Thursday, April 25, 2013

FAQs on Chit funds

West Bengal’s ‘chit fund’ mess and inaction of MCA 

The massive money, which is raised surely shows somewhere on the balancesheet of the company, filed regularly with the MCA. The primary recipient of the information about these companies is the MCA, and surprisingly the MCA is the least proactive in the entire process of bringing these perpetrators to regulatory focus, sooner before tonnes of money vanish

As the bottom-of-the-pyramid population continues to fret about having lost one’s life savings in the West Bengal “chit funds”, it is interesting to find politicians promising new stringent laws against such funds. In fact, law-making is the least of the reasons for suchschemes to have flourished in the state. However, as political connections of one of many that have gone bad are exposed, the easy face-wash for the politicians is in law-making, to cover-up what is quintessentially an implementation issue. The reality is that we are not short of such laws—in fact, we have a plenty of laws that prohibit such schemes and impose sternest penalties for the perpetrators of such scams. But if a Rs22,000-crorescheme questions the very institutions that define our system—Supreme Court, SEBI, or whoever else—there is little surprise that the only succour for political face-saving is in law-making. And this is what we have done over the decades—as the write up below shows.

This article gives a quick overview of the laws regarding “chit funds” or devices of sourcing public deposits.

First of all, the West Bengal “chit funds” are not chit funds at all. Chit funds are a different structure altogether. Chit funds are mutual credit groups where money circulates among the group members, and the monthly contributions of the chit members are received circularly by one of the members who bids for the same at the highest interest rate or lowest “net present value”. Chit funds are perfectly legal, if they are registered under the Chit Funds Act, 1982, and run under the provisions of the law. The several names that keep popping up in West Bengal are not chit funds—these are collective investmentschemes  or public deposit schemes which on the face of it do not fall under any law, as they are structured so as to be neither a “public deposit” nor a “collective investmentscheme”. But that facial structure is so gullible that any regulatory investigation may easily expose that these schemes were effectively nothing but public deposit schemes.

The evolution of regulatory structure in India is a rare case of human learning—we have burnt our fingers every time to learn that the fire is too hot to handle. So, every scam brought a law; in essence, the law is the edifice built on scams and not on intuition.

  • • Deposit regulation: These rules were inserted in the Companies Act in 1975 after several cotton mills in Gujarat and Maharasthra burnt public savings.  In fact, India is one of the few countries in the world which allows non-banking companies to raise deposits from the public. World-over, access to public deposits is allowed only to banks. In India, companies may raise pubic deposits—however, subject to provisions of Section 58A of the Companies Act. This allows only deposits to the extent of 25% of the net worth of the company, places restrictions on interest rates, brokerage, etc.
  • • Chit fund laws and money circulation scheme laws: Money circulation schemeswere banned by a law in 1978, after Sanchayita Investments went down with money pooled from a few lakh investors in West Bengal. Soon after, chit funds became a hotpolitical issue, leading to chit fund law in 1982.
  • • NBFC Regulations: Non-banking financial companies (NBFCs) are allowed to raise deposits up to 10 times their net worth, but this privilege is granted only to so-called “depository NBFCs”. This is a fairly well-regulated institution coming under the RBI, and the regulations have been toned after hard lessons were learnt with the CRB scam of 1997. Accordingly, NBFC Directions were framed in 1998 after few hundreds of NBFCs had gone down with public savings.
  • • Private placement scams: Several hundred companies raised money by way of “private placement” of shares taking advantage of a Companies Act provision whereby only “public offers” required regulation by the securities regulators (now Securities and Exchange Board of India—SEBI, earlier Controller of Capital Issues). This resulted into a “deeming rule” in Section 67 of the Companies Act, inserted in 2000, whereby any offer of securities to 50 or more persons was deemed to be a public offer.
  • • Collective investment scheme regulations: Plantation companies with schemessuch as “money grows on trees” continues to raise public money against collectiveinvestment schemes, and it took SEBI several years before the Collective InvestmentScheme Regulations were framed in 1999. A collective investment scheme is one where public money is raised for investment in any asset or scheme, other than by way of shares, deposits, mutual funds, etc.
  • • Alternative investment funds: This is a new a regulatory instrument under SEBI, to regulate privately pooled vehicles for collective investments. This became effective in 2012. This is by far the only regulation which is not “reactive”.
So, with all these laws, how to scamsters still end up raising several thousands of crores? Obviously, so much money is neither raised overnight, nor raised silently enough, as there is a massive machinery of agents who raise the money from the very bottom of the population pyramid. Each scamster innovates an ingenious device, but none of these devices are not iron-clad to avoid regulatory action, provided there was a will power.
Here is an inclusive inventory of the schemes currently in use:

