Behind Sebi’s CIS failure

Nobody kicks a dead dog! While this adage may be applied to many agencies, financial regulatory authorities are rarely amongst them. They are subject to constant, substantial public scrutiny, which gets magnified during times of crises.

Sebi has been globally recognised as a successful securities market regulator. Empowered with substantial statutory powers, it has achieved many milestones in pursuing a proactive approach to conduct regulation of the entities under its purview. It brings out regulations following due process and passes quasi-judicial orders in accordance with law. Its regulations have withstood time with hardly any legal challenge. Many of its landmark quasi-judicial orders have been upheld by the Supreme Court, and became instrumental in many legislative/regulatory changes.

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However, despite such success in its core tasks, Sebi’s DTR dues indicate that something is seriously wrong somewhere.

The disaggregation of DTR itself captures the culprit—Collective Investment Schemes (CIS). The nature of this beast is such that these are evasive entities/schemes. They start off in small/medium scales, stealthily targeting generally less/uninformed investors with hefty promises. They come with strange, even disparate schemes such as emu, ghee and milk, survey options, etc, in addition to the more standard ones—gold schemes, holiday units, land parcels and so on—all involving pooling and management of collected funds.

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In fact, based on investor or whistleblower complaints in the mid-1990s, Sebi only highlighted these entities operating in the Indian financial landscape with impunity. In the early stages, Sebi had to literally struggle hard to bring some of them to books. After years of efforts, the orders of the Supreme Court in PACL, Sahara, etc, brought out the strangulating tentacles of some large CIS entities before other authorities and the public.

CIS are avatars of Ponzi schemes. Moreover, since they were unregulated entities and/or illegal schemes, Sebi did not have any data on the number of investors, amounts collected, use/diversion of funds and so on. Their book-keeping was archaic and unreliable, and hence both the liabilities and assets sides were black holes. Their officials extended no support to Sebi officers. After all, such entities were above all financial sector laws, allowed by their own Memoranda/Articles to do all activities, probably other than space exploration and atomic energy. One such entity’s Memorandum lists activities covering around 50 printed pages, with an interesting omnibus provision: “to invest in all schemes, except own scams”! Sebi’s attempt to bring ‘any scheme or arrangement which satisfies the conditions’ stated under sub-section 11AA of Sebi Act, and requiring them to register with Sebi and conduct their business in tune with Sebi CIS Regulations 1999, met with no success.

Because CIS sprouted and flourished in the twilight zones of regulation, enabled by the fragmented regulatory architecture in terms of activity-based regulation. They cherished their free will. They were neither banks and payment systems regulated by RBI, nor entities connected with securities markets regulated by Sebi, nor insurance or pension funds regulated by IRDAI or by PFRDAI. They were any or all of these, though, cleverly evading these tight classifications or simply avoiding the regulations and regulators.

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Some of them are also audacious enough to carry on with tightly regulated activities like issue of standard securities, equities or convertible instruments, to the public and claim that those were private issues/ placements. No wonder, deemed public issues are next only to CIS in DTR dues, though much lower, in outstanding percentage (22.8%) to be recovered by Sebi.

Of course, all such recovery matters, which Sebi has been perusing relentlessly over the years, are under parallel proceedings of various courts. This is also quite natural since such entities have nothing to lose but everything to gain through long, protracted legal process. While such proceedings go on, some of the people involved would leave the country or the world or simply disappear from the radars of authorities. Some of the companies would go dormant, others would get into insolvency proceedings and get legally exempted from recovery proceedings.

The recovery rate from Sebi supervised and regulated entities is very high; disgorgement 97%, and penalties 99%. Even in matters of deemed public issue, recovery is 77%, but in the case of CIS, it is only 23%. Coupled with fact that the maximum amount of dues is in this category, Sebi’s reputation got damaged. The considerable success of Sebi in terms of its original, core mandate of regulating the securities markets, participants and intermediaries has been dented by foisting regulation of unregulated entities/schemes on the shoulders of Sebi. It is ironical, since it was because of the very success of Sebi that its mandate got legally extended to cover CIS in 1999. However, that grafting was done forgetting a basic regulatory principle that regulation and supervision have to go together.

CIS/Ponzi schemes are best handled at the sprouting stage itself. Their frequency and ‘illegality’ can be handled only by authorities close to the ground, having the reach to locate and prevent them at early stages of operation. That was the reason behind enacting “The Banning of Unregulated Deposit Schemes Act, 2019 (BUDS Act), to be implemented by the state governments.

Effective implementation of this law and recasting other financial-sector laws/regulatory architecture are necessary to remove the fertile ground for CIS entities to start and flourish. Grafting problematic operators to the shoulders of any regulatory body is an inefficient shortcut to financial sector regulation. Effective regulation needs an overarching legal-institutional framework.

The writer is Director, National Institute of Securities Markets (NISM)

Views are personal