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)
Ponzi Scheme
Another Sahara: How Saradha built a ‘brand’ and duped investors
Vivek Kaul
Sudipta Sen, the man behind the Saradha group, who has been on the run, was finally arrested yesterday in the beautiful alpine valley of Sonamarg in Kashmir. Sen is accused of running a Rs 20,000 crore Ponzi scheme.
A Ponzi scheme is essentially a fraudulent investment scheme where money brought in by the newer investors is used to pay off the older investors. This creates an impression of a successful investment scheme. Of course, as long as money entering the scheme is greater than the money leaving it, all is well. The moment the situation is reversed, the scheme collapses.(For a more detailed and historical treatment of Ponzi schemes click here).
The scheme gets its name from an Italian American called Charles Ponzi who in 1919 ran an investment scheme in the city of Boston, which promised to double the investor’s investment in 90 days. This was later cut to 45 days. At its peak the scheme managed to collect around $40 million and had nearly 15,000 investors.
Ponzi thought he had figured out an arbitrage opportunity which would help him earn stupendous return. In the end he couldn’t execute the arbitrage and started using the money being brought in by newer investors to pay off the older investors whose money needed to be returned.
While every Ponzi scheme is different from another in its details, there are certain key characteristics that almost all Ponzi schemes tend to have. And Saradha was no exception to this.
The rate of return promised is high and is fixed at the time the investor enters the scheme: For an individual to get interested, the returns on offer in a Ponzi scheme need to be higher than the returns he can hope to earn from other modes of investment available at that point of time.
An order issued by the Securities and Exchange Board of India yesterday, explains this point beautifully. This order has asked Saradha Reality, one of the companies being run by the Saradha Group, to wind up operations in three months.
Saradha Reality catered to all kinds of investors. It had had instalment plans with tenure varying from 12 to 60 months where minimum investment was Rs 100 per month. It raised money from investors with contributions ranging from Rs 10,000 to Rs 1 lakh for a tenure of 15 months to 120 months. It also had a lump sum investment scheme (with minimum amount of 1000/- and multiple thereof) with tenure varying from 12 months to 168 months. The rates of interest on offer where different for different investment plans.
At the end of the tenure the investor had the option to get allotment of land or a flat or to simply get a refund of the money he or she had put in, along with the promised interest. And what were the returns on offer? As the Sebi order points out “The average return offered by the noticee (i.e. Saradha), in lieu of the land when the investor opts for returns were between 12% to 24%.”
So clearly the returns being offered by Saradha were higher than the returns on offer through other investment avenues. And most investors seem to have opted for the absolute return option rather than claiming land or a flat at the end of the investment tenure. As the Sebi order points out “As informed by the noticee (i.e. Saradha), not many of investors have opted for allotment of land rather, more investors have opted for the pre-determined returns as promised by it.”
The higher returns clearly got investors to invest in Saradha.
The most important part of a Ponzi Scheme is assuring the investor that their investment is safe.
How did an upstart like Saradha managed to assure investors that their investment would be safe? The story that seems to be coming out is that Saradha employed agents of Peerless General Finance and Investment Co. Ltd. Peerless, formed in 1932 had pioneered the collection of small savings in eastern India, primarily West Bengal. Hence, it had a reasonable reputation among the people of West Bengal.
As The Mint points out “Though it didn’t ever default on repayments, Reserve Bank of India (RBI) forced Peerless to stop taking deposits in 2005-2006. This spawned the growth of unregulated deposit-taking companies in West Bengal and other eastern Indian states.”
Agents of Peerless were used to collect money for the Saradha group. In that way the brand name of Peerless rubbed onto Saradha. The Mint story cited earlier talks about one Debasish Banerjee, who used to work for Peerless and then became the blue eyed boy of Sudipta Sen, and presided ove 10,000 sub-agents working across eight districts in West Bengal.
The instrument in which the scheme will invest appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors. If you go to the website of Saradha Group (http://saradhagroup.com/index.html) you will find that they were in multiple lines of business. From real estate to two wheelers to media to tours and travels to even bio gas. The company had presence across sectors. But where they doing any business? Largely, the answer is no. The various businesses were just used as a façade to collect money from investors. They were used to show investors and agents as to what the company was doing with the money it was collecting.
