Why Amway case is similar to a ponzi scheme

amway-logo111

Vivek Kaul 

William S Pinckney, the chief executive officer of Amway India, was arrested yesterday by the crime branch of Kerala Police along with two other directors of the company.
A report in the Daily News and Analysis (DNA) quotes a top official of Economic Affairs Wing (EOW), Kerala as saying “With the call of easy money, they have been luring people to come and invest. And in turn, the new members had to get more people and this was leading to illegal money circulation. As a result, we had received several complaints against the company and we decided to arrest the officials.”
The company is said to have been violating the Prize Chits and Money Circulation Schemes (Banning) Act. More specifically, Pinckney and the two other directors were arrested in connection with a case filed by a certain Visalakshi of Kozhikode. She claimed to have incurred losses of Rs 3 lakh in trying to sell the products of Amway through its multi-level marketing network.
A report in The Mint quotes P A Valsan of the EOW of Kerala Police as saying “They were charging 10 times the value of their product. For instance, they sold product priced at Rs 340 at anywhere between Rs 2,700 and Rs 3,400…Also, they were involved in money chain, which is prohibited under the Prize Chits and Money Circulation Schemes (Banning) Act 1978.”
So there are multiple reasons behind the arrest. It is for the Police and the Courts to establish whether the products were being sold at many times their price. But the other part about whether Amway is a money circulation scheme or not, needs some discussion.
A money circulation scheme is essentially a Ponzi scheme. A Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns to lure investors in and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
Before we get into a detailed discussion on whether Amway is a Ponzi scheme or not, it is important to understand how Amway and other multi-level marketing(MLM) companies go about their business.
An MLM company like Amway appoints independent distributors to sell its products. Amway sells products like diet supplements, toothpastes, shampoos, multi-purpose liquid cleaners, soaps, grooming products etc. These distributors are not employees of the company. They make money by selling Amway products.
As per the Amway Business Starter Guide there are three ways a distributor can make money. First and foremost he makes what the company calls the retail profit margin. “Distributors buy Amway products at Distributor Acquisition Price (DAP) and may resell products at a retail price, not to exceed the maximum retail price, as published. In this case, the Distributor’s income would be the difference between the DAP and retail price,” the Business Starter Guide points out.
This is the way almost any distributor for any company makes money. He buys goods directly from the company at a certain price and then sells them at a higher price, which cannot be more than the maximum retail price.
The second way a distributor makes money is through what Amway calls the commission on personal purchases. “Distributor may earn commission on the volume of the Distributor’s individual purchases of Amway products during the month,” the Business Starter Guide points out.
The third way a distributor makes money is through earning commissions on group sales. “A Distributor may recruit a sales group and based on the success and productivity (as defined by product sales) of the sales group, a Distributor may earn commissions. It is important to note that a Distributor only earns commissions on the volume of Amway products actually sold,” the Business Starter Guide points out. So a distributor can sponsor other distributors and then make a certain commission on the amount of Amway goods sold by those distributors. The new distributors can appoint more distributors and so the chain grows. The original distributor gets a commission on all the products sold under his chain.
Prima facie this sounds like a perfectly legitimate though not a normal way of doing business. Amway products are not available in shops. If you want them, you have to buy them directly from Amway distributors.
There are many multi-level marketing companies in the market which claim to sell a certain product. These products include gold coins, holiday memberships and so on. These MLM companies appoint distributors who in turn appoint new distributors, with the idea of selling the product of the company.
The catch here is that the product is just a façade. Nobody really interested in selling the product. The money is made by distributors by appointing new distributors who are a charged a certain commission for joining the MLM scheme. The new distributors in turn appoint newer distributors and so the chain continues.
The return to the upper levels comes from creating new levels rather than the sale of the product. The wealth gained by participants at the higher levels is the wealth lost by participants at lower levels. So these MLM schemes are essentially Ponzi schemes where money being brought in by newer distributors is paid off to older distributors. There is no legitimate business activity going on.
The Federal Trade Commission in the United States looked at Amway in the 1970s and tried to answer the question whether Amway was a legitimate business or a Ponzi scheme?  The Commission held that, although Amway had made false and misleading earnings claims when recruiting new distributors the company’s sales plan was not an illegal pyramid scheme (another name for a Ponzi scheme). “Amway differed in several ways from pyramid schemes that the Commission had challenged. It did not charge an up-front “head hunting” or large investment fee from new recruits, nor did it promote “inventory loading” by requiring distributors to buy large volumes of nonreturnable inventory,” said Debra A Valentine, a general counsel for the FTC, in a seminar organised by the International Monetary Fund in May 1998.
So that’s another point in favour of Amway not being a Ponzi scheme.
But there is one thing that we need to understand here. Like in an MLM scheme which is a Ponzi scheme, the business that an Amway distributor does, depends on finding new distributors and then hoping that these new distributors sell Amway products and at the same time are able to appoint newer distributors. If a distributor is successful at this he makes more and more money.
The trouble is that we go along it becomes more difficult to appoint new distributors. Lets t
ry and understand this through an example. Lets say the first distributor that a genuine MLM company appoints, in turn appoints five distributors.
These five distributors now appoint five distributors each. So we now have 25 distributors at the second level. Each of these distributors now in turn appoints 5 distributors.

