Column: Of Ponzi scams & financial exclusion

Written by Sandeep Parekh | Updated: May 2 2013, 05:54am hrs
The exclusion of the common man from the formal banking system in the name of KYC is the root cause of such scams

Saradha is now synonymous with all that is wrong with Indias financial world. Financial exclusion, surfeit of laws, entrapment of gullible investors, political-scamster nexus, poor enforcement of existing laws and a complete and unmitigated disillusionment with the financial world. As if mocking us, the companys website is still up and running and continues to market its castles in nowhere land.

Before we talk of Saradha, we must invoke the God of pyramid schemes. In fact, he has so well found his place on mount Olympus along with other Gods that few people use the phrase pyramid scheme to describe the fraud. Most people instead say Ponzi scheme to describe the generic fraud.

The fraud is, of course, deceptively simple, but lethally effective. It is the payment of, often huge, interest to investors (who have invested previously) from the capital of others (who invest later). As word spreads about the excellent track record of the fund, more and more investors invest in the scheme (Saradha was dutiful in its payments in the first year). Some money goes to older investors who often bring in even more money to supplement their previous excellent investment. A fair bit goes to distributors who peddle the fraud, sometimes unwittingly (in Saradha, few distributors had much idea of the elaborate hoax) and the chunky residue goes to the promoter of the scheme to support his (its usually a he) lavish lifestyle.

The master, Charles Ponzi, at the peak of his pyramid scheme in 1920, had a queue of people which went on for several kilometres. People were ready to hand over their lifes savings to him in the hope of getting extraordinary returns. Of the three police investigators sent to investigate his financial affairs, two ended up investing in his scheme. In any case, like all other bogus bubbles, his burst too when investors got a whiff of what he was doing.

The root cause of the Indian story of such schemes is not the smartness of the crooks or the greed of investors. Rather it is the fact that formal banking and finance has so excluded the common man that less than half the eligible Indian population has a bank account. This is usually justified in the name of know your customer or KYC.

Take my own case. When I moved to Ahmedabad several years ago, I found it nearly impossible to open a new bank account. My passport, driving licence and a dozen other proofs of ID and address were insufficient to open a bank account as I didnt have a local lease deed or address proof. My ability to prove my ID and my real address were apparently not sufficient, even though I was teaching at IIM Ahmedabad.

Millions of people who work outside their hometowns are similarly excluded from opening bank accounts. These rules have not prevented scamsters from getting bogus IDs and opening unlimited number of bank accounts. One recent scamster had over two dozen IDs in different names. Poor people and even ordinary middle-class people are often left with no option but to invest in shady schemes. Lazy enforcement against black money has been substituted with nonsensical levels of so-called KYC.

It is also not correct to blame the victim, saying he or she was too greedy. Though that is often a red flag for more knowledgeable investors, many schemes do not even provide extraordinary returns. Saradha itself, for instance in one scheme, promised only 50% interest over five years, and in another scheme 12% per annum, neither of which is substantially above bank deposit rates. The whole idea of investor awareness, though clearly required, is not morally defensible as a means of reducing these schemes. It is the job of the state to prevent pyramid schemes with swift and preventive enforcement action. The credulity of small and sometimes even large investors can never be blamed for the effectiveness of such schemes.

The scam was not a result of either a lack of proper laws or because of unwillingness to enforce the law, though that often happens in other such scams. The Securities and Exchange Board of India (Sebi) has, for instance, been pursuing the group for several years and was stalled, sometimes with physical force, from doing its job. The problem is not so much of multiplicity of financial regulators but rather the ability of scamsters to play up between different laws, sometimes claiming the states jurisdiction and the often the laziness of some regulators using the same arguments of we dont have jurisdiction to support their behaviour.

Sebi has shown itself to be the exception to the lazy regulator moniker, particularly in this case. That, of course, begs the question, what is the regulatory maze that we have currently. A non-exhaustive list of financial products and structures are Sebis mutual funds, collective investment schemes, alternative investment funds; RBIs non-banking financial companies, banks; Insurance Regulatory and Development Authoritys unit-linked insurance products; ministry of corporate affairs company public deposits; and lastly the regulatory orphansstate cooperative banks and chit funds. Technically, they have multiple parents, but factually they are somewhat orphaned.

While many are self-explanatory, Sebis collective investment schemes and chit funds deserve some explanation. Collective investment schemes are essentially a financial product where there is pooling of money, expectation of profit and efforts by others, i.e. not the investors. Since it is quite independent of the concept of securities, the concept can capture a vast array of financial products. Art funds have recently been held to be collective investment schemes; similarly, plantation schemes have been the origin of the drafting of the collective investment scheme law. Collective investment schemes are not prohibited, but require registration and various valuation and auditssomething which most schemes have avoided and instead decided to litigate.

Chit funds have been held by court rulings to fall within the scope of both the Centre and the states under the Constitution. Besides, RBI has the power to inspect the books of chit funds. Therefore, even though chit funds can be legitimate business, they can often be the best source of a fraudulent scheme. A chit fund can ostensibly be used to raise money and, with friendly state politicians, can be an ideal breeding ground for fraud.

While it is difficult to stamp out these schemes completely, they require at least three immediate actions. First, an investors charter by each regulator should specifically mention what all is covered by them and what timelines investors should expect from the regulator for taking action. Second, a small statutory amendment should give one regulator all the residuary power to enforce where a subject falls under more than one areas of investment. This should also provide that no person should be able to raise money from investors unless they fall within one or other regulatory structure. Finally, and most difficult, there will need to be some level of intelligence gathering about any deposit taking place outside the formal channels, so the horse does not bolt before the stables are locked.

The author is founder of Finsec Law Advisors and visiting faculty, IIM Ahmedabad