As the Sebi order points out in the context of the reality division “It was prima facie observed that under the scheme of the noticee(i.e. Saradha) the real objective is to mobilize fund from public by showing some real estate projects to the investors and the noticee indirectly promises return of funds with high interest rates.”
The company had even bought a two wheeler company called Global Motors to show off to its agents. As the Business Standard points out “The Hooghly factory of Global Motors, acquired by Saradha sometime back, had closed down in 2011. But 150 of its employees had been kept on rolls to show, when agents made visits, that all was hunky dory and operations were on in full swing.”
All this was enough to create an illusion that the company was putting the money it collected from its investors to some use. Turned out it was not. It was simply rotating money.
The period between the investment and the pay out in a Ponzi Scheme is short. This ensures that the word spreads fast and more money comes in. Every additional investor gives legitimacy to the Ponzi Scheme. As we can see in case of Saradha the minimum tenure on offer was around 12-15 months. While there is no conclusive proof to say that most investors opted for the minimum tenure or lower tenures, I feel it would be safe to say that most new investors who were checking out the scheme would have opted for lower tenures. And gradually as the scheme spread and got some legitimacy only then would the investment tenures have gone up.
Also the fact that the scheme has collapsed tells us at some level that not many investors opted for long investment tenures. If they had, money would still be coming in and Saradha would have managed to continue operations. The fact that its more or less shutdown tells us that money has clearly stopped coming in.
Brand building is an inherent part of a Ponzi Scheme. Sudipta Sen ensured that the Saradha Group had huge presence in the media. “His first entry into the space was through Channel 10 and thereafter he expanded into dailies—Bengal Post & Sakalbela—in 2010. Sen bought out Tara channels, as well. At the time of closing down, the group had 10 media outfits — news TV channels, newspapers and magazine,” the Business Standard points out. This gave the group a lot of credibility and helped build its brand. The cine actor Mithun Chakraborty was the brand ambassador for Channel 10.
Trinamool Congress was also seen to be close to the group. As Reba Mitra a Saradha agent told NDTV.com “We put our faith in Saradha because big leaders of the Trinamool, like Madan Mitra, Didi…the chief minister, Kunal Ghosh, Shatabdi Roy, Mithun Chakraborty – when these big people are with them, government people, then would this money be stolen from us?”
Julie Potua, another agent of Saradha told NDTV that “they told clients in their pitch that other companies could collapse but Saradha would not as “Kunal Ghosh is with us, Mamata didi is with us, so invest in us.”
Kunal Ghosh, was editor and chief executive of Saradha Group’s media business. He is also a member of the Rajya Sabha nominated by the Trinamool Congress. Shatabdi Roy is a Bengali actress who is also a Lok Sabha MP from the Trinamool Congress. Being seen close to the leading political party of the state was like the icing on the cake and attracted investors by the drove.
There are some indications being given now that the Reserve Bank of India had warned the state government on the mushrooming of chit funds in West Bengal.
What is interesting is that the SEBI has been investigating the Saradha Group since June 2010. The Saradha Group, like Sahara now, had managed to delay the process by submitting voluminous documents. At various points of time in 2012, Saradha submitted 16 cartons, 19 cartons, 170 boxes and 35 cartons, as a strategy to avoid submitting the specific information being asked for by SEBI.
After this Saradha Group was directed to provide information in excel sheets. This helped Sebi to nail the group. As the SEBI order points out “On sample study of the data (in excel) provided by the noticee (Saradha), veracity of which cannot be verified, it is noted that agreements for sale was entered into with two investors namely Dhruba Bose and Arindam Pani on January 01, 2010 for flats having number 1A and 1C, respectively, both admeasuring 1437 sq ft. area in the same building i.e., Ten Katha. It is further noted that the consideration amount for flat number 1A was Rs 37,69,000 and for flat number 1C was Rs 1,17,75,850. It is highly unlikely that in a real estate business the difference between consideration amounts for sale of two similar flats at the same building on the same day shall be in the ration of 1:4. In view of these facts the possible inference will be that the allotment of plots/flats are simply a farce, and might have been done to mislead the regulatory authority.”
