Sleight of Hand

Dipak Mondal/Money Today        Print Edition: March 2012

Retail investors, who are scared of equity market volatility but not satisfied with returns from bank fixed deposits, often fall prey to dubious schemes that promise them the moon.

The greed to make 'easy' money is so intense it sometimes overpowers their financial wisdom. They get attracted to flashy schemes , promises of impossible returns and weird business models of little-known companies.

SPECIAL:The battle against corporate fraud


Stock market scams involving the likes of Harshad Mehta and Ketan Parekh in the past explain investors' disillusionment with the stock market, but their vulnerability to Ponzi schemes despite reporting of numerous such frauds regularly remains inexplicable. Call it victory of 'greed' over good sense!

We take a look at the most recent investment frauds committed in India, give a low-down on the modus operandi of the perpetrators and draw lessons for investors . In the end, let's face it-there's no easy money; wealth creation is a long-term process that needs time and patience and requires the investor to be vigilant all the time.

Now, consider this: Promoters of a little-known company in Jaipur promised 27 times return to investors in 18 months, mopped up over Rs 200 crore and then made off with the money, leaving close to 200,000 people in the lurch. The company, Gold Sukh, was a multi-level marketing (MLM) company which told investors that their money would be invested in gold. More than the business model, investors were lured by the promise of stellar returns. The Rajasthan police caught one of the fleeing directors of Gold Sukh, Narendra Singh, at the Indira Gandhi International Airport in New Delhi on January 30.

REGULATORY JURISDICTION
  • Any company desirous of engaging in any business must register itself under the Companies Act, 1956.
  • The Reserve Bank of India, or RBI, regulates non-banking finance companies, or NBFCs. These include loan companies, investment companies, asset finance companies and residuary non-banking companies.
  • The Securities and Exchange Board of India, or Sebi, regulates listed companies, mutual funds and collective investment schemes (CIS). A CIS invests money pooled from investors in plantation and real estate ventures.
DEPOSIT NORMS FOR FIRMS
  • Companies should not accept or renew deposits which are repayable after less than six months and more than 36 months
  • They cannot offer interest that is more than the approved rate, which may change from time to time (it is 12.5 per cent at present).
  • They cannot pay agents brokerage of more than 1 per cent on deposits for one year, 1.5 per cent for one-two years and 2 per cent for two-three years
  • Companies which have defaulted on payment of principal or interest in earlier schemes cannot accept/renew deposits.
RULES FOR NBFCs
  • An NBFC must be registered with the RBI and have specific authorisation to accept deposits from the public.
  • NBFCs which accept deposits should have at least an investment grade credit rating from an approved rating agency
  • NBFCs cannot offer an interest rate that is more than that approved by the RBI from time to time (which is 12 per cent at present).
  • NBFCs cannot accept deposit for a period less than 12 months and more than 60 months
A simple calculation shows that you need 800 per cent annual return to grow your investment 27 times in 18 months. The price of gold, in which the company was supposed to invest, has grown at an annual average rate of 23.5 per cent in the past five years. At the present average bank fixed deposit rate of 9 per cent, your investment will take over 38 years to grow 27 times.

Who won't fall prey to such an offer? Many did, and lost all their savings.

This is not an isolated case. Everyday we hear about fraudsters using complex schemes and false promises to dupe investors. Take Abhinav Gold, a Bhilwara-based company which promised to pay investors Rs 1.72 lakh after two years on an investment of Rs 6,000. It duped 20,000 investors in Surat, Gujarat.

Then there was Speak Asia, a Singapore-based company which promised Rs 4,000 monthly payout on an investment of Rs 11,000. The company claimed it did online surveys for big companies such as ICICI Bank and State Bank of India. It managed to collect Rs 2,500 crore in less than two years before the authorities nabbed the company brass in India. Hundreds of investors could not even recover their initial investment.

Another such scheme was floated by Mumbai-based City Limousine (India). The company promised investors Rs 4,000 every month for five years if they made an initial investment of Rs 97,000.

The scheme, launched in 2002, was supposed to invest the money collected to buy cars that were to be run as taxis. The post-dated cheques for monthly payouts that the company had issued started getting dishonoured in 2007.

