Inside the Nirav Modi Scam

INTRODUCTION

In January 2018 The PNB which is the second-largest Public Sector Bank in India, reported fraudulent transactions of approximately $ 1.77 Billion, to Stock Exchanges, the Central Bureau of Investigation & the Reserve Bank of India. The Punjab National Bank (PNB) Fraud is the biggest scam that has ever emerged to date in India. The scam which initially was estimated to 11,400 Crore, now added up to 12,700 crore which is nearly one-third of the Net worth of Punjab National Bank (PNB) and is now termed as a country’s biggest banking fraud. The banks are already facing turmoil due to weak capital management. This scam comes as a blow to the Country’s banking environment & credibility to the Public banking system as it was the biggest loss after “the great depression”.

Nirav Modi & his maternal Uncle Mehul Choksi along with several PNB’s employees were accused of this fraud. This scam was almost seven years old and was not detected by anyone. Therefore, there this poses serious questions on the internal operations and auditing processes of the bank and also the main regulatory body RBI.[1]

WHO IS NIRAV MODI?

Nirav Deepak Modi was born on 27th February 1971 into a Gujarati family in Antwerp City of Belgium. His father was a diamond jeweler & his mother was an interior decoration professional. His family has been dealing with diamond jewelry for around seven generations. He is also a luxury diamond merchant & the owner of Gitanjali gems & Firststar diamond. He was ranked 57 in the Forbes list of billionaires in 2017. His maternal uncle Mehul Choksi is also a famous face in the jewelry business. He is the CEO & Managing Director of the World’s largest jewelry retailer company, Gitanjali Gems.

Nirav started working with his Uncle at the age of 19 & set up his own business, Firestar Diamond in 1999, which dealt with buying & selling diamonds, by 2004, Firestar’s revenue crossed 400 Crore Rupees. To maximize his footprints, he bought a retail division owned by Fredrick Goldman, an American diamond retailer with a nationwide presence in 2005. Later, in 2007 he bought Sandberg & Sikorski, the largest jewelry supplier to US Armed Forces & A Jaffe, a 120-year-old luxury bridal jewelry label owned by Sikorski.

On 29th Jan 2018, Avneesh Nepalia, Deputy General Manager at the Zonal Office of PNB in Mumbai, filed a Police complaint against Nirav Modi, Ami Modi, Nishal Modi & Mehul Choksi who were partners in three Companies (Diamond R US, Solar Exports, and Stellar Diamonds), saying they had defrauded PNB and caused a loss of 2.8 billion rupees ($43 million). Later PNB filed a criminal complaint with India’s investigative agency CBI and stock exchanges, in a regulatory filing on Feb. 14, the bank updated the sum involved in the fraud to 113.94 billion rupees ($1.77 billion), which was determined after further investigation at Mumbai’s Brady branch.

METHODOLOGY ADOPTED TO COMMIT FRAUD

The scam was a well-planned white-collar crime, in which not only the accused but also the key management persons were alleged to be involved. Two methods of committing fraud were adopted by Nirav Modi & his associates. The first method was to issue a Letter of Understandings (LoUs) without incurring any liability. LOU is a kind of bank guarantee, under which a bank allows its customer to raise money from another Indian bank’s foreign branch in the form of short-term credit. Nirav Modi, Mehul Choksi, and their companies secured (LoUs) without proper authorization and collateral security by colluding with officials from PNB’s Brady House branch, Mumbai in the issuance of fraudulent LoUs.

In addition to this, the Rotation Policy of staff was not implemented, as the employee involved in issuing LoU was holding the position for last seven years which is against the rotation policy requirement i.e. transfer of employee after every three years.  Hence, several Indian Banks including Axis Bank & State Bank of India gave dollar loans to PNB’s NOSTRO Account which were ultimately transferred to overseas parties who were foreign suppliers of diamonds.[2]

Gokulnath Shetty who was Deputy Manager at PNB, was accused of using his access to the SWIFT messaging system used by banks for overseas transactions to authenticate guarantees given on LOUs without any authorisation. Relying on such authentications, overseas branches of several Indian Bank gave forex credit.[3]

In the second method, Foreign Letter of Credit (FLCs) were issued to importers i.e. Nirav Modi and his associates for importing diamonds. The value of these FLCs was modified from time to time as per requirements and was recorded in Society for Worldwide Interbank Financial Telecommunications (SWIFT) which is a global messaging system used for transactions by financial entities. In the FLC documents, a higher value than the actual amount was posted in PNB’s core banking solution (CBS) as the suspected employees knew that PNB has not integrated its SWIFT network with Bank’s CBS as it was not made mandatory by RBI. These FLCs were later used to obtain loans abroad ostensibly to pay for imports to foreign suppliers.

These foreign suppliers were shell firms created by accused which transferred money back to India through fictitious transactions in different companies owned by Nirav Modi & Mehul Choksi. The LoUs issued from PNB India were used to partly clear the previous dues and remaining for fresh loans to firms. This circular rotation of unauthorized LoUs went on undetected until February 2018.