Table explains the number of distributors.
So we now have 125 distributors at the third level. If the chain continues, at the 12th level we will have around 24.45 crore distributors. This is equal to around 20% of India’s population. The total number of distributors will be around 30.51 crore.
What this simple example tells us is that it is difficult to keep appointing more and more distributors. This is similar to a Ponzi scheme, where for the scheme to keep going more and more newer investors need to keep coming in, so that the older investors whose money is falling due can be paid off. The trouble of course is that that the number of people is not infinite, as the above example shows us.
The problem for Amway distributors (or any other genuine MLM company) entering the game late is that it is difficult for them to sponsor new distributors. It is also difficult for them to sell Amway products given that there are so many distributors already operating in the market and they have selling relationships in place. Also, products sold by MLM companies typically tend to be more expensive than similar products being sold in the open market, making it more difficult to get customers willing to buy.
Hence, even in a legitimate MLM business like Amway, it is important to enter early. Those entering the business at the lower levels, find it difficult to get on new distributors and also end up with a lot of unsold inventory, thus leading to losses.
Amway requires its distributors to buy back unsold inventory from the new distributors that they sponsor. But that is easier said than done.
To conclude, an individual entering a legitimate MLM business at lower levels is likely to face losses and be unsuccessful at it. To that extent, even legitimate MLM businesses are similar to Ponzi schemes, where it is important to enter the scheme early. Also, like Ponzi schemes even legitimate MLM businesses project the prospect of unrealistically high returns while soliciting new distributors.

The article originally appeared on www.firstpost.com on May 28,2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

 

