Around April this year, when Saradha and some other companies, all with no defined business activities, surfaced for duping about 1.7 million small investors, a similar scam was brewing in Odisha. Within a month, a few Odisha-based companies shut shop after raising deposits from thousands of investors. The two scams, put together, are now set to drain nearly Rs 800 crore as compensation from state exchequers, though the size of the scams could be many times the compensation.
In the last two months, owners of more than five companies across India have been arrested for deceiving investors. Each of the scams was too small in magnitude to attract widespread public attention, but together enough to wipe out a substantial amount of household savings.
Ironically, the number of scams involving small investors is almost commensurate with the number of regulations for investor protection. But with the loopholes in the laws exceeding the number of regulations, opaque financial transactions have found their way into the formal financial system.
Chit Funds
Chit fund, one of the oldest and recognised financial instrument, has been a perennial source of scams, although there are well defined laws under the Chit Funds Act, 1982 to regulate them.
According to the Act, any chit fund company having 20 per cent subscribers domiciled in a certain state, has to be registered in that state. Further, the chit fund companies are required to deposit a sum equivalent to the total chit fund amount in public-owned banks or securities. However, the Act vests the responsibility of framing rules with the state governments.
Until recently, several states bypassed the central Chit Fund Act by not framing rules for enforcing the Act or implementing their own laws governing chit funds.
Two states-Haryana and Jammu & Kashmir- neither had any Act governing chit funds nor did they frame rules to implement the central Act.
"Laying no rules for the Act is as good as having no Act," said S Sivaramakrishnan, General Secretary, All India Association of Chit Funds.
In May 2012, the Supreme Court passed a verdict that only Central Chit Funds Act, 1982, would be applicable to all chit fund firms operating in the country.
The biggest setback from the judgment was to Kerala, where the state government operates one of the biggest chit funds in the country.
However, with Haryana and Jammu & Kashmir not having any law to regulate chit funds, the SC verdict was of little significance. As a result, in the last one year there has been a proliferation of chit fund companies.
While a chit fund can be registered in one state, it can enroll members from any other state in the country.
"Haryana did not come up with any rule even after the SC verdict. So the implementation of the central Act did not take place, and the very purpose of the Act was defeated," said S Sivaramakrishnan.
The association is now planning to move the court with the intention of bringing Haryana under the purview of the central Act.
In 2011, the Union government constituted a key advisory group to amend the Chit Fund Act, 1982, but the amended Act is yet to be framed.
The size of the registered or legal chit fund industry is estimated to be close to Rs 30,000 crore, but the turnover of unregistered chit fund companies is almost 100 times that of the registered chit fund industry, according to Sivaramakrishnan.
Deposit taking Multi-level Marketing Companies
One of the murkiest strata of the dubious finance industry is embedded in the layers of multi-level marketing companies, or companies that work on the principle of chain marketing. The two laws that allow dubious companies to raise public deposits are a) Companies (Acceptance of Deposits) Rules, 1975 b) Collective Investment Schemes (CIS), which fall under the Securities and Exchange Board of India's (Sebi's) purview.
Companies (Acceptance of Deposits) Rules, 1975
The law allowed companies to raise deposits for the purpose of meeting any of its short term requirements for funds under the Companies (Acceptance of Deposits) Rules, 1975.
This allowed several tainted companies, including Saradha, to raise money, often as advances for booking real estate project. A more informal aspect of this tool took the shape of raising money for booking rooms in resorts owned by the firms.
This apart, companies used to raise money from the public by forming small societies that raised money through private placement of debentures, a crude instrument that had its genesis in the rural areas.
Many companies, which used to raise money by way of debentures or shares, offered returns as high as 20 per cent on investment, almost double the rate of interest offered by banks. However, this was not a very popular instrument for raising large scale deposits, as under Section 67 of the Companies Act any issue of preferential shares to more than 50 people would be deemed as a public issue, and require Sebi clearance.
"Most companies that raise deposits through debentures appoint very close relatives as trustees while for the public at large, they are categorised as independent trustees," said Mamata Binani, former chairman, Institute of Company Secretaries of India (ICSI), eastern region.
The recently released Companies (Acceptance of Deposits) Rules, 2013 has laid down stringent rules for raising deposits.
"The rules to raise deposits are very stringent in the new Act. A lot of responsibility has been vested with the debenture trustee. Also, if share application money is kept beyond a particular time period, it would be deemed as deposit,"said Binani.
Collective Investment Schemes
The second way of raising deposits, CIS, is a recognized financial tool to raise deposits. However, none of the companies running such schemes possess a valid certificate from the Sebi.
In the past year alone, the regulator has passed more than four orders against companies running CIS.
However, a long chain of agents of the company collectively act as a shield to protect them from any regulatory clampdown.
Often, when Sebi passes an order against such CIS schemes, agents act as litigants in fighting legal cases against Sebi orders, citing livelihood grounds. In the process, the companies are able to obtain ex-parte stay on Sebi orders at district level courts, which is a major hindrance in curbing the operations of such companies.
Gold schemes
Gold loan schemes are yet another popular, but widely misused instrument for raising public deposits. RBI allows jewellery companies to take advance, which is not treated as a deposit.
"It will amount to acceptance of deposits, if in return for the money received, the jewellery shop promises to return the principal amount along with interest," according to RBI.
In a typical gold jewellery scheme, a gold retailer collects monthly instalments from customers for 12 or 15 months, and offers discount on the gold value of the investments in the form of gold jewellery at the end of the term.
Soon after the Saradha crisis, several Bengal-based tainted companies opened jewellery outlets, through which they could collect deposits.
"Some big jewelers have enough gold to back up purchase advance. However, some jewelers are diverting it into real estate, which might be a cause for trouble," said Cheeran Verghese, chartered accountant .This apart, forming credit cooperative society is another convenient way to raise deposit. According to RBI, co-operative credit societies cannot accept deposits from the public in general.
However, they can accept deposits only from their members within the limit specified in their bye laws.
With so many avenues laid open to raise public deposits, who knows whether another Saradha is in the making?
