Simply put, a 'Ponzi scheme' is a scam investment purposed at cheating investors. It involves persuading the public to invest in fraudulent, seemingly lucrative, schemes. With nearly no real income, these thrive on a consistent progression of new money to survive. When it reaches a point of no new investors, or the existing one's cash out, the scheme collapses. On the face of it, its irrationality is evident. Yet, the threat it has posed in domestic society is undeniable.
Resorting to investment schemes that offer high returns is not uncommon. Undoubtedly, extraordinarily high returns to the tune of 100-120% are red flags. But this continues to remain a deeply ingrained socio-economic problem.1
Charles Ponzi in the early 1920s notably duped thousands of New England residents by having them invest in a certain postage stamp speculation scheme.2 Engaged in an unlawful arbitrage business, he promised 100% returns in 90 days on profits from international reply coupons (these enabled a sender to pre-purchase postage and incorporate it in the correspondence). The plan fell apart in a year and caused a loss north of 20 million dollars to investors.
Such schemes are largely in the form of 'Collective Investment Schemes'. That is, it attracts new investors and uses these investments to repay the existing investors. Repeating this process numerous times, it eventually reaches a stage where it can no longer pay its investors. This is a repetitive process where it reaches a point of incredibly high liability at which point the company disappears.
A fundamental distinction between Ponzi and pyramid schemes is, a Ponzi scheme only has a single "official" promoter. Both of them are fraudulent investment plans with unrealistic returns on capital promised, they thrive on reinvestment of profits and actively encourage it, they depend on new investors to fulfil obligations of the existing ones. Most frustratingly, both are perpetually insolvent.
Pyramid schemes are ordinarily comprised of a few levels through which a product reaches the final consumer. The essential element to a pyramid schemes thus end being the intensive program of recruiting new members for a commission instead of the actual sale to the consumers itself.
Chit funds are legal if registered under the Chit Funds Act, 1982. Here, one enters into an agreement with a few others, accepting a certain sum of money (or grains) for a specified period. On regular collection, certain members received the majority chunk of the collection. The process, based entirely on faith and cooperation repeats till each contributing members receives their share of the prize money.
II. DOMESTIC LEGISLATION
India has a number of legislations that attempt to tackle the problem of Ponzi schemes. There is a tendency of it working out to be a complex network of laws. To that extent, this article attempts at analysing what these laws are and how they function.
A. The Chit Funds Act, 1982
A significant populace is classified in the low-income category. As such, formal banking services are of no avail. Here is where local money lenders stepped up with their exorbitant interest rates. In an otherwise bleak financial rural environment, companies began to offer Ponzi schemes promising high returns, easy processing and borrowing facilities to their investors. These came to be known as chit funds and soon flourished.3 These Non-Banking Financial Companies are based on trust and coordination; they may be carried out by organised financial institutions or through unorganised schemes.
Under this Act, only schemes registered and regulated by the state governments are permitted to function. They are then regulated by the Registrar of Chits as appointed under section 61 of the Chit Funds Act. Once a chit group takes off, it must register itself with the Registrar and a security is to be paid that is withdrawn once the group reaches its end. The Act further mandates an arbitration procedure before the Registrar with powers similar to a civil court under the Code of Civil Procedure, 1908. The Registrar is empowered to attach properties of any party to the dispute and he may further wind up a registered chit if contravening with the Act.
Per the Act, all chit companies are banned from appropriation of the chit collections as well as accepting any deposits. Owing to increased charges on operation, fund operators moved to larger value funds. This then effected the rise of unregistered chit fund operators for the poor. With lucrative and flexible borrowing mechanisms, lack of stringent law, duping investors only became easier.
How does a Chit work?
Section 2(b) of the Act defines a 'Chit' as a transaction by way of which someone enters into an agreement with a certain number of people that the latter subscribe a fixed sum of money (or grain) by way of periodical instalments over a determined period. Each subscriber would then, as determined by lots, auctions, tenders or such, be entitled to the prize amount. Chits compliant with the above definition may be run by the state governments or PSUs, big business houses, and lastly unregistered and unorganised schemes. It is the last which is problematic.