Decoding the great Indian real estate ponzi scheme

India-Real-Estate-MarketVivek Kaul
A headline can sometimes tell you the complete story. The May 20, 2013, Hindi edition of the Business Standard had one such headline. “Intehan ho gayi intezar ki, aayi na kuch khabar ghar bar ki (Its been a long time waiting, and there is still no news of the house),” went the headline.
The headline was a play on the hit Amitabh Bachchan-Kishore Kumar song “
Intehan ho gayi intezar ki, aayi na kuch khabar mere yaar ki (Its been a long time waiting, and there is still no news of my love) ,” from the movie Sharabi.
The story which appeared in the English edition of Business Standard as well with a rather drab headline ‘Supply blues persist in realty sector‘, basically made two points:
a) More and more real estate companies were delaying the promised delivery of homes due to various reasons. As the story pointed out “The year 2013 was projected as the year of delivery for residential projects which had been stuck for years. While developers claim they are on course to supply a large number of units this year, sector watchers doubt it.”
b) This delayed delivery had not stopped real estate companies from announcing and launching new projects. As the story pointed out “Notwithstanding the delays in ongoing projects, a number of real estate companies, including DLF, Unitech, SVP and Supertech, are going ahead with launches, to generate cash flow in a tight market situation.” What this means is that people who have paid for homes continue to wait, whereas the real estate companies continue to launch new projects.
These two points basically tell us very clearly that the Indian real estate sector has degenerated into an out an out Ponzi scheme. A Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns to lure investors in and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
The important point here to remember is that in a Ponzi scheme the money being brought in by newer investors is used to pay off the older investors whose investment needs to be redeemed. Lets apply this in the context of real estate companies and understand why they have become Ponzi schemes.
The real estate companies have offered various reasons for the delay in delivery of homes. “Builders cite several reasons — not getting requisite approvals, slowdown in the market, land acquisition and farmers issues, among other,” the 
Business Standard points out.
Anyone who is not familiar with the way Indian real estate companies work would be surprised at this. You would expect a company to have sorted issues like land acquisition and getting the requisite approvals before a project is launched. If there is no land where will the homes be built? If there are no permissions how is the real estate company going to get around building the homes? And given this why is a project even being launched?
But typically this is not how things work (at least in large parts of Northern India, and particularly in and around Delhi). The real estate company first launches a project, collects money for it, and then gets around to acquiring the land and getting the permissions in place. And once it has raised some money, only then does it finally getting around to building homes. So when a real estate company says that homes have not been delivered due to these reasons, then they are largely true though not fair on those who have bought homes hoping to live in them.
However, that is just a part of the problem. The real estate companies loaded up on debt during the few years running up to 2008. Money back then was cheap and the possibilities of what you could do with it were endless.
Take the case of DLF, India’s largest listed real estate company. It had a net debt of Rs 21,350 crore as on December 31, 2012. Interest needs to be paid on this debt. At the same time this debt needs to be repaid as and when it matures.
But the slowdown in the real estate market due to the high prices has ensured that these companies are not selling enough to be able to repay these debts. In case of DLF, the sales for the period between April 1, 2012 and December 31, 2012, were down by 9% to Rs 6,777 crore.
What has happened because of this is that companies are using money that has been raised for new projects to pay off interest on debt as well as repay debt. Hence, there is no money left to build homes. In this situation, the only way left for the company to raise more money to build homes, is to launch newer projects. It can also hope to raise money from big private money lenders, where the interest can be as high as 3-4% per month. So launching newer projects is an inherently cheaper way of raising money.
So the money lets say raised for Project A is used to pay off interest on debt and repay debt that is maturing. To build homes that have been already sold under Project A, a Project B is launched. This money is now used to build homes for Project A, assuming its not used to meet debt payments. So, this ensures that Project A is delayed. Now to build homes promised under Project B, a Project C is launched. And so the cycle continues.
So money being brought in by investors into Project B is being used to build homes for Project A. Money being brought in by investors into Project C is being used to build homes for Project B. A perfect Ponzi scheme is one where money brought in by the newer investors is used to pay off older investors. In this case money brought in by newer investors is used to build homes for older investors.
The important part here like any Ponzi scheme is that it will keep running as long as the money keeps coming in. And the money will keep coming in as long as people continue to have faith in real estate as a great investment that has given fabulous returns in the past.
This faith is built on various myths. The biggest myth is that India has a huge population and hence a large amount of land will be required to house this population. And land is scarce. As the great American writer Mark Twain once remarked “Buy land, they’re not making it anymore”.
Given this scarcity of land, real estate prices will only go up. The argument though doesn’t quite hold against some basic number crunching. As economist Ajay Shah 
wrote in a recent piece in The Economic Times “Some claim that India has a large population and there is a shortage of land. A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India’s land area assuming an FSI(floor space index) of 1. There is absolutely no shortage of land to house the great Indian population.”
But as they say perception is reality. And given this money keeps coming into the Indian real estate sector. What helps in keeping this perception going is the fact that politicians have their black money invested in the real estate sector and it is in their interest to ensure that real estate prices do not fall.
One way of doing this is having some sort of a control on supply of new homes. The best way to do this is having a low FSI, which ensures that real estate companies cannot build enough to meet demand. As Shah points out “The biggest story about the future of real estate prices in India is the FSI. In most of India, the FSI is below 2. This is an abysmally small number by global standards. All over Asia, FSIs are above 5, going up to 20 or to no limit….A higher FSI results in lower rental rates for households and firms, as was seen in Hyderabad which was a pioneer in FSI reform. When FSI goes up, this will unleash supply on a big scale. As an example, if Bombay(the city is now called Mumbai) moves from an FSI of 1 to 2 — which would still make it worse than the FSI seen anywhere else in Asia — this would trigger off a doubling of supply.”
The other way politicians ensure that real estate prices continue to remain high is by nudging the banks to give newer loans to cash starved real estate companies. As Ajit Dayal 
wrote in a column in 2009 “Their act of giving the loan to real estate developers gives them badly needed cash. The real estate developers no longer need to sell their real estate to get “cash flow” to stay alive.”
If at that point of time banks hadn’t bailed out real estate companies, they would have had to sell homes at lower prices, and real estate prices would have thus come down. And that would have meant lower returns for real estate investors. This would have led to the real estate Ponzi scheme that is in operation breaking down because investors would have had some doubts before parking more money in real estate. But that was not to be.
What is interesting is that loans that banks give to what the Reserve Bank of India calls commercial real estate(i.e. to companies and not individuals buying homes) continues to grow at a much faster rate than overall bank lending.
Given these reasons, real estate companies will continue to launch new projects and delivery of homes will continue to be delayed.
The article appeared originally on www.firstpost.com on May 22, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 
 

