We don’t blame the journalists for not knowing better. They, along with politicians, have called the Saradha scam, illegal MLM company and chit fund, amongst many other things. What is it actually? Let’s understand the concepts first – and then we’ll talk about what happened in the Saradha scam.
What is a “Chit fund”?
According to the Chit Funds Act, 1982, a chit is an arrangement under which a person enters into an agreement with a specified number of persons that every one of them shall subscribe a certain sum of money by way of periodical instalments over a definite period and that each such subscriber shall, in his turn, as determined by lot or by auction or by tender or in such other manner as may be specified in the chit agreement, be entitled to the prize amount.
This can be complicated to understand – so let’s take a simple example:
A, B, C, D and E put in 10000 rupees each. They have an aggregate fund of rupees 50000 (10000 * 5). This fund is the chit fund. Now the fund will be auctioned to the person who is willing to give maximum discount. “B” is willing to give a discount of 2000 rupees, i.e. he wants 48000 rupees, “c” is willing to give a discount of 2500 rupees (he wants 50,000 – 2500 = 47,500 rupees) and “D” is willing to give a discount of 5000 rupees (he wants 50,000 – 5000 = 45,000 rupees), which is the maximum discount offered by any one of them. So, “D” will get the amount left after deducting the discount and organisational charges say 1000 rupees]. Therefore “D” will get 50,000 – 5000[discount] – 1000[organisational charges], that is, 44,000 rupees. The remaining 6000 will be divided equally among A,B,C,D and E.
Benefit: D gets a larger sum of money in hand than what he could have afforded which can be used for various purposes like taking a loan or buying a car, etc. This has been made possible by pooling of funds of several other people. In another cycle, the same money will be pooled for the benefit of another participant.
A chit fund does not have pre-determined return as in the case of corporate deposits and MLM schemes. The return depends on various factors like discount and organiser’s charges.
What is a Collective Investment Scheme (CIS)?
According to Section 11 AA (2) of the SEBI Act, any scheme or arrangement made or offered by any company under which the contributions, or payments made by the investors, are pooled and utilised with a view to receive profits, income, produce or property, and is managed on behalf of the investors is a CIS. Investors do not have day to day control over the management and operation of such scheme or arrangement.
Difference between chit-fund, MLM company, corporate deposits and chit funds
Multi-level marketing or MLM schemes – An MLM company is one which is involved in multi-level marketing. It is a plan for the distribution of products whereby participants earn money by supplying products to other participants in the same plan. They, in turn, make their money by supplying the same products to other participants. It is possible for multi-level marketing businesses to generate funds by sale and distribution of genuine products or services – however, often MLM businesses generate money exclusively by charging enrolment or subscription fees from new participants, and the fraction of revenues generated from sale of products and services is nil or insignificant, in which case they become similar to ponzi schemes (see below for a description of Ponzi schemes).
Most multi-level marketing schemes in India qualify as money circulation schemes under the Prize Chits and Money Circulation Schemes (Banning) Act, 1978 Act and are hence illegal, unless the schemes are carefully structured to be compliant with the law. The act defines money-circulation schemes as schemes for the making of quick or easy money on any event or contingency applicable to the enrolment of members into the scheme, irrespective of whether the money paid out is derived from the entrance money of the members of the scheme.
Note that even if a particular MLM scheme has been structured to be compliant with the law, it does not prevent risk of investigative proceedings being initiated by the police against the promoters of such schemes.
Ponzi schemes – The expression ‘ponzi scheme’ has been borrowed from US experiences, but businesses have used similar models across the world. Let’s refer to the definition given by the Securities and Exchange Commission (SEC):
A ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from profit earned by the individual or organization running the operation.
Corporate deposits – Corporate deposits are very similar to fixed deposits, with the difference that the deposit is made with a company instead of a bank. The company pays a fixed rate of interest on the deposit according to the terms and conditions on which the deposits were invited from the public. Note, in the case of deposits it is understood that the company will repay depositors from the money generated from conducting its business.
Understanding the Saradha group’s activities
Saradha group was running a wide variety of collective investment schemes. The group appointed agents who were recruited from local rural communities – these agents collected money from the public by issuing secured debentures and redeemable preferential bonds on commission basis. This money was raised by over 100 companies under the Saradha Group.
