OVER THE PAST several months, business dailies have been following the progress of Jignesh Shah and his exchanges with breathless interest. Among the latest pieces of news is that Shah has sold his Singapore-based exchange to raise money to handle the crisis at National Spot Exchange (NSEL)—his commodities exchange based in Mumbai. Reports say NSEL investors are hoping that the money from this will go to settle some of the Rs 5,600 crore that the exchange owes them.

The huge loss was the result of what has turned out to be an elaborate fraud implicating the main promoter of NSEL, Financial Technologies (FTIL), in which Shah is the majority shareholder, and a few of its personnel. It’s all reminiscent of the ’90s and 2000s, when the Harshad Mehta and Ketan Parekh scams rocked the business community. But there’s a big difference between the cases: Shah, going by reports in most leading business dailies, managed to subvert the system because of his connections in the government, something neither Mehta nor Parekh could boast of.

The basis for much of this speculation came from the fact that politicians such as finance minister P. Chidambaram (then home minister) and President Pranab Mukherjee (then finance minister) had, at some point, been present on the same public platform as Shah, at Shah-promoted events. There’s also the fact that people in the market regulator, the Securities and Exchange Board of India (Sebi), who had come out publicly against one or the other of Shah’s ventures, suddenly found themselves removed from those positions. Now, with politicians of all hues gearing up for the general elections in a few months, it seems nobody has time to spare for Shah.

The truth is that with the huge payment default at NSEL made public, nobody can do anything. Add to this the sharp rise in public scrutiny, thanks to platforms such as Facebook and Twitter, and there seems little hope that Shah can escape unscathed. But with all the noise, accusations and counter-accusations, arrests and questioning, and the various regulatory bodies and their various pronouncements, there’s no clear picture of what this issue is about and where it’s heading.

Cutting through the rumour, the innuendo, and the half-facts, we put together the story of the crisis, where it played out, and what it actually means to Shah and to investors. (Shah and his top management team refused to meet Fortune India for this story.)

SHAH'S FAMILY is in the business of trading iron and steel, but he was clear that he didn’t want to join that. An engineer (he studied electronics engineering in Mumbai), he said in an early interview (in 2008) with personal finance magazine Moneylife that he planned to do his MS in the U.S. and then set up his own business. But around the time he graduated, the Bombay Stock Exchange (BSE) had started an ambitious electronic networking project to take the exchange across the country. Shah was hired as part of the first team of engineers to automate BSE. “Though I was hired for networking, I started taking an interest in the working of the exchange: how brokers transact; how liquidity is generated; the role of jobbers [day-traders or arbitrageurs—traders who buy shares and sell them almost instantly to take advantage of intra-day price fluctuations], etc.,” he says in the interview.

The result of his first job was Financial Technologies, a company Shah set up to provide an electronic trading platform for market participants. From there, it was a short step to setting up his own exchanges. Shah set up the Multi-Commodity Exchange (MCX), the first listed, and the nation’s largest commodities exchange, as well as exchanges in five other countries. But Shah’s dream was to set up a stock exchange in India to take on the might of the BSE and the National Stock Exchange (NSE). The MCX-SX was born—and was born in trouble, with the NSE challenging its existence. But Shah won the day then.

In 2005, Shah conceived of NSEL to allow buyers and sellers of agricultural commodities and precious and base metals to trade on an electronic platform. Shah had got permission to start a spot exchange, but it was a struggle getting traders to use the exchange.

THE FIGHTER: Jignesh Shah has his back to the wall, but claims he has done nothing illegal.
THE FIGHTER: Jignesh Shah has his back to the wall, but claims he has done nothing illegal.

One of the problems NSEL faced was in the settlement period; since it was set up as a “spot” exchange, settlement (or payment for trades) was to be immediate, or within two days, which is the globally accepted practice. To attract more traders, Shah sought and received an extended settlement period from the Ministry of Consumer Affairs, Food, and Public Distribution, the ministry in charge of trading in agricultural commodities. With this, NSEL offered longer term contracts, where payment could be made 11 days after the trading day (T, or trading day +11). That was in 2007.