Of Subbarao, inflation, gold and Saradha scam

Subbarao
 
 
Central bank governors rarely indulge in any plain speak. You have to always read between the lines to understand what they are really saying. They never say what they mean. And they never mean what they say.
But D Subbrarao, the governor of the Reserve Bank of India, indulged in some plain speaking on Wednesday and questioned the logic of the Mamata Banerjee government in West Bengal setting up a Rs 500 crore relief fund to compensate the losses of those people who had invested in deposits raised by the Saradha Group in West Bengal.
A part of this relief fund will be funded by a 10% tax on cigarettes and the rest of the money will be raised through other sources. “If you go back to the West Bengal Saradha scheme, the Chief Minister said ‘I will levy additional taxes on cigarettes and some other things to compensate the people who have lost money’ … Is it fair?” Subbarao asked.
Why should people who smoke fund those whose money has gone up in smoke, is a reasonable question to ask. It is like robbing Peter to pay Paul.
Subbarao also dwelled into why Ponzi schemes like Saradha have become fairly popular. “The reason it (the Ponzi schemes) is happening because ordinary people… the low income people are not sufficiently aware of where they can put their money. They don’t have enough avenues to put their money. They can’t get into the banks like we all do. They face both formal and informal barriers…So they fall prey to these fraudulent schemes,” Subbarao explained.
This is an explanation similar to the one his deputy
K C Chakrabarty had come up with a few days back when he said: “The need of the hour is to ensure that our unbanked population gains access to formal sources of finance, their reliance on informal channels and on the shadow banking system subsides and, in the process, consumer exploitation is curbed.”
This is a very one-dimensional explanation of why Ponzi schemes have become so popular in India in the last few years. Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
This writer has explained in the past that lack of a bank in their neighbourhood is not a reason good enough to explain why people invest money in Ponzi schemes. Many of the Ponzi schemes over the last few years have been very popular in urban as well as semi-urban areas, where there are enough number of banks going around. At the same time some of the Ponzi schemes have even needed bank accounts to ensure participate. So saying that people invest in Ponzi schemes because there are not enough banks going around, is not good enough. There are other bigger factors at work.
Ponzi schemes have become a big menace in India over the last few years. There numbers have gone up many times over. While there is no hard data to support the claim, but there is enough anecdotal evidence going around. Be it Speak Asia or Stock Guru or MMM India or Emu Ponzi schemes etc, there has been endless list of Ponzi schemes hitting the market.
This has also been a period of high inflation where interest offered on fixed deposits and postal savings deposits, has been very low or even negative once it is adjusted for inflation. There are other reasons as well why people find fixed deposits and postal savings deposits unattractive.
As Ila Patnaik wrote in a recent column in The Indian Express “Even those who have access often find it unattractive. Interest rates paid to depositors have been pushed down through years of policies of administered interest rates and lack of competition in banking. Regulatory requirements for priority sector lending and holding of government bonds have further resulted in lower returns. The result is low or negative real interest rates for depositors.”
It has been an era where bank fixed deposits have offered around 9% interest before tax when the inflation has been at 10% or more. The returns from post office savings deposits have been even lower than bank fixed deposits. Hence, in the strictest sense of the term, money deposited in banks or post office, has essentially been a losing proposition, given the high inflationary scenario that has prevailed.
And not surprisingly in this situation people have been looking at other investment avenues where there is a prospect of making higher returns. Gold has been one such investment avenue. As the
Economic Survey released by the government in late February this year pointed out “Gold imports are positively correlated with inflation. High inflation reduces the return on other financial instruments… This observation, in line with global trends, is easily explained by the declining real returns on the gamut of financial instruments available to the investor and soaring ones on gold (23.7 per cent annual average return between April 2007 – March 2012 versus 7.3 per cent return on Nifty and 8.2 per cent on savings deposits).”
So money came into gold because there was a prospect of earning a high real return instead of bank and post office deposits where the individual would have actually lost money after adjusting for high inflation.
A similar explanation can be offered for people investing their hard earned money in Ponzi schemes like Saradha. They were looking for a higher return which helped them at least beat the rate of inflation. And this is where Ponzi schemes like Saradha came in. These schemes offered deposits which promised higher returns than bank or post office deposits.
As an article in the Business Standard pointed out “Sen(in reference to Sudipta Sen who ran Saradha) offered fixed deposits, recurring deposits and monthly income schemes. The returns promised were handsome. In fixed deposits, for instance, Sen promised to multiply the principal 1.5 times in two-and-a-half years, 2.5 times in 5 years and 4 times in 7 years. High-value depositors were told they would get a free trip to “Singapur”.”
In case of Saradha, the credibility it had built through its media empire as well as being seen closely aligned to the ruling Trinamool Congress, also helped. The deposits being raised may have even been seen as very safe, by those investing.