But by the time the SEBI order came out, Saradha had already collapsed. What is intriguing is that the investigation against Saradha started in mid 2010, but it took the company more than two years to submit the relevant data. If SEBI had cracked the whip and acted a little faster, the situation might have been a little better.
The article originally appeared on www.firstpost.com on April 24, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Saradha and Ponzi schemes: Why there will be more suckers
Vivek Kaul
In Ek Thi Daiyan, the latest horror flick to come out of Bollywood, the dying daiyan (witch) says something to the effect of “main wapas aaongi (I’ll be back).” Ponzi schemes are a tad like that. They keep coming back one after the other.
Only sometime back we were talking about the Stockguru Ponzi scheme. Before that the emu ponzi scheme and Speak Asia had been in the news. More recently the MMM Ponzi scheme and Saradha chit fund have taken up a lot of news space.
MMM India recently put itself into what it calls a calm regime where operations like money transfer will remain suspended and hence those who have put money into the scheme won’t be able to withdraw it. The Saradha Chit fund has collapsed.
The question is why do Ponzi schemes keep occurring over and over again in India? A popular explanation is that India is an under-banked country and that gets people to invest in Ponzi schemes rather than deposit money in the bank.
As The Economic Times points out in an editorial “the repeated sprouting of dubious Ponzi schemes across the country points to a failure of the formal saving and banking system.” This maybe true to some extent but does not really explain why Ponzi schemes keep cropping up all the time and why people invest in them.
Take the case of MMM India Ponzi scheme. To participate in it, an individual needed to have a bank account. To be a part of Speak Asia an individual had to participate in two online surveys per week. An individual who has access to an online connection is more than likely to have a bank account as well.
So Ponzi schemes are not just about India having fewer banks. There is a clear mental dimension at play which makes individuals invest in Ponzi schemes over and over again. And this makes sure that there are always scamsters looking to cash in.
Robert Shiller, an economist, defines a Ponzi scheme in a research paper titled From Efficient Market Theory to Behavioural Finance as follows: A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors. It creates a false perception of high returns for initial investors by distributing to them money brought in by subsequent investors. Initial investor response to the scheme tends to be weak, but as successive rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. Finally, the scheme collapses when new investors are not prepared to enter the scheme.
The phrase to mark in this definition is “high returns generate excitement”. Very recently, MMM India promised returns of 100% per month to prospective investors. The prospect of high returns pushes individuals to take on the risky bet of investing in a Ponzi scheme.
As Robert Shiller writes in Finance and the Good Society“The mere presence of uncertainty in a positive direction creates a pleasurable sensation (in the brain), and so the reward system creates an incentive to take on risky positive bets…This human tendency also helps explain why people like to gamble, and why many people will return every day to bet a small sum in a lottery. It also helps explain why people are willing to speculate aggressively on investments.”
This gets individuals to invest in a Ponzi scheme. And after one lot of investors has invested in a Ponzi scheme it tends to take on a life of its own. The initial lot of investors then become the advertisers for the scheme. If a person wants to invest, the chances are he will look around to see what his acquaintances, neighbours or relatives are doing with their money. If the people around the potential investor invest in a certain way, there might be a tendency for him to follow them. Much like the ‘circular mills’ of ants. The mill is created when an army of ants find themselves separated from their colony. Once they are lost they obey a simple rule: Follow the ant in front of you.
Decisions of investors, much like the circular mills of the ants, are not made at the same time but in a sequence. People who invest in the Ponzi Scheme assume that the scheme is a good bet simply because some of the people they know have already invested in it. So everyone ends up making the wrong decision because the initial investors get into the scheme by chance.
This happens because the attraction of easy money is something that investors cannot resist. Ponzi Schemes offer the prospect of huge returns in a short period of time vis a vis other investments available in the market at that point of time. Greed also results when investors see people they know make money through the Ponzi Scheme. As Charles Kindleberger wrote in Manias, Panics and Crashes “There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”.