If the valuation of a chit in an unregistered chit fund is greater than INR 100, it is illegal. To flesh out the abovementioned definition, let us assume there is a 'Chit Group' comprising of 12 investors (including a Foreman responsible for auctions, collections and maintaining records) and the group lasts for as many months. The group contributes in definite intervals INR 4000 (Chit amount) for the 12 months accumulating a common fund of INR 48,000 a month. The first month, the Foreman takes the entire amount. For each subsequent month auctions are conducted where the person with the lowest bid is secured the Chit Prize (there is a lower limit, that is, one cannot bid less than a certain percentage of the collected amount). The prize is deduced by deducting a certain percentage of the collected amount from itself. If the percentage is 25%, then the prize money is 75% of INR 48,000 i.e. INR 36,000. The 'Auction Discount' is this deducted 25%, i.e. INR 12,000. Thus, the original collected amount stands divided into the prize money and the auction discount. While the entirety of the prize money goes to the successful bidder, the auction discount goes to the foreman and the rest of the group. A foreman's commission is 5% of the chit amount, i.e. INR 2,400. Thus, the rest of the group is left with INR 12,000 – INR 2,400, i.e. INR 9,600. Thus, each person then gets INR 9,600/10, i.e. INR 960. The process repeats for the remaining 10 months, and the prized member cannot make bids anymore for the duration.
B. Prize Chits and Money Circulation Schemes (Banning) Act, 1978
A predecessor to the prior mentioned Chit Funds Act, this law came about subsequent to a report by a Reserve Bank of India Study Group under the chairmanship of James S. Raj in 1975. The group was of the opinion, prize chit/benefit/savings schemes benefit primarily the promoters and do not serve any social purpose. The Group had found these prejudicial to public interest that affect the efficacy of the fiscal and monetary policies of the country.
Section 2(a) of the PCMCS Act explains 'conventional chit' as a transaction by any name under which a person responsible for the operation of the chit enters into an agreement with a number of persons that each of them would subscribe a certain sum of money (or grain) by periodical instalments through a definite period and each subscriber would receive by way of tender, lot or auction a prize amount. This is not prohibited under the PCMCS Act. What is however banned are 'Prize Chit' and 'Money Circulation Schemes'.
Section 2(c) of the PCMCS Act explains money circulation schemes as those for making quick or easy money, or receipt of any money or valuable thing as consideration for a promise to pay money on any contingency relative or applicable to enrolment of members into the scheme. Section 2(e) of the Act explains prize chits as any transaction under which a foreman collects money and utilises the same or any income arising from it for the purposes of awarding periodically to a specific number of subscribers determined by lot or otherwise, whether or not the prize recipient is liable to make further payments in the scheme. Alternatively, for the purpose of refunding the same to those who haven't won the prize on the termination of scheme or after expiry of any stipulated period.
Section 3 of the Act bans prize chits and MCS and enrolment to these schemes. Sections 4 and 5 are penal provisions. Section 6 entails offences committed by companies. Section 7 empowers a police officer, not below the rank of officer in charge of a police station, to exercise power to enter and search premises and to seize things used for such scheme. Section 8 provides for forfeiture of newspaper and publication containing money circulation scheme. Certain exemptions are assured to state government run bodies amongst others as per Section 11. Section 13 of the PCMCS Act empowers the State governments to make rules on consultation with the RBI.
C. The Companies Act, 2013 & Companies (Acceptance of Deposits) Rules, 2014
The primary focus under the Companies Act, 2013 is from the perspective of corporate frauds. Section 447 defines a corporate fraud including any omission, concealment of any fact or abuse of position submitted by any individual with the aim to deceive, to acquire benefit from, or to harm the interests of the company or its investors or its shareholders, regardless of whether or not there is any wrongful gain or wrongful loss.