The other thing that has happened over the last few years is that household savings have come down. In 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010), savings stood at 25.2% of the gross domestic product (GDP). In 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012) the savings had fallen by nearly three percentage points to 22.3% of the GDP.
This has primarily happened because of high inflation which has pushed up expenditure as a proportion of total income. But incomes haven’t gone up at the same pace. And this has led to a fall in savings.
Given that savings of people have come down, there might be a temptation to invest them in avenues where they thought a higher return could be earned so as to ensure that investment goals continue to be on track, even with a lesser amount of savings being invested. This might have increased people’s appetite for taking on investment risk.
Hence, high inflation may have had a big role to play in people investing their money in Ponzi schemes. And we all know who is to be blamed for that.
Inflation has had Subbarao worried for a while now. “There is an important constituency in the country that is hurt by inflation. Their voice also needs to be heard. It is the responsibility of public policy institutions like the Reserve Bank to go out of our way and listen to silent voices,” the RBI governor said on Wednesday.
To conclude, it is very easy to argue that more Ponzi schemes spread because people people lack access to basic banking. But the reality is a little more complicated than that. As they say, truth is often stranger than fiction.
The article originally appeared on www.firstpost.com on May 9,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

 

Dear KC Chakrabarty, here’s the real reason why people invest in Ponzi shemes

KC-Chakrabarty
Vivek Kaul 
A standard explanation that seems to be emerging about why Ponzi schemes keep occurring in different parts of the country is that India does not have enough banks. And this lack of banks leads people to invest in fraudulent Ponzi schemes.
A Ponzi scheme is a fraudulent investment scheme in which the illusion of high returns is created by taking money being brought in by new investors and passing it on to old investors whose investments are falling due and need to be redeemed.
K C Chakrabarty, the deputy governor, is the latest individual who has jumped onto the more banks equals fewer Ponzi schemes, bandwagon. “The fact that people have to rely on such entities for their saving needs indicates a failure on the part of the formal financial system to reach out to such groups and earn their trust and confidence through a transparent and responsive customer service regime,” Chakrabarty said yesterday.
“The need of the hour is to ensure that our unbanked population gains access to formal sources of finance, their reliance on informal channels and on the shadow banking system subsides and, in the process, consumer exploitation is curbed,” he added.
So what Chakrabarty is effectively saying is that only if people had a bank in their neighbourhood they would have stayed away from a Ponzi scheme like Saradha. While it simple to come to this conclusion which sounds quite logical, the truth is not as simple as it is being made out to be.
Lets consider a few Ponzi schemes that have done the rounds lately. MMM India which promises to double the investment every month, needs prospective investors to have bank accounts. So here is a Ponzi scheme which is using what Chakrabarty calls the ‘formal financial system’ to flourish.
Before that there was the Speak Asia Ponzi scheme. In this scheme investors needed to fill online surveys. Anyone who has access to internet in India is most likely to have access to a bank account as well. So people who invested in Speak Asia, did so because they wanted to not because they had no banks in their locality.
Then there are Ponzi schemes which involve investments in gold coins. People who can buy gold coins won’t have access to a bank account?
Or lets take the case of Emu Ponzi schemes which had become fairly popular in parts of Tamil Nadu. The pioneer among these schemes was Susi Emu Farms. It promised a return of at least Rs 1.44 lakh within two years, after an initial investment of Rs 1.5 lakh had been made. This was the model followed by nearly 100 odd emu Ponzi schemes that popped up after the success of Susi.
Again anyone who has Rs 1.5 lakh to invest in a Ponzi scheme will not have access to a bank? That is rather difficult to believe. As Dhirendra Kumar of Value Research puts it in a recent column“Could it be that all those people who put money into Saradha wouldn’t have done so if they had a bank in their neighbourhood? Very unlikely. A lot of the deposits seem to have come from towns where there would have been banks. Moreover, almost every ponzi scheme that has come to light in the last few years has actually flourished in towns and cities. The investors who fell for StockGuru or the Emu farms or other schemes all had access to legitimate alternatives.”
So what is it that gets people to put their hard earned money into Ponzi schemes rather than deposit it into banks? The simple answer is ‘greed’. We all want high returns from the investments we make. And Ponzi schemes typically offer significantly higher rates of return than other investment options that are available at any point of time.
Having said that ‘higher returns’ are not the only reason that lures people into Ponzi schemes. There are other factors at work, which along with the lure of higher returns, ends up making a deadly cocktail.
Typically people do not like handing over money to someone they do not know. In small towns, people end up investing money into a Ponzi scheme through an agent they happen to know. So even though they have no clue about the company they are investing in, they feel they are doing the right thing because they know the agent.
In the case of Saradha, agents of Peerless General Finance and Investment were used to collect money. Peerless had a good reputation among the people of West Bengal, having been in the business of collecting small savings since 1932. This helped Saradha establish the trust that it needed to, during its initial days of operation.
As a report in The Indian Express points out “The selection of agents, a crucial link in the chain, was done very carefully by Saradha. Those picked were generally ones who wielded influence in their locality and in whom people had confidence.”
What also helps is the fact that agents are paid reasonably high commissions, leading to a higher level of motivation and thus better service. The agents typically come to homes of prospective investors to get them to invest money. So clearly there is better service on offer unlike a bank. There is very little need for documentation ( PAN No, Address proof etc not required) as well, unlike is the case with a bank.
Let us briefly go back to the more banks fewer Ponzi schemes argument. As the Indian Express report cited earlier states “One important reason for chit funds mushrooming(they are really not chit funds, but Ponzi schemes) in West Bengal is the absence of easy access to banks and other financial institutions. According to an estimate of the state Finance Department, of the 37,000 villages in the state, nearly 27,767 have no bank branch.”
While villages may not have access to a bank, they do have access to post offices. And India Post runs many small savings schemes, in which people can deposit money. But in West Bengal people seemed to have stayed away from these schemes. A report published in December 2012, in The Hindu Business Line quotes 
Gautam Deb, a former housing minister as saying “small savings and post office collections in West Bengal during the April-October 2012 period were merely Rs 194 crore, against the targeted amount of Rs 8,370 crore.”
So why did people stay away from the post office schemes and get into Ponzi schemes? For one the returns offered on Ponzi schemes were significantly higher. The second reason obviously is the significantly better level of service that Ponzi schemes offer with agents getting higher commissions.
In fact, there are no commissions on offer for selling post office savings schemes. As Kumar points out in his column “The post office offers excellent schemes with a huge reach in rural and semi-urban areas but can it compete on sales and marketing? In fact, when the government eliminated commissions on PPF and other deposits in post offices in 2011, it effectively eliminated whatever little sales muscle there was.”
The formal financial system thus finds it very difficult to compete with unscrupulous operators like Saradha. It is not easy for it to offer higher commissions as and when it wants to simply because it has got rules and regulations to follow. As Kumar puts it “They (i.e. the Ponzi schemes) spend much more on sales commissions, on offices, keeping politicians happy and getting media coverage because they can just dip into the deposited money for all these expenses. Therefore, even if legitimate financial services are available passively, they won’t be able to compete.”
Another reason why the people of West Bengal fell for Saradha was the fact that the Ponzi scheme came to be very closely associated with Trinamool Congress, the party that rules the state. The ‘formal financial system’ cannot afford to do anything like that.
When we take all these reasons into account it is safe to say that the more banks fewer Ponzi schemes argument doesn’t really work. Even if more banks are established, the banks will not be able to compete with the level of service and commissions that Ponzi schemes can offer. Hence, it is very important that unscrupulous operators who are caught running Ponzi schemes are punished and justice is delivered as soon as possible. This will ensure that anyone who wants to start a Ponzi scheme will think twice before he acts. And that is the best way to protect people from Ponzi schemes.
The article originally appeared on www.firstpost.com on May 3, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 
 