Overconfidence also has a part to play. Most people are confident that they won’t become victims of financial frauds. This also leads them to invest in Ponzi schemes. Ove
rconfidence is also at play when investors understand that they are getting into a Ponzi scheme, but they are still willing to enter the scheme, because they feel that some greater fools could be depended on to enter the scheme after they have and this would give them handsome returns on their investments.
The contract effect is also at play. It becomes relevant in the context of a Ponzi Scheme when the prospective investor starts comparing the returns on the various other investment avenues available in the market for investment at that point of time. The high returns of offered by a Ponzi scheme stand out clearly and attracts investors.
So a Ponzi scheme just doesn’t spread only because of a weak banking structure though that might be true in case of Sahara or even Saradha chit fund. Also it is important to remember the first sentence in Shiller’s definition of a Ponzi scheme, which is: “A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors.”
So people running Ponzi schemes spend a lot of time in building a ‘supposed’ business model and building a great brand. The Saradha chit fund had built a huge media empire in West Bengal. It had also purchased a motorcycle company, to give some semblance of a business model to its investors.
Sahara is similarly into a lot of businesses and even sponsors the Indian cricket team. Similarly, Speak Asia was in the magazine and survey business. It also advertised majorly in the publications of The Times Group, to build credibility. Emu Ponzi schemes were in the business of rearing and selling emus. And Stockguru helped investors make money by investing in stocks.
MMM, in its original Russian avatar, sponsored the Russian football team in the 1994 football worldcup. When questions were raised about the huge returns, it had promised, MMM stated that it had solid investments, but did not want to disclose them as its competitors might imitate its investment strategy.
Over the years, investors have been fooled into investing their money into Ponzi Schemes which keep appearing in various forms. They ignore the most fundamental principle of investment theory: You cannot expect to make large profits without taking risk. Whenever a large amount of money is at stake, individuals should logically seek large amounts of information on where they should invest. But most investors do not do so. Few ask the right questions at the right time and are naïve enough to believe in what is communicated to them by the people carrying out the fraud.
Indeed, many Ponzi Schemes do not get reported as people do not like to admit that they have been fleeced because of their greed. The ones, which are reported and investigated, get stuck in the quagmire of our legal system. This encourages more people to run Ponzi Schemes. And every time a Ponzi scheme is exposed, the confidence of the investor in the financial system goes down.
The most commonly suggested solution for prevention of Ponzi Schemes is sharing more and more information with the investing public. But research in psychology shows that more information does not necessarily improve judgement. Any extra information is helpful only if it comes without any bias. But that is rarely the case. Moreover, the ability of the common man to assimilate information is limited.
Rather than assuming investors are knowledgeable about investment opportunities, the best solution to the problem of Ponzi schemes might be ensuring swift legal mechanisms to punish the unscrupulous masterminds behind the Ponzi Schemes. This will ensure that every prospective fraudster will think twice before launching another Ponzi scheme.
The article originally appeared on www.firstpost.com on April 23, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Grow Rs 5000 to Rs 3.4 crore in a year – Is MMM the biggest Ponzi scheme ever?
Vivek Kaul
Charles Ponzi, the man on whom Ponzi schemes have been named, has been dead for more than sixty years. And after all these years, it looks like that the world may have finally found a successor to Ponzi. His name is Sergei Mavrodi (featured above) and he is a Russian.
But before he get to Mavrodi, lets first try and understand what a Ponzi scheme is.
Charles Ponzi, an Italian immigrant into the United States, promised investors in the city of Boston that he would double their money (i.e. give them a 100% return on their investment) in 90 days.
Ponzi had hoped that to make this money through a huge arbitrage opportunity that he had spotted among the international postal reply coupons being sold across different countries. But due to various reasons both bureaucratic as well as practical, he could never get around to execution.
But by the time Ponzi realised this, big money was coming into his scheme and he had got used to a good lifestyle. At its peak, the scheme had 40,000 investors who had invested around $ 15 million in the scheme.