The provision further stipulates that the misrepresenting individual is liable for detainment for a period between 6 months and 10 years in addition to a fine. If the fraud relates to public interest, the minimum imprisonment is 3 years.
The Central Government may order investigation into the affairs of a company on receiving a report from the Registrar or inspector; on intimation of a special resolution passed by a company that the affairs of the company ought to be investigated or in public interest.
Serious Fraud Investigation Office
Section 211 of the Act empowers the Central Government to establish a Serious Fraud Investigation Office for the purpose of investigation into company related frauds. For the duration of the SFIO's investigation beginning from assignment of case to the officer, no other parallel investigation may subsist. The SFIO may arrest individuals if it has reason to believe that he is guilty based on the material in possession. SFIO shall submit a report to the Central Government on conclusion of investigation. Central Government may direct SFIO to initiate prosecution against the company. SFIO shall share information they possess regarding a case being investigated by the latter and vice versa.
Auditors and Audit Committee
Auditors shall report material fraud to the Central Government within 30 days. Immaterial fraud shall be reported to the board or the audit of the company. Audit committee is required to monitor that every listed company shall establish a vigil mechanism for directors and employees to report genuine concerns. The vigil mechanism shall provide for adequate safeguards against victimization of persons who use such mechanism.
Companies (Acceptance of Deposits) Rules, 2014
Section 73 and 76 of the Companies Act, 2013 concern deposits and are read with the Companies (Acceptance of Deposits) Rules, 2014.
Per the 2014 Rules, fund raised by an entity with a promise to refund with or without interest at the end of a specified period will be treated as deposits. With the detailed and stringent definition of deposits, operators raising funds through surrogates have been largely suffocated.4
Per the definition clause, eligible companies that do intend to raise public deposits would need to have a minimum net worth of INR 100 crores or a turnover of at least INR 500 crore rupees. Further, the rules include a definition of "deemed deposit" where any scheme that provides returns to investors, whether in cash or kind, is deemed to be a deposit; a gap earlier misused.
D. Securities and Exchange Board of India Act, 1992 & Securities and Exchange Board of India (Collective Investment Scheme) Regulations, 1999
The Securities and Exchange Board of India has so far initiated as many as 567 cases against illegal investment schemes collecting public money.5 These Collective Investment Schemes are defined under Section 11AA of the SEBI Act, 1992. They have been regulated by the Act and the SEBI (CIS) Regulations, 1999.
Collective Investment Scheme
The primary participants in a scheme such as this are, the Collective Investment Management Company, the Fund Manager, trustee, and shareholders. It is an investment scheme whereby numerous individuals come together to pool their money for investing in a particular asset(s) and for sharing the returns arising from that investment pursuant to an agreement.
The constitutional validity of Sec 11AA and Sec 12(1)(b) (no entity is eligible to initiate CIS before registering it with SEBI) has been challenged on the grounds of the excessive delegation and violation of Art. 14 of the Constitution of India. The Supreme Court opined, the disputed provisions were purposed at protecting investor interest and SEBI has sufficient safeguards against an abuse of power. In M/s PGF ltd. Vs Union of India, the court applying the doctrine of pith and substance stated that the Parliament introduced such provision to protect the interest of the investors which is the prime object of the SEBI.
The Securities and Exchange Board of India has however sought to relinquish its powers to regulate Collective Investment Schemes that involved illegitimate pooling of public funds after having failed to bring to a close even a single case.6
The Board has found itself out of its depth in addressing these cases.7 In August 2016, SEBI in response to a concern posed by a bench led by the then Chief Justice of India, T.S. Thakur in a PIL filed by NGO Humanity Salt Lake concerning unauthorised and illegal deposit schemes and CIS, denied any regulatory purview over Ponzi schemes, placing all responsibility of protection of investors on state governments.8 They pointed out, it was the PCMCS Act and respective State government agencies that were responsible.
