The recent Saradha scam in West Bengal highlights three aspects concerning our regulatory and legal frameworks governing such companies and the schemes they run.
First, such firms, under the cover of running real estate, agri-business and other seemingly legitimate activities, have resorted to financial frauds by essentially running Ponzi schemes in gross violation of regulatory norms and/or license conditions.
Second, the Saradha case highlights how our legal framework has failed to keep pace with the fast-changing landscape of innovative, but financially fraudulent investment vehicles or products. Third, it exposes how such firms have continued to offer dubious hybrid investment products or schemes, taking advantage of the blurred role and scope of various regulatory authorities to monitor, investigate, and prosecute the guilty.
Saradha is one among a continuum of similar scams seen in the recent past across India. Whether it is in West Bengal, Kerala, Delhi and Andhra Pradesh, or even Bihar and Jharkhand, there has been an explosive growth of so-called chit funds, multi-level marketing, collective investment and pyramid investment schemes in the past few years. So have the scams resulting from them.
Targeting the gullible
In most cases, the firms concerned target unsuspecting and naive investors, particularly low- or middle-income daily wage earners. These are people, who under the current system, face difficulties in furnishing collateral for taking loans or cannot cope with the cumbersome processes of banks. Therefore, they are easily lured by unscrupulous companies promising supernormal returns on their investments or quick loans involving least amount of paperwork. Their inability to understand the risk-return tradeoffs on such products, leave alone basic banking laws, makes them most gullible.
In this case, Saradha Realty — one of the group’s many front companies — was under the Securities and Exchange Board of India’s (SEBI) scanner since as early as April 2010. This particular concern, under the guise of selling land plots, was found to be collecting money from investors, who were largely from lower middle or low income sections.
They could pay from Rs 10,000 to Rs 100,000 for different tenures, and either get land/flats or be refunded along with the benefits laid out in the scheme. The group also had similar schemes in the nature of chit funds.
Although chit funds have now in India become synonymous with ‘cheat funds’, these are well established institutions globally. Rotating Savings and Credit Associations or ROSCA, as they are called, basically offer schemes having a unique property of an in-built loan and saving mechanism.
The auctioning system followed allows borrowers to choose the interest rate they are paid as well. Whether individual borrowers can actually calculate the interest rate altogether is a different question; the reducing balance concept is always amendable to wrong interest rate calculations.
That said, it cannot still, however, be denied that chit funds fulfil crucial needs of relatively unbanked populations. In the Saradha case, the problem was that the company, although claiming to be running a chit fund — governed by more lenient and ‘manageable’ State Government regulations — was actually running a collective investment scheme (CIS). The chit fund route was only meant to circumvent the more stringent regulations governing the latter (that is, SEBI CIS Regulations 1999).
The limited capacity of regulatory authorities to monitor and detect the scope and scale of products — not to speak of lengthy prosecution process — provides very little deterrent to the companies offering them with fraudulent intentions.
Moral hazard
It is worse when governments respond after the fraud gets disclosed in ways that negate the basic philosophy of caveat emptor, which will only accentuate the propensity of firms to float more such schemes in future.
Take the already fiscally-stressed West Bengal Government, which, in response to the political uproar that Saradha has generated, has announced a Rs 500-crore fund to ostensibly protect beleaguered investors. Such an approach can create serious moral hazard problems by encouraging the belief of the government always being there in the worst case situations.
The Government’s approach should, instead, focus more on financial inclusion, which is now confined to just promoting opening of no-frills bank accounts. Unless ordinary people are given access to more banking services, including availing of small credit facilities, scams such as Saradha will keep recurring.
There is also an urgent need to inculcate financial literacy among the lay public, including through dissemination by media (especially vernacular dailies, regional channels, SMS).
Moreover, school curriculum should include, apart from basic mathematics, knowledge about simple financial concepts such as loans, saving accounts, and so on. It is good that the Central Board for Secondary Education and the National Stock Exchange have started a joint certification course in financial markets management for classes XI and XII.
While a separate regulator for CIS and other schemes — as mooted by SEBI’s International Advisory Board — merits serious consideration, equally necessary, though, is to make the current laws and regulations more effective. That, among other things, requires giving more teeth to the regulators.
(The authors are with the Indian Institute of Management, Ranchi.)