Ponzi kept his investors happy by using money brought in by the new investors to pay off the old investors who wanted to redeem their investment. And that is how the scheme operated upto a point. On 26th July 1920, the Boston Post ran a story questioning the legitimacy of the scheme. Within a few hours, angry depositors lined up at Ponzi’s door, demanding their money back. Ponzi asked his staff to settle their obligations. The anger subsided, but not for long. On Aug 10th, 1920, the scheme collapsed. The auditors, the newspapers and the banks declared that Ponzi was definitely bankrupt.
Ponzi was not the first person use this trick of using money being brought in new investors to pay off old investors. Neither was he the last.
Ponzi promised a 100% return to his investors in 90 days. But Sergei Mavrodi has managed to do evern better than Ponzi. His scheme MMM India (where MMM stands for Mavrodi Mondial Moneybox) is telling investors that their deposits will grow at 100% per month. Yes, dear reader, you read it right, 100% per month.
In fact as the following table on the webiste www.MMMindia.in shows, an investment of Rs 5000 made on April 15, 2013, is likely to grow to nearly Rs 3.4 crore in a year’s time. (You can check out the link here and even put in different amounts to see how much would it grow to at the rate of return of 100% per month).
Sum of deposit: Rs 5000
| 100% | ||
|---|---|---|
| Today: | 15 April 2013 | 5 000.00 |
15 May 2013 | 11 003.04 | |
15 June 2013 | 22 553.19 | |
| After 3 months | 15 July 2013 | 44 042.55 |
15 August 2013 | 101 717.32 | |
15 September 2013 | 198 693.00 | |
| After 6 months | 15 October 2013 | 437 401.20 |
15 November 2013 | 896 230.98 | |
15 December 2013 | 1 750 607.86 | |
15 January 2014 | 3 853 784.10 | |
15 February 2014 | 7 896 443.57 | |
15 March 2014 | 15 424 270.12 | |
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Mavrodi brought MMM to India in 2011. The way it operates is very simple. The system is constructed around two concepts, give help and get help. So an individual logs on to the website www.mmmindia.in. Here he can help someone. To do this he needs to transfer money. This can be done through online banking, NEFT or even a direct cash deposit.
This amount is treated as a deposit in terms of a currency called Mavros, which is a virtual currency, whose exchange rate is decided personally by Mavrodi, twice a week on Tuesdays and Thursdays. This deposit in Mavros is supposed to grow at the rate of 100% per month.
Now if someone wants to sell these Mavros he needs to press the get help button. As the MMMIndia website points out “First the system calculates the amount of requests for payments (GET HELP button). And then, as per these calculations it will send request for transfers randomly to the participants (GIVE HELP button). Not necessarily, a request for transfer may or may not occur within a month.”
This basically means a couple of things. First you can get into the scheme anytime you want, but you can’t get out anytime you want. The second point is even more interesting. In order to get out of the scheme it is necessary that other people are willing to get into the Give Help mode. This means that they should be willing to transfer money from their account to your bank account.
This is like a classic Ponzi scheme where money being brought in by the newer investors (or more money being brought in by the older investors) is used to pay off those who want to exit the scheme.
In fact MMM India clearly shows on its website the structure of the way it operates.
This clearly tells you that pyramid structure that the scheme has. Also the scheme has no ‘supposed’ business model per se like a lot of other Ponzi schemes tend to have. In fact the website clearly points out “Do not forget this! There are no investments! No business activity! There is no company! There are no shares transactions, any relationship with the professional participants of the shares market, no shares or any product you do not get! Any source of income is ALSO NOT HERE!”
Despite this, the scheme has found many takers in India. As a recent article in the Business Standard points out “In India, adherents in the countryside of Maharashtra, Gujarat and Punjab are growing by the day. There are plans to take the network to other states.”
This is not the first time that Mavrodi has successfully launched a Ponzi scheme. He has done so in Russia in the past. The sudden switch from communism to capitalism in Russia created an unstable environment that made it ripe for running Ponzi Schemes.
MMM Corporation was the largest and the most famous of the lot. It was started by Sergei Mavrodi, a former mathematician, MMM issued share certificates which looked like bank notes. (These share certificates were not traded on any stock exchange).
