PNB Fraud: Understand the inner mechanics

Punjab National Bank (PNB) scam has traumatized the nation. Immediately, the scam must be cracked and accountability fixed. Holding only the lowest officer, or a clerk accountable will be a cruel joke on India. Some heads at the highest level of governance must roll as well.

From 2011 to May 2017, hundreds of Letter of Undertaking (LOUs) were issued by PNB, Mumbai Branch, on request of applicants, Nirav Modi and Mehul Choksi. Against the security of these LOUs, the overseas branch of Indian banks lent dollar to PNB. These dollars were credited to PNB’s Nostro account in New York (NY). From PNB’s Nostro account funds flowed to the overseas supplier of goods.  The overseas supplier then routed the export (import to India) documents to PNB. PNB then debited applicant’s account and remitted dollar with interest to the overseas banks/branches. LOUs were discharged in this manner.

All four players -  PNB, applicant, overseas banks/ branches, overseas supplier – gained. PNB earned commission from LOUs. Applicant obtained cheaper dollar loan. Overseas banks/branches earned interest on dollar lending secured fully by LOU of PNB. And the overseas supplier received funds while dispatching the items to India. Where is the irregularity?

Irregularity commenced with the issuance of LOU without PNB’s internal sanction backed by security. Every LOU created liability for PNB. This liability was operationalised by PNB with its SWIFT (Society for Worldwide Interbank Financial Telecommunication) network. PNB’s  SWIFT network was not linked with CBS (Core Banking Solution). That’s why the irregularity escaped immediate detection, particularly when the applicant kept paying money to PNB and/or PNB kept renewing LOUs. This process continued from 2011 to 2017. During this phase, no liability appears to have been crystallized since LOUs were either paid for by the applicant or renewed by PNB.  The Deputy Manager of PNB who was issuing LOUs was due to retire on May 31, 2017. It is at this juncture that the irregularity took a fraudulent colour. From  March 1 to May 2, 2017, in 63 days, 143 LOUs were issued. This created huge contingent liability for PNB. The new  Deputy Manager who took over in June 2017 must have come to know about the irregularity and must have shared this with top management, assuming that the top management of PNB did not know about it.  At this stage that PNB must have realized that it had already created a contingent liability of Rs 11,400 crores.    

If PNB commits irregularities in issuing/renewing LOUs, or in complying with exchange control regulations, can liability be fastened on third parties who deal with PNB bonafide in good faith? According to the British doctrine of indoor management, people transacting with companies are entitled to assume that internal company rules are complied with even if they are not. This was propounded in the decision of Royal British Bank v Turquand in the UK in 1856 (1856) 6 E & B 327, and endorsed by the House of Lords in 1874 [Mahony Vs East Holyford Mining Company].  This rule continues to apply even today. On the other hand, according to the doctrine of “constructive notice”, persons conducting business with a company are deemed to have knowledge of any restriction on the authority of agent. Since coded/secret passwords were given by the PNB to the employee to send messages by SWIFT, there is no question of invoking the doctrine of “constructive notice”.  So, neither the overseas banks/branches who relied on LOUs, nor the applicant of PNB can be foisted with the liability of constructive notice, unless they were in collusion with PNB. It is absurd to allege that overseas branches were in collusion with PNB. Alleged collusion between PNB and the applicant in Mumbai is a subject matter of investigation.

Some questions, however, arise: What did the overseas supplier do with the funds? Did they actually export goods to India or simply dispatched documents to PNB Mumbai? Banks deal in documents, not in goods; so, it is difficult for banks to ensure that the bills of exchange drawn by the overseas supplier are genuine and not accommodation bills. In accommodation bills, seller and the buyer accommodate each other by simply drawing bills of exchange to raise funds without movement goods. This is called kite flying.  Secondly, what is the link, if at all, between the overseas supplier and the applicant?  Thirdly, when did the applicant default first? Was it on January 2018? The answer to these questions may indicate that irregular transactions since 2011 became fraudulent only in 2017.

The scam needs to be cracked forthwith. Without PNB’s authorisation, the funds could not have been provided to the overseas supplier. Entire money trail of dollar has been transacted from PNB’s own Nostro account which PNB has permitted to be credited and debited. So, PNB can’t claim that it did not know for seven years where the funds came from and how these were applied. PNB  will have to own responsibility. It is also difficult to believe that PNB did not share information about these irregularities with the government, particularly after May 2017 when the previous Deputy Manager retired. PNB’s top brass should be questioned about when was it that they first came to know about the irregularities, and when did they first share it with the central government? The answer to these questions can open a can of worms. But will CBI muster the courage to get to the bottom by questioning the top in the government?  RBI as a regulator cannot disown its responsibility, but the prime responsibility is that of the central government which owns both PNB and RBI.  The central government must punish itself first before fixing auditors or before blaming the RBI.  The rot in banking system must be stemmed! The Finance Minister must own responsibility!

The author is a former Additional Solicitor General of India and is a Senior Advocate at the  Supreme Court. Views expressed are personal.