According to RBI, it was a case of operational risk which was a result of delinquent behaviour by one or more employees of the bank and failure of internal controls. It was the fault of the PNB employees who wanted to make faulty procedure of issuing LOUs for their own benefit. The SWIFT had bypassed the CBS. There was no internal coordination and also no proper monitoring which resulted in this operation. It was the responsibility of external as well as internal auditor to trace the transaction also contingent liability figure. It was noted that Failure of Concurrent, Internal & Statutory Auditors cannot be overlooked & a proper enquiry was necessary & the same was conducted by ICAI (Institute of Chartered Accountants of India).

UNCOVERING THE FRAUD

According to the Article, the fraud was uncovered when the officials from the diamond firms approached the PNB officials to raise a fresh guarantee to import rough stones from overseas. When the three firms approached PNB in January 2018 for bank credit via an LoU, the official concerned in the bank sought collateral security in form of a 100% cash margin since there was no pre-sanctioned limit for these firms.

The diamond firms contested the bank’s demand and claimed that they have been availing this facility in the past years also. However, the PNB branch records did not reveal details of any such facility having been granted to the said firms. This raised an alarm, forcing the bank to launch an internal investigation in the previous bank credits.

The internal investigation revealed that two junior employees of PNB had been sending these unauthorised guarantees in form of LOU & FLC for past seven years. Then one of them retired from the bank. It was discovered that he had in the past fraudulently issued LoU to the said firms without following due process. These fraudulent LoUs were then transmitted across the SWIFT messaging system, based on which credit was offered to the said firms.

As per other Article, The Income Tax investigation report had red-flagged bogus purchases, over-valuation of stocks, dubious loans and many more, eight months before the scam surfaced. Although], the report was not shared with any other agency like CBI, Enforcement Directorate etc.

KEY FINDINGS BY REGULATORY AUTHORITIES

On 5th February 2018, CBI launched investigation in the alleged scam. The Investigations revealed that the companies involved in the transactions abroad were shell firms with their directors having been previously employed by Nirav Modi and Mehul Choksi. Two firms Firestar Diamond and Gitanjali Gems laundered & misappropriated funds raised from LoUs. Investigators discovered that, in many instances, the funds brought in by Choksi from the Overseas Account to Gitanjali’s Account were directed towards the accounts of various shell companies describing the transfers as unsecured loans, from where money was siphoned off through various means, including cash withdrawals.[4]

The CBI arrested Rajesh Jindal, a general manager of the PNB posted at the bank’s head office at New Delhi. He was the head of the Brady House branch of the Mumbai bank during 2009-11. It was suspected that the fraud began during his tenure.[5] In addition to this external & independent auditor, M.K. Sharma was also found to be responsible for manipulating accounting system was also arrested. It was observed that several PNB Officials were bribed with gold & diamond for issuing false IoUs.

Enforcement Directorate seized, redeemed and sealed many properties like shares and other securities, farmhouse, luxurious cars of Nirav Modi and his uncle Mehul Choksi. Further, bankruptcy proceedings were initiated against them. The Corporate Affairs Ministry asked the Serious Fraud Investigation Office (SFIO) to investigate the case with help of officials of other banks as well.

Modi fled India before the scandal broke. As a result of the fraud, the Reserve Bank of India (RBI) discontinued the acceptance and issuance of LoUs. The RBI observed that it is high time financial institutions have integrated the SWIFT network with their central information systems as it is the bank’s internal control measure. However, it has issued a detailed document to PNB for strengthening internal control. RBI has also imposed a penalty of Rs. 2 Crore against the violation of SWIFT operating rules.[6]

On June 2,2018, Interpol issued Red corner notice against Nirav Modi for money Laundering.

Mumbai Court issued an order & non-bailable warrant against Nirav Modi and Mehul Choksi to be present before a court or be declared as fugitives according to the special Prevention of Money Laundering Act (PMLA).

The Interpol UK informed the Indian External Affairs Ministry about the whereabouts of Nirav Modi. The Indian Government requested UK authorities for extradition of Nirav Modi. Pursuant to which, Westminster Court in London issued arrest warrant against fugitive Nirav Modi. He was arrested in London & has filed several bail applications since then, which are continuously being rejected by the Westminster Court. The Proceedings are due to be held in 2021.

IMPACT OF SCAM

1. On banking System: PNB Scam showed its bad effects since the day it surfaced. Due to this, market value of PNB per share decreased by 36.11% during the period of 14 Feb 2018 to 23 March 2018.[7] Not only this, share value of other banks who were engaged in false exchange was also severely affected. In the wake of this scam, many banks have run internal audits and reviews and are more conscious and suspicious of their clients especially businessmen. It has reduced the net worth of Public Sector Banks and increased the level of NPA in our Country. This has also resulted in downgrading of global credit ratings of PNB bank by CRISIL, ICRA etc.

• On Investors: Though the PNB announced that it’ll return to normalcy within half year, it was highly speculative that confidence of Investors will remain the same. It has affected the to the core values of PNB & investors relationship.

• On Jewellery Sector: The share value of Geetanjali gems fell by 18%, PC jeweller’s stock by 19.5%, and Tangamayil jewellery by 2%. The scam has increased the stress on Jewellery firms as it is difficult for them to get LoU which was an advantageous & easy method of financing, as Banks lost confidence in said instrument.