E. The Banning of Unregulated Deposit Schemes Act, 2019
The Banning of Unregulated Deposit Schemes Act, 2019 or the BUDS Act, was introduced to ban illicit deposit taking schemes. Initially in the form of an Ordinance effective from 21st February 2019, the Act soon replaced it on 31st of July 2019.
The BUDS Act was purposed at curbing all fraudulent, unregulated, deposit schemes. In so doing, it lists certain deposit schemes valid and regulated by MCA, SEBI, RBI, etc., such as certain collective investment schemes, alternative investment funds, portfolio management services, employee benefit schemes, mutual fund schemes, etc. regulated by SEBI; deposits accepted by NBFCs, etc. as regulated by RBI, insurance contracts regulated by IRDAI; schemes or arrangements made or offered by co-operative societies, chit funds, etc. regulated by the relevant State Government or Union Territory Government; housing finance companies regulated by the NHB; pension funds regulated by the PFRDA; pension schemes or insurance schemes framed under the Employees' Provident Fund Miscellaneous Provisions Act, 1952; Deposits accepted or permitted under the provisions of Chapter V of the Companies Act, 2013 regulated by MCA.9 ix]
Section 2(4) of the Act explains, deposits are the amount of money received by way of an advance or loan or in any other form, by any deposit taker with the promise to return whether after a specific period or otherwise, either in cash or in-kind or in the form of the specific service, with or without any benefit in the form of interest, bonus, profit or in any form.
This Act forbids and penalises the acceptance of deposits under any course of action which is not regulated or under ordinary course of business. Penalty is further stipulated on failure to return monies are accepted by way of regulated deposit schemes on maturity of any promised service in lieu of the deposits.
The Act, further provides exceptions to the list of deposits. Section 2(17) explains unregulated deposit schemes as schemes or arrangements under which the deposits are accepted or solicited by any deposit taker in the way of business and is not managed by any sectoral ministry or administrative authority and is not given under the first schedule of the Act.
Broadly, the offences may be—
- Soliciting deposits under the unregulated deposit schemes,
- Acknowledgement of deposits under the unregulated deposit schemes,
- Fraudulent default in registered deposit schemes and
- Unfair instigation in relation to unregulated deposit schemes.
The Act provides for a designated court or authority that is constituted by the Government of India in consultation with the respective Chief Justices of High Courts for matters concerning the Act. It is presided over by a Judge not below the rank of a District or Sessions Judge or an Additional District or Sessions Judge. The Designated Court shall—
- Issue a show cause notice to the deposit taker and any other whose property is attached under the same within 30 days from issue, under Section 14 of the Act.
- Issue a notice to all persons represented to it as having any likely claim to the interest or title in the property attached.
- Prescribe an order releasing a part of attachment or directing the competent authority to sell the property appropriately.
- In case of malafide transferees by the deposit taker, summon the person in question to appear on a given date.
The Designated Court is empowered to—
- Approve the statements and particulars of the dues of the deposit taker from the debtors.
- Evaluate assets of the deposit taker and create a list of the dues.
- Order for full payment to depositors by the competent authority or, proportionate payment in case the fund is insufficient.
- Direct any person who has made a profit or averted loss by indulging in any transaction or activity related to the contradiction of the act, to give out an amount for the wrongful gain made in the same.
Section 20 allows the Supreme Court to transfer the case from one Designated Court to another Designated Court.
As per Section 10 of the Act, every deposit taker is required to intimate the Authority about its business in the prescribed form and manner within 30 days of the commencement of business. While, the explanation to the provision makes it apparent that the condition applies to regulated deposit schemes, the second explanation to the section specifically mentioning companies accepting deposits under the Companies Act, 2013 may be to taken to exempt all other regulated deposit schemes.
