Chit funds and not Cheat funds ! Weapon of mass destruction

Collective Investment Schemes (Chit funds ) under regulatory scanner in Bengal

This is one investment avenue which is growing at a dangerous level in the villages. One should be very carefuol while dealingwith these. I came across a good article on this , which one should know  (by Namrata Acharya / Kolkata Dec 23, 2012, in Business Standard )

A few days back, members of the West Bengal assembly practically wrestled on the floor of the House. The reason: an adjournment motion moved on chit funds by the Left Front (LF). The unprecedented scene in the assembly was, however, a culmination of events that go back to the LF rule, when former housing minister Goutam Deb alleged that money was flowing from chit funds into television channels that were being used to defeat the Left.

Political rhetoric apart, concerns over chit funds have been voiced over the last couple of weeks from different quarters. Recently, Reserve Bank of India ( RBI) governor Duvvuri Subbarao said chit fund companies were working under the banner of multi-level marketing (MLM) companies, but the onus of regulating them was with the state government. The Securities and Exchange Board of India( Sebi) has also taken a stern view, cautioning investors against collective investment schemes of some companies.

Multi-level marketing companies

Small investments, which have been a big concern for regulators, have their roots in MLM companies, which work in the principle of “referral marketing”, where one salesperson is not only compensated for selling a product, but also for roping in other salespersons. Most MLM schemes are in the business of agro products and real estate in West Bengal. These companies offer financial instruments like secured debentures, bonds and even limited liability schemes, under which they offer partnership to investors in real estate projects. The returns assured to investors under these instruments vary from 20-50 per cent in a two-to-three-year time frame.

All these schemes are collectively referred to as collective investment schemes (CIS), a financial instrument recognised by Sebi since the 1990s. During the late 1990s when the government noticed that certain entities were operating in the securities markets, who issued instruments against investments such as agro and plantation bonds by offering very high rates of return, the government decided to bring them under the vigil of Sebi under the CIS category.

The rule made all CIS operators to get registration certificate from Sebi to float new schemes and operate the existing ones. While there is no authentic data in the public domain to ascertain the amount of money raised through CIS schemes, that West Bengal has become a melting pot for most of them is no secret. According to Surya Kanta Mishra, leader of the Opposition in the West Bengal assembly, a few chit funds have raised about Rs 15,000 crore to Rs 16,000 crore from small investors over the past few years.

Financial instruments floated by companies to raise money include instruments like Potato Bonds, which offer assured returns to investors between 20-50 per cent in 15 months, according to a company salesperson. The company that has floated the bond is in the business of agro-products, and exports potatoes to south-east countries.

The payments to the investors are made from the repayments it gets from exports. Another agro-based company, in the business of seed exports, has been offering an assured 40 per cent return for investments in its secured debentures.

Potato, and seed bonds apart, there are teak, plantation, agro and even donation bonds doing the rounds in the market.

Under regulator's glare

The risks which CIS schemes carry stem from the huge asset-liability mismatch. Most companies raising money through CIS are in the business of real estate and media, that have a long gestation period. Thus, the repayments are from fresh deposits.

According to the rating rationale of I CRA: “Such schemes are extremely speculative. The rating revision takes into account (the company's) substantial debt repayment obligations over the short to medium term, which is likely to result in significant cash flow mismatches for the company.” Thus, most debt obligations by the company are being met by fresh debt, which makes the investment a high risk one.

“Sebi cannot remain a silent spectator in the case,” notes the markets regulator in one of its orders. Last December, RBI initiated action against two companies for raising public money without approval. “No registration certificate has been given to any CIS scheme. Prosecution process is on in some cases,” said a Sebi official based in Kolkata, requesting anonymity.

Added the managing director of the company against whom the Sebi notice was issued: “We have all the necessary documents to raise deposits.”

Chit Funds and CIS

Apart from CIS schemes, unregistered chit funds are another source of worry for regulators, even though the mode of operation of the two are entirely different. In September 2011, Somen Mitra, a Trinamool Congress MP, had written to Prime Minister Manmohan Singh, saying: “Chit funds are collecting deposits mostly from the guileless rural and semi urban public, unrestrained by any regulatory administrative mechanism, luring them with the promise of sky-high return.”

By promising as high as 200 per cent return to investors in one or two years, several unregistered companies have been siphoning off money in rural areas. Chit funds are regulated by the state government under the Money Circulation Banning Act. But there are enforcement issues in West Bengal, which keep such companies operating in the state, according to B P Kanungo, regional director--West Bengal, Sikkim and Andaman and Nicobar Islands, RBI.

However, the chit fund association has been irked by clubbing registered chit funds with flimsy investment schemes. “Here (under MLM mode), most commonly, the salespeople are expected to sell products directly to consumers by means of relationship referrals and word of mouth marketing. The only problem as far as we are concerned in this context is that they are not conventional chit companies registered under Chit Act 1982. They are mostly residuary non-banking financial institutions. Due to lack of awareness, our image is getting spoiled,” said T S Sivaramakrishnan, general secretary, All Indian Association of Chit Funds (AIACF).

In spite of regulations

In spite of regulatory supervision, MLM companies have been operating unabashed. According to a senior RBI official, there are legal loopholes which allow companies to raise money, skipping regulations.

Most of these companies have been raising money from the public as advances. According to Companies (Acceptance of Deposits) Rules, 1975, companies can raise deposits as advances, but the period of repayment cannot be less than six months or more than 36 months. According to an RBI official, most MLM companies have been resorting to this clause to raise funds from the public, but not many stick to the clause of repayment timeline. “Also, such companies prefer to drag the matter to court so that they can continue raising funds until a judgment is arrived at,” explained the RBI official.

Another mode of raising funds by MLM companies is through secured debentures. These instrument offers as high as 40 per cent return in one or two years. However, most of the underlying securities in the debentures are overvalued, and thus in case a company fails to repay the money in time, an investor is left with an asset value, much lower than the actual investment.

source : http://www.business-standard.com/india/news/collective-investment-schemes-under-regulatory-scanner-in-bengal/496480/