For years after, NSEL was cruising along, with almost no regulatory controls. Perhaps emboldened by this, Shah and his team decided to expand NSEL’s operation to include “novel products” in 2010. Anjani Sinha, then CEO and managing director of NSEL (now in jail), introduced “paired contracts” for agricultural commodities such as wheat and castor seeds. This innovation soon became hugely popular with investors.

It essentially meant that an investor would enter into two contracts. A buyer (generally a mill owner), would buy the commodity from the market paying cash for it, and store the commodity in warehouses accredited to NSEL. The buyer then used the warehouse receipts as proof of ownership of the commodity, and sold the commodity to financial investors as standard short-term contracts (T+2). Immediately after buying the contract, the investor would put the commodity up for sale—on a T+26 basis. The commodities were bought back by the original contract seller (the mill owner). The investor generally got returns of 14% to 18% on investment, and the mill owner got short-term funds at a reasonable rate.

The transactions were touted as risk-free because the financiers not only had a warehouse receipt for the goods but had the assurance that NSEL stood as guarantee. Turnover on the platform zoomed to Rs 73,390 crore in FY13 from a few hundred crores in 2010, and 97% of the transactions were as paired contracts. It seems like a reasonably easy way to make money—on the face of it. In 2012, the deep flaw in the system was exposed when Lotus Refineries, a mill owner, defaulted on payment. And then investors found that the underlying asset, the oilseeds that were supposed to be in the warehouse, were missing. “The company was actually manipulating stock records and issuing false bills,” said Sinha in his first affidavit filed before the Mumbai judicial magistrate on Aug. 14 this year. The exchange chose to hush this up, paying investors out of its own margin money.

Over the next year, the defaults started mounting, till, by mid-2013, they crossed Rs 5,600 crore. There was no way the exchange could hush this up or pay off investors, who were getting increasingly vocal. The Forward Markets Commission (FMC), the regulatory body for futures and commodities trading, got into the act and began scrutinising the contracts. Under the Forward Contracts (Regulation) Act, 1952 (FCRA), payment should take place within 11 days of the contract date. The FMC asked NSEL to explain why 55 contracts had settlement periods of more than 11 days.

On its part, NSEL officials claimed that the settlement period for one-day forward contracts was not specified in the FCRA. An NSEL official, on condition of anonymity, says: “Even the Ministry of Consumer Affairs earlier accepted that it is a grey area and suggested 30 days for settling one-day forward contracts in the FCRA Amendment Act, currently before Parliament.”

Unsatisfied with this, in February, the FMC, acting on the advice of the Ministry of Consumer Affairs, barred NSEL from launching any further fresh contracts and settle the existing ones on the due dates as notified by the exchange. (The exchange has defaulted on 13 payment deadlines at the time of going to press.)

With a freeze on new contracts, mill owners had no new source of funds, and were unable to pay existing dues. With all settlement efforts failing, NSEL stopped all trading and merged delivery and settlement of all contracts with a 15-day deferment. An estimated 13,000 investors were affected. The investors set up the NSEL Investors Forum to collectively pressure the exchange to settle their dues.

TODAY, SHAH'S EMPIRE is in a shambles, his accounts frozen, property seized, and reputation in tatters while most of his confidants are being questioned by the Mumbai police or are already in custody. His plans of launching new exchanges in India and abroad or even re-launching NSEL seems like a distant dream. “This is the end of the road for Shah’s ownership of NSEL,” says S. Motilal Oswal, chairman, Motilal Oswal Securities. (Motilal Oswal Securities is one of the investors in NSEL.)

Meanwhile, the FMC is examining whether Financial Technologies (FTIL) is “fit and proper” to run an exchange, and its ruling could have a strong bearing on MCX-SX. While Sebi renewed its recognition to the exchange in September for one year, it made it clear that an adverse ruling from another regulator could affect its decision to allow the group to operate a stock exchange.