F. The Banning of Unregulated Deposit Schemes Rules, 2020
The Central Government is empowered to make rules under Section 37 of the Act by way of notifications for the protection of actions taken in good faith by the competent authorities. Under Section 40, the Central Government is empowered to amend the First Schedule if it considers necessary by the way of notifications and lay it before the two Houses of the Parliament. Similarly, Section 38 empowers the State Legislatures to make rules in consultation with the Central Government for carrying out the functions of the Act.
As a result, the Finance Ministry, on the 12th of February 2020, notified the Banning of Unregulated Deposit Schemes Rules 2020.
The BUDS Rules define the term 'competent authority' as an authority appointed by the appropriate government under Section 7 of the BUDS Act, according to which the Authority has the same powers as vested in a civil court under the Code of Civil Procedure, 1908 (CPC) while conducting investigation or inquiry in respect of offences under the Act.
The Rules provide for:
- Important information to be considered prior to issuing a notice of provisional attachment of deposit takers' properties who contravene the Act. (Rule 3)
- The procedure to be followed by the Competent Authority in relation to provisional attachment of property, its administration and application to the Designated Court to make such attachment absolute. (Rules 4 & 8)
- Data in regard to deposit takers working in India to be maintained by the Central Online Repository in an online database. (Rule 6)
- Full and fair retraction on the part of newspapers and other publications, withdrawing any prior promotion or inducement to any person to join an unregulated deposit scheme. (Rule 11)
a) Provisional Attachment of the Property
The competent authority has the power to provisionally attach the properties of the deposit taker, or any person soliciting deposits for the deposit taker. To that extent, it has the powers of a civil court under the CPC including summoning witnesses and calling for evidence. This order of the competent authority is to be served on the property's proprietor, individual professing to be its owner, or individual who has interest in said property. It is to be published in a leading newspaper having wide circulation. The authority may take possession of both movable and immovable property.
To make the provisional attachment absolute, the Competent Authority must apply to the Designated Court along with the following details:
- Complete list of the property, money or deposits attached.
- In case of immoveable property, the name and particulars of the owner of the property, any person who claims to be in possession of the property, and any other person who has an interest in the said property.
- Record maintained by the Competent Authority in relation to the provisionally attached property.
- List of depositors from whom the deposit taker has accepted or collected deposits.
- List of dues owed to depositors including amounts that may be realised from sale of any attached property of the deposit taker
The Rules also outline procedure to be followed by the Designated Court, and lay down the material to be searched by the officer-in-charge of a police station for investigating into any offence under the BUDS Act.
b) Central Database and Intimation to Repository Authority
As per Section 9 of the Act, the Central Government has the power to designate an authority (existing or already constituted) that shall create, maintain and operate an 'online database' for information on deposit takers operating in India.
- The Repository Authority (RA) maintains & operates an online portal accessible by the public. The portal contains a database which provides (a) list of deposit takers operating in India, extent and areas of their operation; (b) any action taken under any law for the time being in force against any deposit taker for collection of deposits (c) updates regarding proceedings for restitution of depositors.
- Every deposit taker is mandated to intimate the RA, in the Form annexed to the Rules, about its business within 30 days from commencing the business or continuing the business of a deposit taker. The reporting requirements apply to all deposit takers, including those accepting a deposit under a regulated deposit scheme. Companies accepting deposits under the Companies Act, 2013 are also required to comply with the reporting requirement.
- The details to be intimated are (a) name and registered address of the deposit taker; (b) address of branches (if any) of the deposit taker; (c) unique identification number of registration / incorporation; (d) authority to carry on a deposit taking business; (e) name and address of persons responsible for the management of the deposit taker (CEO and directors/ partners, proprietors / board); and (f) permanent account number (PAN) of the deposit taker.
c) Restrictions to Advertising
According to Section 33 of the BUDS Act and Rule 11 of the BUDS Rules, newspapers which have distributed commercials or proclamations inducing deposits as part of an unregulated deposit scheme may be directed to publish a full, fair, and unequivocal retraction, free of cost, within two days from the date of the appropriate government's direction. The retraction is required to be as prominent as the original advertisement.
The Government shall direct the owner of any newspaper or other publication of any nature either in print or in electronic form, to publish a full and fair retraction, unequivocally withdrawing any offer, promotion or inducement made earlier in any advertisement, statement or information to any person to become a member of any Unregulated Deposit Scheme.
While there is legislation to tackle chit funds in India, the growing menace of unregulated and fraud chit funds in India requires easy procedure, transparent and stringent enforcement of laws. The 21st century saw the major Saradha scam, masterminded by Sudipto Sen, that duped more than 10 million Indians. Even after this came the Rose Valley chit fund Ponzi scheme that gained prominence in 2013. Per reports, more than INR 17,000 crores of money came to be duped.
When it comes the BUDS Act and Rules, Section 10 remains shrouded in mystery; whether the specific mentioning of certain companies exempts all other regulated deposit takers from communicating to the authority their business? Placing such requirements on the regulated might be unreasonable and counter-intuitive.
Clarity in the BUDS Rules is needed to sufficiently tackle Ponzi schemes. Especially in relation to the online repository. The database is purposed at detecting the unregulated companies and such purpose must be furthered instead of burdening the compliant, regulated, companies.
With the numerous ways in which Ponzi schemes take form, it may be predictable that there is a multiplicity of legislation. However, the primarily legislation taking charge of the concern, the BUDS Act, is yet to be completely fleshed out in its nuances and it may be interesting to see how Courts interpret the law.
1. Jaideep Verma, Ponzi/Pyramid Schemes and Regulatory Framework in India, Linkedin, (https://www.linkedin.com/pulse/ponzipyramid-schemes-regulatory-framework-india-jaideep-verma/) (last visited Aug. 23, 2021).
2. Ponzi Scheme, Corporate Finance Institute, (https://corporatefinanceinstitute.com/resources/knowledge/other/ponzi-scheme/) (last visited Aug. 30, 2021).
3. Prof Silpy Gupta, Chit Funds as an Indian Saving Scheme: A Conceptual Study, Intl. J. Busi. & Admin. Res. Rev., Vol. 2, Issue 5, April-June, 2014, page 45.
4. Atmadip Ray & Sutanuka Ghosal, New Companies Act may sounds death knell for disguised ponzi plans, Economic Times, (https://economictimes.indiatimes.com/news/economy/finance/new-companies-act-may-sound-death-knell-for-disguised-ponzi-plans/articleshow/33227204.cms?from=mdr) (last visited Aug. 30, 2021).
5. Sebi goes after Ponzi schemes, files 567 cases so far, Economic Times, (https://economictimes.indiatimes.com/sebi-goes-after-ponzi-schemes-files-567-cases-so-far/articleshow/53508762.cms?from=mdr) (last visited Aug. 30, 2021).
6. Sebi plans to give up powers to regulate ponzi schemes, Live Mint, (https://www.livemint.com/Money/YfpU9WxukULhFqs8DgHB0I/Sebi-plans-to-give-up-powers-to-regulate-ponzi-schemes.html) (last visited Aug. 30, 2021).
7. Sebi finds it tough to refund investors in Ponzi schemes, Live Mint, (https://www.livemint.com/Money/m7L8RxBFANq5ijxmxXZDKP/Sebi-finds-it-tough-to-refund-investors-in-Ponzi-schemes.html) (last visited Aug. 30, 2021).
8. Ponzi schemes not under our purview, The Hindu, (https://www.thehindu.com/news/national/Ponzi-schemes-not-under-our-purview-SEBI/article14559017.ece) (last visited Aug. 30, 2021).
9. Timothy Lopes, Regulated deposit takers: Whether need to intimate under BUDS?, Vinod Kothari Consultants, (https://vinodkothari.com/2020/02/regulated-deposit-takers-whether-need-to-intimate-under-buds/) (last visited Aug. 30, 2021).
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