Here’s why Saradha was not a chit fund but a Ponzi scheme

 
Saradha-Group-headquarters-650x430
Vivek Kaul 

Saradha chit fund has been in the news lately for all the wrong reasons. But the question that no one seems to be answering is whether Saradha chit fund was really a chit fund? A little bit of digging tells us that Saradha was nowhere near a chit fund. It was nothing but a Ponzi scheme, where money brought in by new investors was used to pay off the old investors. Before we get into the details, lets first try and understand what exactly is a chit fund.
A chit fund is basically a kitty party with a twist.
Yes, you read it right.
The essential part of any kitty party organised by ‘bored’ housewives across India, other than the eating, drinking and gossiping, is the money that is pooled together. So lets say a kitty has twelve women participating in it, with each one of them putting Rs 5,000 per month. The women meet once a month.
When they pool their money together it works out to a total of Rs 60,000 every month. Twelve names are written on chits of paper. From these twelve chits, one chit is drawn. And the woman whose name is on the chit gets the Rs 60,000 that has been pooled together.
When they meet next month eleven names are written on chits of paper and one chit is drawn. The woman who got the money the first time around is left out because she has already got the money once. The woman whose name is on the chit gets the Rs 60,000 that has been pooled together this time around. And so the system works. Every month a chit is drawn and the pooled money is handed over to the woman whose name is on the chit that has been picked.
Of course, the women need to keep paying Rs 5,000 per month, even after they have got Rs 60,000 once. By the time the women meet for the twelfth time everyone who is in on the kitty gets Rs 60,000 once. And that is how a kitty more or less works.