There are also various other issues that are yet to be resolved. The Enforcement Directorate is probing the money laundering angle under the Prevention of Money Laundering Act 2002; the Serious Frauds Investigation Office is scrutinising the company’s books and coordinating with the FMC to dig deep into the crisis. Sebi is examining the data to see if FTIL misrepresented facts and figures to shareholders and officials; the Department of Company Affairs is inspecting the company’s books to check whether the money received was used for the purpose defined; and the Bombay High Court is looking into complaints filed by investors.

SHAH HAS MADE SERIOUS efforts to distance himself from the scam. However, the First Information Report filed by the NSEL Investors Forum has implicated him, claiming that he had created a false impression in the minds of investors regarding the operations at NSEL. The complaint alleges that 99% of the delivery business was fraud, evidenced by complete absence of underlying assets and the issuance of fake warehouse receipts. It has since been established by the Economic Offences Wing of the Mumbai Police that NSEL did not have 20% of the stock that it claimed was in its possession. The stated amount in the Settlement Guarantee Fund of Rs 839 crore was also found to be false; there was only Rs 65 crore in the kitty.

Then, there’s the warehouse receipt fraud. “It was not mandatory for warehouses to be registered with the Warehouse Receipt Regulatory Authority and in many states it was regulated by the Agricultural Producers Marketing Corporation Act,” says an NSEL official. So, companies got away by giving fake addresses; where the warehouses were real, there was nothing in them. Investigation by the Economic Offences Wing showed that the warehouse address given by Namdhari Food International was the office of a chartered accountant. Nine other companies were found to be bogus.

News reports quote one of the police officers conducting the investigation as saying: “Cheating by defaulting companies of this quantum cannot take place without the connivance of NSEL office-bearers. After all, NSEL was the custodian of the interest of investors.” Meanwhile, there have been questions asked about why NSEL was allowed to function without a regulator, and why public sector firms approved investments in the exchange knowing that it was an unregulated body. These issues were also raised by Finance Minister P. Chidambaram on Sept. 26, when he set up a committee headed by Arvind Mayaram, secretary, economic affairs, to investigate the fiasco.

As far as NSEL’s side of the story is concerned, it did not break any existing laws when it launched “paired contracts”. The chairman of the FMC, Ramesh Abhishek, acknowledges this, and says there was a “regulatory vacuum with respect to spot exchanges”. However, he adds, there was never any loophole that permitted short-selling, which, it now turns out, was what NSEL was doing.

In its report, the Mayaram Committee blamed companies and investors equally. It also blamed NSEL’s auditors (Mukesh P. Shah & Co) for failing to verify the existence of goods before certifying NSEL’s books. Auditors of both NSEL and FTIL withdrew the audited annual reports of the two companies in the wake of the scam. The NSEL Investors Forum has asked the Institute of Chartered Accountants of India (ICAI) to take disciplinary action against Rajesh Hiranandani, partner of the firm, for withdrawing the report. They also want the Mumbai police to investigate the role of the auditor, S.V. Ghatalia & Associates, an Ernst & Young affiliate, which audited the books of the exchange between FY10 and FY12 and gave it a clean chit.

The focus of the ICAI probe is to ascertain whether NSEL’s auditors failed to carry out a physical assessment of stocks. According to the rules of accounting standards, the stock constitutes an important segment of current assets, and it is up to the auditor to ensure that they are properly disclosed in the financial statement. Experts say that the auditor must be present at the time of counting inventory to ensure that they exist and assess their condition, which was not done in NSEL’s case. Kaushik Dutta, former partner at consulting firm PricewaterhouseCoopers, says: “Auditors of FTIL, who are consolidators of accounts of the subsidiaries, too, are responsible for irregularities in the books of NSEL and MCX since they are subsidiaries of FTIL. They can also be held accountable for the period when they signed on the balance sheet (May 30, 2013) till the day they withdrew the report (Aug. 23, 2013).”

Amid all this, Shah’s biggest setback, perhaps, has been stepping down from the board of his favourite child, MCX. “The NSEL crisis has destroyed everything I have worked hard to build over the past two decades,” he said, announcing his resignation. He claims that he will fight back. At a press meet on August 5, he said: “Right now, my focus is only on getting back the money.” He seems to be on a wild goose chase.

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