Attracted by promised returns of 10% per week, the investors lapped up the share certificates. MMM became a market maker for these share certificates. The money collected by selling share certificates to the investors was not invested but essentially used to pay off the investors, selling the share certificates back to MMM. Effectively, money from the newer investors was used to pay off the older investors.
When questions were raised about the huge returns, it had promised, MMM stated that it had solid investments, but did not want to disclose them as its competitors might imitate its investment strategy. The returns offered were higher than those offered by Russian commercial banks, which were not very stable at that point of time. So many people withdrew their deposits from banks and bought share certificates issued by MMM. In the 1994 football World cup, which was held in the months of June-July in the United States of America, the Russian soccer team was sponsored by MMM. MMM advertisements ran extensively on state television and became very famous in Russia.
In July 1994, the Ministry of Finance warned investors about the unsustainibility of the scheme. This started a run on the scheme with investors dumping the share certificates enmasse. Soon the amount of money leaving the scheme was greater than the amount of money entering the scheme. On 26th July 1994, the share certificate scheme collapsed with all but one offices of the firm being closed down.
By getting elected to the Russian Duma, Mavrodi obtained immunity from prosecution, as per the Russian Constitution. After refusing to honour his previous commitments, Mavrodi decided to start a similar scheme which promised very high returns. Despite his past failure, many investors queued up to invest. In Oct 1995, Mavrodi was expelled from the Duma. He tried his best to get re-elected, but failed. A case was filed against him.
And it is the same Mavrodi who has now come to India to a run a Ponzi scheme. The beauty of this scheme is that he is even telling his potential customers that he is running a Ponzi scheme. But people being people, are still falling for it.
The article originally appeared on www.firstpost.com on April 15, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Wiser after Stockguru: 5 ways to spot a Ponzi scheme
Vivek Kaul
So a Ponzi scheme is in the news again. Last time it was the emu Ponzi scheme. Before that there was Speak Asia. Now it’s the turn of Stock Guru to take investors across the county for a ride. The modus operandi as is the case with all Ponzi schemes is the same: the lure of high returns. In the end more than the frauds who ran Stock Guru it’s the investors who invested in the scheme have only themselves to blame. There greed did them in.
While one Ponzi scheme differs from another, but despite the details changing, the structure abides. Let’s first try and understand what exactly is a Ponzi scheme and why is it so called.
Charles Ponzi
Chalres Ponzi was an Italian immigrant who landed in America in 1903. Sometime in August 1919, in the process of starting an export magazine, he realised that there was money to be made through an arbitrage opportunity that existed. Ponzi sent an offer to a person in Spain requesting him to subscribe to the magazine. The subscriber agreed and sent Ponzi an international postal reply coupon. This coupon could be exchanged at the post office for American stamps which would be needed to send the magazine to the Spanish subscriber. The coupon in Spain cost the equivalent of one cent in American currency. In America when Ponzi exchanged the coupon, he got six cents worth of stamps. And this set Ponzi thinking.
What was the plan?
The plan was very simple. Ponzi could buy international postal reply coupons convert them into American stamps and sell those stamps and make money. So he would need one cent to buy an international postal reply coupon in Spain. That coupon could be exchanged for stamps worth six cents in America and those stamps could then be sold for six cents. Hence there was a clear profit of five cents, assuming there were no other charges, to be made on every one cent that was invested. The trouble of course was that Ponzi needed money to get started.
Double your money in 90 days
So Ponzi launched an investment scheme asking people to invest. He promised them that he would double their money in 90 days. Ponzi would make a profit of five cents for every one cent that he invested. That meant a profit of 500%. As far as investors were concerned he was only promising to double their money and that meant a return of 100%. Hence, on the face of it looked like a reasonably safe proposition. At its peak, the scheme had 40,000 investors who had invested around $ 15 million in the scheme.
What went wrong?
As if often the case what sounds great in theory cannot be put into practise. The idea was brilliant. But Ponzi had not taken into account the difficulties involved in dealing with various postal organizations around the world, along with other problems involved in transferring and converting currency. Also with all the money coming in Ponzi couldn’t stop himself from living an extravagant life and blowing up the money investors brought in.
But soon doubts started arising on the legitimacy of the scheme. The Boston Post newspaper ran a story on July 26, 1929, and within a few hours, angry depositors lined up at Ponzi’s door, demanding their money back. Ponzi settled the obligations of the people who had gathered. The anger subsided, but not for long. On Aug 10th, 1920, the scheme collapsed. It was revealed that Ponzi had purchased only two international postal reply coupons and was using money brought in by the new investors to pay off old investors.
So what is a Ponzi scheme?
Robert Shiller, an economist at Yale University in the United States defines Ponzi schemes as “A Ponzi Scheme involves a superficially plausible but unverifiable story about how money is made for the investors and the fraudulent creation of high returns for initial investors by giving them money invested by subsequent investors. Initial investor response to the scheme tends to be weak, but as the rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. ( Adapted from Shiller 2003).” Hence, a Ponzi scheme is essentially a fraudulent investment scheme where money brought in by the newer investors is used to pay off the older investors. This creates an impression of a successful investment scheme. Of course as long money entering the scheme is greater than the money leaving it, all is well. The moment the situation is reversed, the scheme collapses.
This kind of financial fraud happened even before Ponzi’s name came to be attached to it. And it continues to happen more than ninety years after Charles Ponzi ran his scam.
Any Ponzi Scheme will differ from another Ponzi Scheme. But if one may borrow a French phrase, Plus Ca Change, Plus C’est La Meme Chose, the more things change, the more they remain the same. The details might change from scheme to scheme, but the structure abides. Here are some characteristics of Ponzi schemes.
The instrument in which the scheme will invest appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors.
In case of the emu Ponzi scheme an investor was supposed to rear emus and then sell their meat, oil etc. In order to become a member of Speak Asia one had to invest Rs 11,000. This investment was for subscribing to the electronic magazine issued by the company called “Surveys Today”.
This also allowed the member to participate in two online surveys every week and make Rs 500 per survey or Rs 1000 per week. This when converted into a yearly number came to Rs 52,000 (Rs 1000 x 52). So an investment of Rs 11,000 ensured that Rs 52,000 was made through surveys, which meant a return of 373% in one year.
And this was basically the main selling point of the scheme. So the business model of the company was pretty vague. The legal advisor of the company Ashok Saraogi said at a press conference “The company is not selling any surveys to panellists but e-zines (electronic magazines) to its subscribers. Surveys are offered as additional benefit and can be withdrawn anytime if the company’s contract with clients comes to an end.”
Stock Guru also worked along these lines. The company claimed to be making money by investing in stocks and had this to advise to its customers: “We advise our clients to buy shares at a low price and sell them at a higher price. Selecting the right share at the right price and entering the capital market at the right time is an art. We help all our clients to make huge profits by investing in good shares for very short/short/medium/long term depending upon the client’s requirements.” Very sane advise when it comes to investing in the stock market but nothing specific about how the company plans to help its clients make a huge profit.
Most of the Ponzi Schemes start with an apparently legitimate or legal purpose.
Let’s take a look at some of the Ponzi schemes of yore. Hometrade started off as a broker of government securities, Nidhis were mutually beneficial companies and Anubhav Plantations was a plantations company. They used their apparently legitimate or legal purpose as a façade to run a Ponzi Scheme. Same stands true for the present day Ponzi schemes. Speak Asia was in the magazine and survey business. Emu Ponzi schemes were in the business of rearing and selling emus. And Stock Guru helped investors make money by investing in stocks.
The most important part of a Ponzi scheme is assuring the investor that their investment is safe.
This is where the meeting of initial obligations becomes very important. Early investors become the most important part of the scheme and spread it through word of mouth, so that more investors invest in the scheme and help keep it going. Ironically enough, in many cases it is their own money that is being returned to them. Let us say an investor invests Rs.100 in a scheme that promises 20% return in 60 days. So Rs.20/- can be paid out of investor’s own money once every two months up to ten months. The Ponzi scheme can keep going by essentially returning the investor his own money. Speak Asia did this by returning around Rs 250 crore to the investors from the Rs 2000 crore it had managed to collect. This gave the scheme a greater legitimacy.