So what is a chit fund?
A chit fund works more or less along similar lines but with a slight twist. Lets assume that the 12 women that we considered earlier come together and decide to contribute Rs 5,000 every month, as they had in the previous case. This means a total of Rs 60,000 will be collected every month. This amount is then auctioned among the 12 members after a minimum discount has been set.
Lets say the minimum discount is set at Rs 5,000. This means the maximum amount any women can get from the total Rs 60,000 collected is Rs 55,000 (Rs 60,000 – Rs 5,000). After this discount bids are invited. All the women bid. One woman bids a discount of Rs 12,000. This is the highest discount that has been bid. And hence, she gets the money.
Since she has agreed on a discount of Rs 12,000, that would mean she would get Rs 48,000 (Rs 60,000 – Rs 12,000). She will also have to bear the organiser charges of around 5% or Rs 3,000 (5% of Rs 60,000). This means she would get Rs 45,000 (Rs 48,000 – Rs 3,000) after deducting the organiser charges.
The discount of Rs 12,000 is basically a profit that the group has made. This is distributed equally among the members, with each one of them getting Rs 1,000. This money that is distributed is referred to as a dividend. Of course the woman who got the money, will have to keep contributing Rs 5,000 every month for the remaining eleven months, like was the case with the kitty.
This is how chit funds works and they are perfectly legal if they are registered under the Chit Funds Act 1982,
a central statute or various state-specific acts.
What if two or more women bid the maximum discount?
It is possible that two or more women in the group are equally desperate for the money and bid the highest discount of Rs 12,000. Who gets the money in this case? In this case there names can be written on chits of paper and one chit can be drawn from those chits. The woman whose name is on the chit drawn, gets the money.
Who do chit funds help?
A chit fundhelps those people who are facing a liquidity crunch and by bidding a higher discount amount they can hope to get the money being accumulated. So in the example taken above the woman gets Rs 45,000 by bidding the highest discount amount of Rs 12,000 and paying charges of Rs 3,000. But her contribution to the chit fund has been only Rs 5,000. So by effectively paying Rs 5,000, she has managed to raise Rs 45,000, which she can spend. Of course she will have to keep paying Rs 5,000 for the remaining eleven months. But by doing that the woman gives herself an opportunity to get a bulk amount once.
The chit fund company typically does not ask what the winner of the amount wants to do with the money. As Margadarsi Chit Fund, one of the largest chit funds in the country
points out on its website The purpose of drawing theprized amount need not be disclosed. It can be used for any need by the member for Example: House construction, Marriage, Education, Expansion of business, buy a Computer or any other purpose at his discretion.”
What kind of returns do chit funds give?
As is clear from the above example, chit funds the way they are structured cannot give fixed returns. The kind of return an individual participating in a chit fund gets depends on the maximum discount that is bid in each of the months. The higher the discount, greater is the dividend that is distributed among the members of the chit fund. In the example taken above the maximum discount bid was Rs 12,000. This meant Rs 1,000 dividend could be distributed among the women who were participating in the chit fund. If the maximum discount bid was Rs 6,000, then a dividend of only Rs 500 would have been distributed.
The returns also depend on the organiser charges. At 5%, the organiser of the chit fund in the example taken would get Rs 3,000 every month. At 3% he would have got Rs 1800 every month. Higher organiser charges mean that there is lesser money to distribute and hence lower returns.
While organiser charges are fixed in advance, the maximum winning discounts are likely to vary from month to month, depending the desperation of the individuals bidding. Given this, there is no way a participant in a chit fund can know in advance the kind of returns he can expect. The same stands true for the organiser of the chit fund as well, who cannot know in advance the kind of returns that a participant is likely to get.
Also even at the end of a chit fund, calculating returns is not easy. There are multiple cashflows. In the example taken above, every month there is an outflow of Rs 5,000 for every women who is a part of the chit fund. There is an inflow of dividend every month, which varies from month to month. One month in the year there is an inflow of the bulk amount that the woman wins because she bids the maximum discount in that month. To calculate the exact return, the internal rate of return formula needs to be used. It is difficult to execute this formula manually and needs access to a software like Excel.
Was Saradha a chit fund?
As we just saw a chit fund cannot declare in advance the return an individual is likely to make, given the way its structured. With Saradha chit fund and its promoter Sudipta Sen, that doesn’t seem to have been the case. Returns were promised to prospective investors in advance.
As an article in the Business Standard points out “Sen offered fixed deposits, recurring deposits and monthly income schemes. The returns promised were handsome. In fixed deposits, for instance, Sen promised to multiply the principal 1.5 times in two-and-a-half years, 2.5 times in 5 years and 4 times in 7 years. High-value depositors were told they would get a free trip to “Singapur”.”