If you think only small investors fall prey to such frauds, you are wrong. Think of the 30-odd high net worth individuals fleeced by a relationship manager of Citibank. The manager promised clients 2-3 per cent returns every month.

He even produced fake bank statements and forged circulars issued by the Securities and Exchange Board of India, or Sebi, to show that the scheme had the approval of the market regulator.

The money that he collected was routed to bank accounts of his family members. He managed to hoodwink the system and cheat investors of over Rs 300 crore.

One of his victims was Sanjeev Aggarwal, a co-founder of Daksh, a business process outsourcing company, and Helion Advisors, a venture capital fund. He filed a complaint with the police alleging 'systemic failure' within Citibank after losing Rs 33 crore.

Charles Ponzi
What is a Ponzi Scheme?
It's a scheme in which investors are paid from money collected from new investors instead of the scheme's earnings. It works as long as new investors keep coming in.

Ponzi schemes are named after Charles Ponzi, an Italian who conned investors in the US and Canada. He promised clients a 50 per cent profit in 45 days by buying discounted postal reply coupons in other countries and redeeming them at face value in the US as a form of arbitrage.

Postal reply coupons were used by people in one country to send to a correspondent in another country, who could use them to pay for the postage for reply. These were priced at the cost of postage in the country of purchase but could be exchanged for stamps to cover the cost of postage in the country where redeemed; if these values were different, there was a profit to be made.

Ponzi claimed a net profit of 400 per cent could be made. In reality, however, the cost of transactions was higher than the profit to be made. Ponzi, though, continued to pay the promised returns to investors through money collected from new investors. His scheme caused investors a loss of $20 million in 1920.

MODUS OPERANDI

A number of such schemes, termed as Ponzi or pyramid schemes, have been busted by the authorities in recent years. However, the worrying part is that many more may still be in operation.

The way these scammers operate is strikingly similar-assure high returns to investors, offer to pay in instalments, and pay the first few instalments as promised so that more investors are attracted through word-of-mouth publicity. For instance, the Citibank manager did give 20 per cent annual returns to some investors before he was busted.

Most Ponzi schemes operate under the guise of multi-level marketing (MLM) or plantation company. Some entities are registered as companies under the Companies Act, some even flaunt an ISO certification, but in most cases they do not have the approval to collect deposits from the public.

They market their schemes aggressively, mostly in rural and semi-rural areas, where awareness levels are low. They also use a network of agents, who are offered high commissions.

What is MLM?
Multi-level marketing, or MLM, is a direct sales strategy under which the agent is compensated for not only selling products of the company but also recruiting new salespersons under him. This creates a hierarchy of salespersons, who sell directly to end-users. These ventures are also known as pyramid schemes.

In the absence of clear definition of direct sales or multi-level marketing and comprehensive rules, many fraudulent companies have been running pyramid schemes in the garb of MLM.

According to the Indian Direct Selling Association (IDSA), a body of direct selling companies in India, in a typical pyramid scheme, people at the bottom of the pyramid pay money to a few people at the top.

"In a fraud MLM scheme, the focus is not on products that you sell but the number of members you recruit," says Chavi Hemanth, secretary general, IDSA.

REGULATORY HELPLESSNESS
In spite of regulatory oversight, MLM and plantation companies have been blatantly violating norms for mobilising public money. Their network is so widespread that the authorities have been finding it difficult to control their activities.

A big handicap for the authorities is lack of clarity on jurisdiction over MLM companies. Neither Sebi nor the Reserve Bank of India (RBI) regulates these schemes.

Chavi Hemanth, secretary general, Indian Direct Selling Association, says multiplicity of regulators and lack of comprehensive rules for direct selling companies have been making it difficult to check the growth of fraudulent entities operating as MLM companies. The Prize Chits and Money Circulation (Banning) Act, 1978, is one law that is often used to curb the proliferation of such schemes. The law prohibits promotion of and participation in any money circulation scheme. Hemanth, however, says it is not sufficient to check MLM frauds.

The RBI and Sebi regularly issue public notices and warnings about such schemes and companies. In a July 2011 notice, the RBI observed, "Certain firms posing as MLM agencies for consumer goods and services have been mobilising large deposits from the public (with promise of high return) by opening accounts at various bank branches. These funds, running into crores of rupees, were being pooled at the principal accounts of the firms and eventually flowing out of the accounts for purposes appearing illegal or highly risky."

The RBI has also asked banks to be more vigilant "while opening agency accounts in the name of proprietary concerns".

A 1998 Sebi committee on plantation companies headed by Dr S A Dave observed that "Invariably, all the (plantation) schemes have assured or indicated high yields (in the region of 18-30 per cent) per annum on investments. These yields have been worked out on the basis of projected growth and price of the plantations. These estimates vary from company to company and scheme to scheme. The projected yield estimates have been disputed by forestry experts, who have concluded that the yields promised by many of these schemes are optimistic and not achievable."

It further noted that "quite often the schemes come up with novel products, for which there is no ready market to compare the forecasts. The promise of returns higher than any conventional debt instrument is a
major attraction for investors."

Despite the similarity in the way these schemes are run and despite warnings from the authorities and reports of these schemes conning investors, people have been too easily succumbing to the high 'guaranteed' return sales pitch.

Lack of awareness makes people gullible. It is important for them to see the red flags when approached with an investment option that's too good to be true.

Here we discuss points common to most investment frauds and signs investors must always be on the lookout for to avoid getting caught in a trap.

Abnormally high 'guaranteed' returns: First, let's face the truth. Returns are directly proportional to risk, that is, the higher the return, the higher is the risk. So, there are no 'guaranteed' high return products. If any scheme promises you abnormally (say 40-50 per cent every year) high returns consistently, it's the first sign of an investment fraud in the making.

Abhinav Gold promised to return investors Rs 1.72 lakh after two years on an initial investment of Rs 6,000. That's 28 times in two years. Gold Sukh promised 27 times return in 18 months; City Limousine promised a 48 per cent return every year for five years. In the Citibank case, the relationship manager promised 2-3 per cent every month, or 24-36 per cent a year.

It's not that one cannot get 24-30 per cent returns from stocks or equity mutual funds. One can. But they will not be consistent. Equity investments are highly volatile.

High initial investment: Usually, in a Ponzi scheme, the initial investment demanded from investors is high. The reason is that the company has no independent source of income and uses this money for day-to-day operations, to pay for promoters' profits and give the returns promised to investors.

City Limousine sought an initial investment of Rs 97,000, Speak Asia demanded Rs 11,000 per account, while Gold Sukh, under three investment plans, sought deposits of Rs 23,000, Rs 1.2 lakh and Rs 6 lakh, respectively.

Neeta Potnis, senior director, Deloitte Touche Tohmatsu India, says, "While organisers of such fraud schemes divert the money received from investors for personal gains, a part of the money received from new members is distributed to the old members as return on investment. Such frauds are uncovered when new investments slow and the money flow breaks."

Vague/complicated investment strategy: If the representative of a company approaches you with a lucrative scheme, ask him the investment strategy they plan to follow. If he gives a vague and complicated investment strategy, and you are not convinced with his explanations, it is quite likely you are dealing with a con. As a general rule, most financial experts advise against investing in schemes you do not understand.

"Firms running Ponzi schemes do not divulge their investment strategy. If asked, they use vague financial jargon such as hedge futures trading, high-yield investment programmes and offshore investment to describe their strategy," says Rohit Mahajan, partner and co-head, forensic services, KPMG India.

Speak Asia, for instance, told investors that it would send them eight online surveys every month for which they would be paid Rs 4,000 per month or Rs 500 per survey. It charged Rs 11,000 as registration fee per account.

Unsustainable business model: The company promising you 'incredibly' high returns must have a sound business model. Are you convinced with it? Does it have sustainable cash flow from core operations, whatever they are? If the answer to these two questions is no, or if you are not convinced, walk away.

Often, a company, whether it is a MLM or plantation company, which intends to fleece investors, does not have a sound core business. The cash for operations comes from money put in by investors.

City Limousine, which asked investors to deposit Rs 97,000 initially, had said the money collected would be used to buy Maruti vans to be registered in the names of investors. The investors would be paid out of the profit (Rs 4,000/month) from the income generated by renting the vehicles.

Rohit Mahajan of KPMG India says the extent of sources of funds from operations as against deposits received from the public is an important indicator of a company's credibility. "If the proportion of funds from operations is significantly lower, it indicates that public deposits are being used to run the show. New schemes are launched to pay investors in existing schemes," he says.

Offers of exclusivity and paying back of losses: The offer of exclusive and restricted access to a scheme and promise that the agent or advisor would pay from his own pocket if something goes wrong should ring alarm bells. Under no genuine investment scheme will an agent or advisor make such an offer. It is typical of schemes involving high net worth investors.

For instance, Bernie Madoff, who was found guilty in a $50-billion fraud by the US federal court, offered modest but steady returns to an 'exclusive' clientele.

FRAUD COMPANY
  • Sells cheap and low-quality products
  • Entry cost high
  • Easy earnings, mostly depend on the number of new recruits
  • Commissions come from new recruits; negligible payout by companies
  • No refund or exit policy
GENUINE COMPANY
  • Sells quality products
  • Entry cost reasonable
  • Earnings are performance-based
  • Remuneration comes from the company
  • Members can exit as and when they want.

STEPS TO FOLLOW
To begin with, an investor must check his greed, says the head of portfolio management of a fund house.

While we agree with what he says, we also believe that greed is on both sides of the fence. However, investors can avoid becoming victims of others' greed if they do a little due diligence on their own instead of blindly believing advisors or agents.
  • Ask for proper regulatory approvals: Being a registered company or an ISO-certified company does not give an entity permission to mobilise public money. It needs approval from either Sebi or RBI. None of the schemes mentioned earlier had approval to raise money from investors.
  • Do not issue cheques in the name of a third party: Issue payment advice only in the name of a bank or an institution and not any individual or third party. Do not issue blank cheques or sign on blank papers.
  • Ask for regular account statements: A genuine investment scheme must provide account statements at regular intervals ' monthly, quarterly, half-yearly or annually. If it isn't doing so, something may be wrong.
  • Match performance with stated investment strategy: The performance of the scheme should be in line with the return promised. If not, ask questions, seek explanations, and if need be, take necessary recourse.
All Ponzi schemes take advantage of people's greed. They continue to capitalise on this. Investors must understand that there are no short-cuts to earning money. As one of Speak Asia's victims, who lost not only his money but also of 55 others whom he roped in as members says, there is nothing called easy money.

CASE STUDY
Case Study 1
Rohit Kumar
(Chartered Accountant)


THE BAIT: I got to know about the scheme through a friend who put in Rs 50,000 and was earning Rs 25,000 a month. I instantly invested Rs 33,000

I initially paid Rs 33,000 to Speak Asia for three accounts. Whatever I got from the company, I reinvested in it, taking my total investment to Rs 1.20 lakh. I got 55 more people to invest in the scheme.

Lost Rs 20,000

Of the 55 members who invested through me, only 10 could recover half their money. The rest lost all their money.

LESSON LEARNT: There is no such thing as easy money

Case Study 2
Sunil Nayak

THE BAIT:
CityLimousine promised Rs 4,000/month for 5 years and a car on a Rs 1 lakh investment. It used to give 12 cheques at the start of the year

Though I recovered the principal, I did not earn any interest. I asked my family members and office colleagues to invest. My brothers lost Rs 6 lakh since they invested few months before the scam was detected.

Lost Rs 600,000

Is the amount Nayak's brothers lost in the scam, though he himself managed to recover his principal amount

LESSON LEARNT: Never fall for such schemes. There are better investment options such as bank fixed deposits



THE CAUTIOUS APPROACH
1.Are schemes offering high returns safe?
2.How to save yourself from credit card fraud
3.Saving yourself from stock market scams
4.Tips to save yourself from accounting fraud
5.Fraud plagues Indian banking sector: Survey

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