Chit fund fraud

1. COVER STORY
regulation chit funds
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
by NEERAJ MAHAJAN
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 opera-tors,
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, insur-ance
companies, stockbroking com-panies
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
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vol. 8, issue 6 | September 2014
www.gfilesindia.com 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 multi-ple
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 govern-ments
only help those trying to take
advantage of the financial system.
“What India lacks is an effective
early warning system for detection of
The Reserve Bank of India headquarters
in New Delhi

2. MLM companies, para-banking ser-vices
and chit fund companies. For
instance, Saradha was, strictly speak-ing,
not a chit fund company. It was
registered as commercial and indus-trial
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
`35,000-crore business, growing by
12-15 per cent annually in India. The
share of unregistered funds is 80-90
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.
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
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issue 6 | September 2014
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 num-ber
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 legiti-mate
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.
MANY of the chit funds, Nidhi
companies, mutual ben-efit,
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,

3. COVER STORY
regulation chit funds
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 intel-ligence
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 col-lapse
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 net-work
of subscribers, enrolling one or
more subscribers to receive direct or
indirect benefit from the enrolment.
Money circulation schemes are clas-sified
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 pro-mote,
run, or participate in the money
circulation scheme, including earning
commissions through sale of prod-ucts.”
Some other glaring lacunae
and examples of weak and improper
investor protection laws governing
chit funds are:
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not extend to Jammu Kashmir,
which is becoming an attractive
destination to start a bogus chit
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vol. 8, issue 6 | September 2014
www.gfilesindia.com fund company.
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subscriptions up to 10 times their
net worth.
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conduct bids even when just two
members in a group are present.
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Insurance and Credit Guarantee
Corporation pays insurance on
deposits up to `1 lakh in case a
bank fails, there is no such thing as
investor protection or settlement
guarantee fund to protect investors’
interests.
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risks in the financial market and
thus get taken in by promises of
higher returns “than the market”.
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frauds like:
ƒ A foreman/fund manager disap-pears
with the corpus amount
ƒ A member defaults in instalment
payment, or disappears after
winning the bid
ƒ Discount rate might be rigged
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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.
While the housing finance compa-nies
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 out-side
RBI regulations. They can direct-ly
or indirectly raise funds, promising
unrealistic rates of returns. Simply
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.

4. The SEBI Bhavan
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issue 6 | September 2014
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.
As per law, NBFCs or chit fund
companies are required to regis-ter,
get a licence and present their
accounts to the district administra-tion
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 pub-lic
money for real estate or manufac-turing
outside the purview of SEBI.
CIS do not fall under the regula-tory
purview of the RBI, which is sup-posed
to regulate and supervise only
those companies which are engaged
in financial activities as their prin-cipal
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 reg-istered,
regulated and supervised by
it. For a company to be engaged in
financial activity as its principal busi-ness,
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 opera-tions
in agriculture, industry, sale/
purchase of goods, services or real
estate. These companies can legiti-mately
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, includ-ing
those registered with the RBI,
are entitled to accept deposits from
the public. Only banks, co-operative
banks and registered NBFCs specifi-cally
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 con-struction,
loans taken from banks,
financial institutions and money lend-ers
and subscription to chit funds. All
other amounts, received as loan or in
any other form, are treated as depos-its.
Chit fund subscriptions are spe-cifically
excluded from the definition
of deposits—while chit funds may col-lect
subscriptions, they are prohibited
from accepting deposits.
All other entities—unincorporated
bodies, proprietorships and partner-ship
concerns or association of indi-viduals—
are prohibited from accept-ing
deposits under the RBI Act 1934
even if they are doing financial busi-ness.
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. g