If the principal multiplies four times in seven years it means a return of 22% per year. The question is how can such a high rate of return be promised, when bank fixed deposits are giving a return of 8-10% per year? Also, the fact that a rate of return was promised in advance clearly means that what Sen was running was not a chit fund.
This is proven again
by a recent order brought out by the Securities and Exchange Board of India (Sebi) which is against the realty division of Saradha. As the order points out“The average return offered by the noticee (i.e. Saradha)…when the investor opts for returns were between 12% to 24%.” At the cost of repeating, a chit fund the way its structured cannot declare returns in advance.
So what was Saradha then?
The various investment schemes run by the various divisions of the so called Saradha chit fund, which were raising money from investors in West Bengal and other Eastern states,
can be categorised under what Sebi calls a collective investment scheme. A collective investment scheme(CIS) is defined as “Any scheme or arrangement made or offered by any company under which the contributions, or payments made by the investors, are pooled and utilised with a view to receive profits, income, produce or property, and is managed on behalf of the investors is a CIS. Investors do not have day to day control over the management and operation of such scheme or arrangement.”
Lets take the case of the realty division of the Saradha chit fund which the Business Standard article referred to earlier says was the company most active in collecting money from depositors.” Against the money collected Saradha promised allotment of land or a flat. The investors also had the option of getting their principal and the promised interest back at maturity.
The land or the flat was not allotted to investors and the investors did not have day to day control either over the scheme or over the flat or land for that matter. The money/land/flat came to them only at maturity. Given these reasons Saradha was actually a collective investment scheme as defined by Sebi and not a chit fund.
Where did all the money collected go?
This is a tricky question to answer. But some educated guesses can be made. If the Saradha group was collecting money and promising land or flats against that investment, it should still have those assets? Can’t these assets can be sold and some part of the money due to the people of West Bengal be returned? Media reports seem to suggest that all this was simply a sham and there are no real assets. Saradha was trying to create an illusion and was trying to tell its investors and its agents that this is what we are trying to do with the money we are collecting from you. But there was nothing really that it was doing.
The
Business Standard quotes a Saradha group agents as follows : “We were bemused to see that only three or four people were working at the site which was being developed as a township. Sen said it would take 20 years to develop the projects as the company had so many businesses and it was not possible for him to oversee all of them,” says Abradeep, a Saradha agent.”
Agents were also frequently taken to Sen’s Global Motors factory which had stopped production in 2011. But when agents came visiting, around 150 people posed as workers in an operational motorcycle factory. If the money being raised from depositors was put to actual use, then flats would have been built and motorcycles made and sold.
All this leads this writer to believe that Saradha and Sen were simply rotating money. They were using money brought in by the newer investors to pay off the older investors whose investments had to be redeemed. At the same time they were creating an illusion of a business as well, which really did not exist.
In the end Sen had to ask his agents to rotate money as well. As the
Business Standard points out “Depositors say Sen’s companies were prompt with payments in the first year. Trouble started in January when his employees didn’t get their salaries on time. Then agents were told to make payments for maturities with fresh collections or make adjustment against renewals.” This is what happens in any Ponzi scheme.
So where do chit funds fit into all of this?
Saradha chit fund is not a chit fund. And that seems to be the case with many other so called chit funds in West Bengal. A report in The Asian Age says that there are 73 chit funds running in West Bengal. The question is how many of these funds are genuine chit funds.
What seems to have happened is that a private deposit raising effort from the general public has been labelled as a chit fund. As
Vinod Kothari writes in The Hindu “The West Bengal ‘chit funds’ are not chit funds at all, since these have a different structure. Chit funds are mutual credit groups where money circulates among the group members, and the monthly contributions of the chit members are received in rotation by one of the members who bids for it — much like a ‘kitty’…The several names that keep popping up in West Bengal are Collective Investment Schemes or Public Deposit Schemes.”
Most of these collective investment schemes or public deposit schemes do not have any business model in place. They simply rotate money using money brought in by later investors to pay off earlier investors. They also pay high commission to agents to keep bringing new investors. That keeps the Ponzi scheme going.
And as long as money brought in by later investors is greater than the money that has to be paid to earlier investors, these schemes keep running. The day this equation changes, these so called chit funds go bust. The same happened in case of Saradha chit fund as well.
The article originally appeared on www.firstpost.com on April 30, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek)