Home Cover Story Exploiting the loopholes
Cover Story

Exploiting the loopholes

Whenever there is a scam, the government and regulators realise the need to plug loopholes in the law. But, after a lull, unscrupulous operators are back in business, promising the moon, and investors again fall prey to them. The regulators too look the other way until another scandal comes along

The Reserve Bank of India headquarters in New Delhi

From big sharks to small fish, the Indian financial system is a haven for conmen and swindlers. All kinds of individuals, structured associations or groups, unorganised, unregulated companies, ponzi operators, Unincorporated Bodies (UIBs), Multi-Level Marketing (MLM) firms, Non-Banking Non-Financial Companies, Non-Banking Financial Companies (NBFC), Residuary Non-Banking Companies (RNBC) like Peerless and Sahara India Financial Corporation Ltd, Collective Investment Schemes (CIS), chit fund companies, Nidhi companies, insurance companies, stockbroking companies and mutual benefit, merchant banking, and money circulation schemes are here to make a fortune. Anyone who gets the opportunity exploits the loopholes in the system and makes a mockery of the law by attracting unauthorised investments in cash, time share, gold, bullion deposits or commodity trading.

The crux of the problem is that there is no single regulator for the entire spectrum of investment schemes by NBFCs, banks and companies. These are governed by different laws and regulations, leading to regulatory loopholes. The existence of multiple laws and agencies, lack of clearly defined areas of responsibility and coordination gaps between regulators like the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI), the Ministry of Corporate Affairs and State governments only help those trying to take advantage of the financial system.

“What India lacks is an effective early warning system for detection of corporate and financial fraud,” says a financial crime expert in the CBI, who has been involved in solving many such cases. The fact that a large number of transactions are in cash leaves no money trail or conclusive evidence to say how the money was paid and for what purpose. Poor penetration of banking services makes the job of unscrupulous operators easy.

Taking full advantage of this are companies which, on the face of it, can broadly be classified as legitimate but are transacting illegitimate businesses. Then there are bogus or unregistered and unmonitored fly-by-night operators. There are many instances where such operators have disappeared with huge amounts of depositors’ money, leaving small investors in a financial soup. Many of them were promising returns of up to 500 per cent whereas, as per the RBI Act, the maximum interest rate that an NBFC can pay should not exceed 12.5 per cent.

To escape being scrutinised by the RBI, many companies claim that the financial aspects are just a small part of their principal business operations in agriculture, industry, sale/purchase of goods, services or real estate.

Many of the chit funds, Nidhi companies, mutual benefit, merchant banking and stockbroking companies seem to be enjoying a regulatory holiday. Not only exempt from registration, they also do not have to maintain liquid assets and statutory reserves. There is a lot of ambiguity between direct marketing, NBFCs, ponzi funds, CIS, money circulation schemes, MLM companies, para banking services and chit fund companies. For instance, Saradha was, strictly speaking, not a chit fund company. It was registered as commercial and industrial enterprises with the Registrar of Companies (RoC).

Genuine chit fund companies need to deposit 100 per cent value of the “pot” with the Registrar of Chits prior to the commencement of the chit scheme. To avoid this, many small funds do not register themselves. This is the reason why unorganised chit funds are rampant in the country. As per industry estimates, chit funds is a Rs. 35,000-crore business, growing by 12-15 per cent annually in India. The share of unregistered funds is 80-90 times that of registered funds. While statistics available with the Ministry of Corporate Affairs lists some 5,412 chit fund companies, in reality four times the number over 20,000 chit fund firms are operating in West Bengal, Uttarakhand, Uttar Pradesh, Tamil Nadu, Rajasthan, Puducherry, Kerala, Karnataka, Jharkhand, Haryana, Delhi, Andhra Pradesh, Maharashtra, Punjab, Odisha and Himachal Pradesh. Three states Kerala, Karnataka and Tamil Nadu—have the maximum number of chit fund companies. Kerala is said to have around 5,000 such companies providing employment to over 70,000 persons directly or indirectly. Thrissur district, once called ‘banking town’, alone accounts for 3,000 chit companies.

Apart from this, some 87 MLM companies are under the central intelligence radar. Seven of them are being probed for major frauds. Almost 95 per cent of the MLM companies in India shut down within three to five months of incorporation and less than 1 per cent survive beyond the first year. Money circulation, multi-level marketing, chain marketing or ponzi schemes promise quick money to members, but their income does not come as much from sale of products from enrolling more members. Any break in the chain leads to the collapse of the pyramid. The members at the base of the pyramid earn the least and suffer the most. MLM companies are easy to start, but very difficult to manage and run profitably.