  • • Debentures: Sahara used the argument that (a) Sahara was issuing optionally convertible debentures which were not ‘securities’ under securities laws, and hence, were free from the securities regulations, and were not ‘deposits’ under the deposit regulations, and therefore, to be regulated by none. The Supreme Court ruling has rubbished the first argument.
  • • NBFC companies: The Companies Act rule restricting issue of  securities to less than 50 in order to escape the “deemed public offer” rule does not apply to NBFCs—hence, several of the “chit funds” use an NBFC to raise instruments such as debentures not regulated under public deposit rules.
  • • Preference shares: Some of the entities issue preference shares to the depositors. A preference share is essentially the capital of the company, and not a deposit.
  • • Land deals: Some companies contend as if the so-called depositor places order for purchase of land by the promoter. Later on, the land deal is cancelled, and money is returned with interest.
  • • Advances for purchase of goods: Some operators show as if the ‘deposit’ had actually placed an advance for purchase of goods. The order is later cancelled and money is refunded with interest.
No matter what is the device used, the common thread in each of these schemes is that the flow of new ‘depositors’ must keep coming in, because the only source from which maturing deposits could be serviced is by inflows from new depositors. Money is initially raised at hefty interest rates, and with attractive periodic prizes, gifts, gala parties, and so on. The agents who mobilise the deposits are given hefty commissions, because the structure essentially relies on a highly incentivised structure of brokers or agents, who reach right to the doors of the depositors to collect deposits. The cost of interest, plus the agency commissions, the luxurious spendings on so-called depositor prizes, and add to all this the lavish remunerations of the promoters themselves—all adds to a huge cost of interest, say, about 25% to 30%, which no lawful business may produce. It is not that these promoters are blue-eyed investors who know tricks of investing—so, they end upinvesting money in illiquid properties, resorts or hotels.

Now, the only way to keep servicing investors is that new depositors must flow in, so that old depositors can be repaid. That is, the base of the depositor pyramid has to continue to expand so that those up in pyramid can be paid—this is what Ponzi schemes are all about.  This is what we call “tiger riding”.

Soon, the ride comes to and, and guess what happens at the end of any tiger ride! In the process, thousands of gullible investors have lost their life savings.

As hundreds of crores are raised though tens of thousands of agents, surely enough the exercise is not invisible to the regulatory eye. The massive money which is raised, irrespective of the label, surely shows somewhere on the balance sheet of the company, which is filed regularly with the MCA (ministry of corporate affairs). The primary recipient of the information about these companies is the MCA, and surprisingly, it is the MCA which is the least proactive in the entire process of bringing these perpetrators to regulatory focus, sooner before tonnes of money vanish.

No, it certainly is not the lack of laws that allows these scamsters to rob people of hard-earned money. It is clearly an implementation issue.

(The author is a noted expert in financial laws. A lots of author’s writings appear and

My personal experience

Now I have to report the readers some personal information I have about these companies. All these companies (CIS) publish a brochure which follows a typical pattern – in the front page there is a picture of landing of plane, an European lady working a call centre with head phone and pictures of some multi-storeyed building (in fact Sei Samay from TOI group on 12.5.13. reported how Saradha group ventured into , at least on paper, aviation sector, call centre or business process outsourcing – to show that the company is into these businesses. In the second page there is a picture of Certificate of Incorporation (COI) given by Registrar of companies, unit of MCA (which comes with Ashok’s stambha emblem). The reason behind this is to tell investors that it is guaranteed by Govt of India. Actually, technical meaning of this COI is, company is in existence and is legally incorporated (i.e. duly submitted memorandum of association, article of association, paid fees as per norms). First time I saw this brochure is when I was going travelling from Bishnupur to Garpanchakot in 2009.In fact on 13.5.13. The Telegraph reported a similar investigative story (how COI given by ROC is shown as proof of Government approval of such scheme).  About three years back my close friend (who was working in a senior position of a segment of capital market) was approached by the management of an MLM Company. My friend was explained that he need not do anything. He has to appoint some agents, who will work under him. Nobody will get to see him even. He will work from the background. For that he will be given a hefty commission. It was also explained to him that after some point of time they will issue shares in lieu of debentures at a premium (i.e. against a debenture of Rs 100 they will be given equity share worth Rs 200) and then will manipulate the market to make the value of share to almost nil. Then the holders of the shares cannot legitimately claim anything against them (however yours truly thinks this is not possible due to strict guidelines issued by SEBI in recent years) . When he explained his inability he was told if you do not join, somebody else will join. We Bengalis are “know it all people “. We seem to know everything under the sun, but the moment they are told fairy tales of money growing in trees, they will forget everything and will fall for greed. They are called “sab janta gamchawala”. They know everything, but at the end of the day they will sale only gamcha (towel). So the greed is God.

But for people who works in the household as domestic help the scenario is somewhat different. They are embarrassed to deposit Rs 100 in the bank and they do not know how to fill up the deposit slip -  which the agents happily do it for them. According to me the solution lies in banks being more proactive in banking correspondent model (as part of financial inclusion – many banks have become pro-active in this matter and Saradha issue will make it more compelling case) and for that Aadhar card or any biometric card will be of great help.

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