This is yet another investment avenue that is infested with blue-collared cheats: chit funds. They do not come under the Securities and Exchange Board of India (Sebi) since they are not mutual funds. Nor do they come under the Reserve Bank of India (RBI) because they are not non banking financial companies.
At the outset, let me point out that the rationale for their existence is excellent and there are a few organisations that are well-managed by hard core professionals who are interested in the motive rather than a quick buck.
The scheme of chits (called kuri in Kerala) originally started as a self-and-mutual-help programme among small farmers. A group of farmers known to one anothe, would periodically give a predetermined quantity of grains to their foreman, in whose integrity they had implicit faith. The foreman, after deducting a reasonable amount for his efforts, would give the bulk of the grains to one member of the group. This was done by rotation, enabling each member to look after his individual needs such as buying land or cattle, building a house and celebrating a marriage. The farmer receiving the bulk quantity would continue to contribute a fixed quantity at every turn, until the last member received his lot.
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In due course, it was realised that those who receive the lot (prize in current terminology) earlier, benefit more. Therefore, members began competing with one another to get their lot early and were prepared to make some sacrifice in terms of discount, which varied depending on the number of competitors and the urgency of individual needs. Auctions were held and the lot was given to the member offering the highest discount, which was distributed as dividend equally amongst all members including the successful bidder. Thus, a member became an investor if he received more discount than he paid. On the other hand, he became a borrower if he paid more discount than he received.
A foremans paradise
Based on the same principle but different intention altogether, the last two decades have witnessed a mushrooming of chit fund companies. The concept has become a means of spinning money for the company rather than a cooperative venture for the participants as a mode of savings and a source of easy credit. In their operations, chit funds have shown many variations, each one adapting itself to the local statutory controls as well as needs of local investors and borrowers.
By ingenious propaganda and publicity campaigns (no expenses spared), the foreman manages to enlist, say, 50 subscriptions at a registration fee of Rs 25 each. Each member pays Rs 1,000 every month for a tenure of 50 months and will receive the lumpsum of Rs 50,000 when he becomes the prized subscriber. He is expected to continue his contribution every month. The foreman lists himself as one of the members and is entitled to 5 per cent commission on the chit amount, which in this case works out at Rs 2,500 per month.
The foreman (its his brainchild after all) is entitled to the first instalment of Rs 50,000. He pockets Rs 1,250 which he has collected by way of registration fees, plus Rs 47,500 by way of the first instalment (Rs 50,000 less his commission). Besides this, he receives Rs 1,500 every month for 50 months as commission (Rs 2,500 less his contribution every month).
The present value of these three components taken together at the modest return of 1 per cent per month (12 per cent a year) works out at Rs 1,08,000. In addition, he also gets the share of the discounts which the other members offer every month in order to be successful bidders.
Though this seems unjust, we must remember that the foreman has to incur promotional expenses and running costs. He is also liable to bear the bad debts. The burden of recovery proceedings has to be borne by him. In view of this, he may be protecting himself a bit overzealously.
The winner loses
But it is rare to find honest promoters dedicated to the principle of cooperation. Often, the foreman instructs a member to make the bidding competitive. Thus, a needy member is forced to offer a high discount to become a successful bidder. (To prevent unhealthy bidding, a ceiling on discount is prescribed in some states.) The foreman does not stop with this, and uses dilatory tactics in paying the prize money. And while the prize winner runs from pillar to post for the money, the foreman sits pretty on it without paying any interest.
When the promoter has harassed the prize winner to the point of breakdown, he uses an ingenious device instead of a direct bribe. He tactfully suggests that the money be invested in a particular finance company, whose fixed deposit receipt will be accepted by the chit company as a satisfactory collateral. The finance company is the one in which the promoter usually has substantial interest. Being a proprietary or partnership company, the RBIs rules for accepting deposits has no jurisdiction over it. Such financial companies accept deposits at a rate marginally over the scheduled bank rates but give loans at substantially higher rates. Clientele is also largely supplied by the chit company.
Punishing defaulting members
Any default by a prized subscriber, even due to temporary financial strains, is severely dealt with. The dividend i.e., the shared discount which is normally awarded to all, is not paid to the defaulting member from the month of default. Thereafter, he is required to pay the full face value of the chit i.e. Rs 1,000 in our example. He is also required to pay about 12 per cent on the promissory note until his default is regularised. The income arising out of the default is pocketed by the foreman.
If the prized subscriber cannot regularise, the security taken from him provides adequate protection to the foreman unless he decides to overlook the aspect as a special favour to privileged clients.
Ironically, the number of such incidents is very high, possibly because such defaults can be used to convert black money into white and vice versa. In many cases, the company insists on security of real property and gets the mortgage under section 69 of the Transfer of Properties Act, under which the lender can bring the property for sale without going to court. The case of a defaulting non-prized subscriber is more pathetic. He will receive the actual value paid by him, less commission (normally 5 per cent) at the end of the term.