• On Government:  As Government owned LIC was the single largest institutional holder in the majorly hit banks, negative impacts on Government finances & strategies are evident.
• RECOMMENDATIONS FOR CONTROLLING BANK FRAUD

There are loopholes in the financial framework that has been utilized by the accused parties. The quantum of frauds & NPA’s in Banking Sector has been increasing tremendously.[8] Following are some ways by which these frauds can either be avoided or detected at early stage:

1. Monitoring the lending protocols: Although institutions cannot eliminate the risk of fraud entirely, it is important to regularly monitor the compliance of lending protocols. Ensuring effective corporate governance & internal control methods will also contribute in building a safe banking environment.[9]

• Due Diligence & effective Auditing: The Bank should exercise due diligence before carrying out transaction involving huge sums. It is the responsibility of Bank to carry out background check of the person entering in contract. A reasonable standard of care should be adopted & implemented effectively across all the departments of the institution.

• Independent specialised Investigating Agency: Government must establish an Agency consisting of Financially & legally literate personnel, in order to ensure early detection of frauds. In addition to this, banks should also establish a proper mechanism to investigate & detect mishandling of transactions. Other than this Banks should also impart fraud detection training to its employees & establish a whistle-blower hotline.

• Use of Latest Technology: In this technology driven era it is important to keep up with technological advancements. This can be ensured by adopting & utilizing the best accessible IT framework to keep track of red-flagged accounts & report early warning signs as recommended by RBI from time to time.

CONCLUSION

It has been well established that corporate frauds are one of the major hindrances to the inclusive growth of the economy. In any economy the rise in corporate frauds is directly proportionate to the fall of economy.[10] The scam highlighted the failure of Indian Banking System & requirement for revamping the regulatory mechanism and corporate governance principles into the practices of Indian Public sector banks.[11] Banking Sector is critical for every country, similarly, Indian Banking system is the backbone of our economy, but time and again the frauds reported by them poses question on the Corporate Governance policies of not only the institutions involved by also of Government.

The complexities & loopholes of banking procedure are well understood by its employees, thus, dilution of process due to involvement of employees with clients has led to jeopardising the situation of Banks. These scam poses question on not only the Public Sector Banking system but also on the ability of Regulatory Authorities, as they also fail to detect them at the early stages. It is interesting to note that, the drawbacks in legislations or policies are amended only after the damage is done. Why can’t we develop a system where precautions are identified and adopted as soon as possible? Though RBI has been actively involved in ensuring avoidance of management risks, but it should also empower the banks to deal with these frauds in swift manner. Hence, it needs to stabilize the banking & governance reforms for the same. The lacunae in the identification, reporting, investigation & procedural requirements should be addressed and resolved, so that monetary loss & reputation loss can be avoided.

[1] G. Singh, S. Srivastav, A. Gupta and V. Garg, “An Analysis of Financial Fraud through PNB Bank Scam and its technical Implications,” 2020 International Conference on Computation, Automation and Knowledge Management (ICCAKM), Dubai, United Arab Emirates, 2020, pp. 436-442, doi: 10.1109/ICCAKM46823.2020.9051500.

[2] S. Gayathri and T. Mangaiyarkarasi:, “A Critical Analysis of the Punjab National Bank Scam and Its Implications”, International Journal of Pure and Applied Mathematics, Volume 119 No. 12 2018, 14853-14866.

[3] Amrish Dogra & Manu Dogra, “Sustainability and Ethical Banking: A Case Study of Punjab National Bank” , Amity Journal of Corporate Governance, Volume 4 (1).

[4] Gagan Kukreja Sanjay Gupa, (2019) : “Gem of the Indian Banking Fraud: A Case of Systemic Control Failures at Punjab National Bank”, Journal of Forensic and Investigative Accounting, Volume 11: Issue 2, Special Edition.

[5] Nisha & Dr. Seema Dahiya (2020), “Scams in Indian Banking System: An Analytical Study” Mukt Shabd Journal, Volume – IX Issue – IV.

[6] Dr. Medha Srinivasa Rao, Dr. B. Kishore Babu, “A Case Study on Punjab National Bank Scam (Is it only a scam or failure of the combined banking system?)”, Journal of Xi’ an Shiyou University, Natural Science Edition.

[7] Dr. Shriprakash Soni, Dr. Harshal Slunkhe, “Impact of PNB Scam on Banking Sector & Investors in India: An Eperical Study”, IJRESS, Vol. 8 Issue 3, March 2018.

[8] Jerin Abraham, “Risk Management in Banking Sector in the Vuca World: How PNB Was Defrauded of Rs. 11,400 Crores?”, ABS International Journal of Management.

[9] Kaur, D. H. (2012), “A Comparative Study of Corporate Governance Disclosure by Private And Public Sector Banks In India”. International Journal of Multidisciplinary Research Vol.2 Issue 2, February 2012, ISSN 2231 5780.

[10] Forensic Audit, Professional Programme, ICSI.

[11] Supra Note 3.https://thecorporate.ninja/wp-admin/post.php?post=1938&action=edit