. While we rest our judgement with these points, investors already holding stocks in listed entities of the group would do well in selling out, even if it means booking losses. The stocks may temporarily bounce back, but would you wish to be invested in companies where the managements have lost credence at large?