In Odisha, many have been duped by money circulation schemes with a multilayered structure, or network of subscribers, enrolling one or more subscribers to receive direct or indirect benefit from the enrolment. Money circulation schemes are classified as an offence under the Prize Chits and Money Circulation Schemes (Banning) Act, 1978, which states, “No individual or firm or business association, in any form, shall promote, run, or participate in the money circulation scheme, including earning commissions through sale of products.” Some other glaring lacunae and examples of weak and improper investor protection laws governing chit funds are:

• The Chit Funds Act, 1982, does not extend to Jammu & Kashmir, which is becoming an attractive destination to start a bogus chit fund company.
• Chit fund companies can collect subscriptions up to 10 times their net worth.
• Chit funds are legally allowed to conduct bids even when just two members in a group are present.
• Unlike banking, where the Deposit Insurance and Credit Guarantee Corporation pays insurance on deposits up to Rs. 1 lakh in case a bank fails, there is no such thing as investor protection or settlement guarantee fund to protect investors’ interests.
• Many investors are not aware of the risks in the financial market and thus get taken in by promises of higher returns “than the market”.
• Chit funds are susceptible to frauds like:
• A foreman/fund manager disappears with the corpus amount
• A member defaults in instalment payment, or disappears after winning the bid
• Discount rate might be rigged
• There is very little scope of recovery in case of a scam.

As a result of these loopholes, many scams have been reported from West Bengal, Maharashtra, Madhya Pradesh, Sikkim and Assam. Gurgaon-based Beetal Livestock & Farm was said to be promising a return of 2 per cent per month to investors from rearing goats. When SEBI suspected foul play and issued a showcause notice to the company, it returned undelivered. Other chit fund companies like Chakra Infrastructure, Icore E Service, MPS Group, Prayag Group, Rose Valley Group, Tower Infotech, Vibgyor Group, URO Group and Saradha Group were said to be involved in ponzi or MLM schemes. Sunshine India Land Developers, Icore E-services, Rose Valley Real Estate & Construction and their subsidiaries were also known to be diverting funds.

The SEBI Bhavan

While the housing finance companies are regulated by National Housing Bank, insurance companies by IRDA, stockbroking, merchant banking, venture capitalists, CIS and mutual funds by SEBI, Nidhi companies by the Ministry of Corporate Affairs, the chit fund companies have no specific all-India regulatory body and are the responsibility of the respective State governments. Surprisingly, even the housing finance companies are outside RBI regulations. They can directly or indirectly raise funds, promising unrealistic rates of returns. Simply by playing with words or changing the nomenclature, many ponzi funds masquerade as NBFCs, chit funds or CIS, or get stay orders whenever it suits them.

The crux of the problem is that there is no single regulator for the entire spectrum of investment schemes by NBFCs, banks and companies. These are governed by different laws and regulations, leading to regulatory loopholes.

As per law, NBFCs or chit fund companies are required to register, get a licence and present their accounts to the district administration before commencing operation. Chit funds classified as CIS have to get themselves registered with SEBI if they raise public money. However, most companies evade this provision by showing that they are raising public money for real estate or manufacturing outside the purview of SEBI.

CIS do not fall under the regulatory purview of the RBI, which is supposed to regulate and supervise only those companies which are engaged in financial activities as their principal business. Ironically, the term ‘principal business’ is not defined by the RBI Act. According to RBI, only companies predominantly engaged in financial activity need to get registered, regulated and supervised by it. For a company to be engaged in financial activity as its principal business, the company’s financial assets should be more than 50 per cent of the total assets and income from financial assets should also be more than 50 per cent of the gross income. If so, it has to register as NBFC with the RBI.

Exploiting this loophole and to escape being scrutinised by the RBI, many companies claim that the financial aspects are just a small part of their principal business operations in agriculture, industry, sale/purchase of goods, services or real estate. These companies can legitimately claim to be a Non Banking Non Financial Company, which is not an NBFC. It just has to show that its principal business is from non-financial activities. Such companies come under the purview of the RoC of the respective State. A Non-Banking Non-Financial Company that accepts public deposits is governed by the Companies Acceptance of Deposits Rules, 1975. Not all NBFCs, including those registered with the RBI, are entitled to accept deposits from the public. Only banks, co-operative banks and registered NBFCs specifically allowed by the RBI can accept public deposit, that too only to the extent permissible.

Deposits mean monies collected in any manner, other than by way of share capital, contribution of capital by partners of a partnership firm, security deposit, earnest money deposit, advance consideration for purchase of goods, services or construction, loans taken from banks, financial institutions and money lenders and subscription to chit funds. All other amounts, received as loan or in any other form, are treated as deposits. Chit fund subscriptions are specifically excluded from the definition of deposits while chit funds may collect subscriptions, they are prohibited from accepting deposits.

All other entities unincorporated bodies, proprietorships and partnership concerns or association of individuals are prohibited from accepting deposits under the RBI Act 1934 even if they are doing financial business. What this means is that it is not legally permissible for other entities to accept public deposits. In principle, the RBI has not issued any Certificate of Registration (CoR) for acceptance of public deposits to a new NBFC during the last seven years.

Likewise, even prize chits and money circulation schemes are banned under the Prize Chits and Money Circulation Schemes (Banning) Act of 1978. The Act prohibits any person or individual from promoting or conducting any prize chit or money circulation scheme, or enrolling as members of its schemes, or anyone from participating in it by either receiving or remitting any money in pursuance of such chit or scheme.

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