In India, raising money from the public (whether it is by equity, debentures or deposits) attracts jurisdiction of a regulatory authority such as the Registrar of Companies (and the Central Government) in case of deposits or SEBI (in case of debentures, etc.). Raising money in the form of debentures or through collective investment schemes attracts SEBI regulations, which have been issued to protect investor’s interest.
Usually, these regulations prescribe the duration, maturity period, return and other conditions pertaining to these instruments, and a number of reporting obligations towards regulators and stakeholders. Such provisions usually prevent businesses from defrauding the public to raise money, and thus help in protecting investor interest.
SEBI has acted against the Saradha group because the group companies would have been required to comply with its regulations pertaining to collective investment schemes while raising bonds and debentures, which has not been done.
Earlier, the Sahara group had run into trouble with the SEBI, as some companies within its group had raised funds from the public without getting listed on stock exchanges (see here for a brief discussion of the Sahara incident).
Unravelling of the Scam and SEBI’s argument
SEBI first took notice of the activities of the Saradha Group in 2009, but to no avail. In January 2013, the cash inflow of Saradha Group was less than its cash payouts for the first time – this usually happens when the payouts a company is not able to generate money from and its Chairman Sudipto Sen fled to Kashmir.
The SEBI contends that the Saradha Group was running a wide variety of collective investment schemes – hence, that it should have complied with appropriate SEBI Regulations. The Saradha Group, on the other hand, claims the same activities to be chit funds which should be under the jurisdiction of Central Government and not SEBI.
Why was it CIS and not Chit Fund?
A chit fund cannot declare in advance the return an individual is likely to make, given the way its structured. The fact that a rate of return was promised in advance clearly means that what Sudipto Sen was not running a chit fund but something else. Moreover, the investors did not have day to day control over the scheme and the money would come to them only at maturity, which makes it a collective investment scheme.
Charges framed under criminal law
Sudipto Sen (Chairman), along with Kunal Ghosh (CEO Media Division), Debanji Mukherjee (Director) and Arindam Das (a key official) have a large number of FIRs lodged against them. The charges framed against them include cheating, money laundering, abetment of suicide (see the Indian Express story here).
Actions taken
On 25 April 2013, Income Tax department and Ministry of Corporate Affairs started separate investigation into Saradha Scam. An FIR has been filed against Sudipto Sen and Kunal Ghosh (see the Telegraph story here). Around 6 officials from Saradha Group have been arrested. CBI investigations are still underway. The Income Tax investigations, of course, are concerned more with the payment of tax on all kinds of earnings (whether they are by legal or illegal means), and not with any punishment for carrying out an illegal business by itself.
Other actions that can be taken against the Saradha Group
The Saradha group has been arguing that it is only required to comply with the Companies Act. In fact, they can be held liable under the Companies Act as well – Section 68 (b) of Companies Act, 1956 states any person who by any dishonest concealment of material facts induces another person to enter into an agreement with the purpose of providing profits for a party from the yield of shares or debentures, can be punished with fine of up to one lakh rupeesor evenimprisonment of up to 5 years.
Hence, disclosure of material facts is an important factor while raising money under the Companies Act. The manner in which the money will be used should be considered to be a material fact – banks or financial institutions provide loans to companies on condition that the manner in which the money is used is fully disclosed to them (often, they also monitor the usage of funds). Similarly, when companies raise money from the public and are listed on the stock exchange (or even from a private investor), companies are required to disclose to investors the manner in which the money will be used in the prospectus as per the Companies Act, and SEBI Regulations.
In the Saradha group case, investors were rarely informed about the true nature of how their investment was used by the group – although this will require to be established in a court. Instead, many investors were assured that they would get high returns after a fixed period, which leaves the possibility of initiating criminal proceedings under Section 68(b) open.
How can proceedings be initiated for defrauding creditors under the Companies Act?
Under the Companies Act, criminal proceedings can be initiated by the Central Government if a company has tried to defraud its investors or creditors – for this, the Registrar of Companies (ROC) must submit a report to the government. Alternately, the shareholders have the power to call a meeting of the company – if 75 percent of the shareholders present pass a resolution in favour of the investigation, such an investigation can be initiated. In reality, it is likely that the promoters of these companies have a dominant shareholding. It may also be extremely difficult at a practical level for shareholders of the 100 companies to coordinate and call meetings, hence initiation of proceedings by the ROC is the only feasible option for proceeding under the Companies Act.