Stock Guru also worked along similar lines. As an article in the Money Life magazine pointed out “You pay Rs10,000 as investment and Rs1,000 as registration fees. There is no limit on the maximum amount one can invest. Stockguruindia.com offered a return of 20% per month for up to six months and the principal amount invested is returned in the next six months. It also gave post-dated cheques of the principal and a promissory note as security.”
As a story in The Times of India points out “People invested between Rs 10,000 and Rs 60 lakh at one go in Stock Guru India as Ulhas promised to double their capital…He (i.e.Ulhas Khaire who ran the scam) also returned money to some investors to win their trust so that they would recommend Stock Guru to others,” said an officer. In fact this initial lot of investors become brand ambassadors and passionate advocates of the scheme. When this writer wrote about Speak Asia being a Ponzi scheme he got stinkers from a lot of people who had invested their money in Speak Asia at the very beginning and made good returns.
The rate of return promised is high and is fixed at the time the investor enters the scheme. So the investor knows in advance what return he can expect from the scheme. The promised returns were substantially higher compared to other investment avenues available in the market at that point of time. The rate of return was also fixed in advance. So there was no volatility in returns as is in other forms of investment. This twin combination of high and fixed returns helps in attracting more and more investors into the scheme.
In Speak Asia the investor knew that he would get paid Rs 1000 per week for conducting surveys. And by the end of the year he would earn Rs 52,000 on an initial investment of Rs 11,000.
In case of Stock Guru a minimum of Rs 10,000 was to made as an investment. And Rs 1,000 was the registration charge. The company promised a return of 20% per month against the investment for the first six months. For a person investing Rs 10,000 that would mean a return of Rs 2,000 per month or Rs 12,000 after the first six months. The principal amount of Rs 10,000 would be returned over the next six months. Hence on an investment of Rs 11,000, a profit of Rs 12,000 was being made in a very short period of time. These were fantastic returns.
Brand building is an inherent part of a Ponzi Scheme.
MMM, a Russian Ponzi scheme marketed itself very aggressively. In the 1994 football World cup, the Russian soccer team was sponsored by MMM. MMM advertisements ran extensively on state television and became very famous in Russia. Hometrade also used the mass media to build a brand image for itself. It launched a high decibel advertising campaign featuring Sachin Tendulkar, Hrithik Roshan and Shahrukh Khan. When the company collapsed, the celebrity endorsers washed their hands off the saying that they did not know what the business of Hometrade was. Anubhav Plantations also ran a huge advertising campaign. Film stars also advocated investing in the emu Ponzi schemes.
Speak Asia ran a huge ad campaign. The irony was it advertised extensively in newspapers which dealt with personal finance. Stock Guru did its level of brand building as well. As a report in the Times of India points out “ Ulhas Prabhakar Khaire andRaksha Urs, masterminds of the multi-crore Stock Guru fraud, would organize their promotional events in Macau, Malaysia, Mauritius and several other countries, taking only a few premium investors on expenses-paid trips, say Delhi Police sources. The events were reportedly organised regularly in five-star hotels, and Ulhas made all the arrangements, including booking flights for investors and celebrities. Ulhas is learnt to have named two Bollywood celebrities he invited to his promotional events.”
All these things lead to people investing in these schemes. The attraction of easy wealth is something that investors cannot resist. Ponzi schemes offer huge returns in a short period of time vis a vis other investments available in the market at that point of time. With good advertising and stories of previous investors who made a killing by investing in the scheme, investors get caught in the euphoria that is generated and hand over their hard earned money to such schemes going against their common sense. Greed also results when investors see people they know make money through the Ponzi scheme. As economic historian Charles Kindleberger once wrote “ There is nothing so disturbing to one’s well being and judgment as to see a friend get rich.”
Given this, even though a lot of questions can be asked they are not asked. Ponzi schemes have not been eliminated. This is sad because for the economy as whole, they are undesirable. The world has not learned from its experience. “Mundus vult decipi-ergo decipitaur-The world wants to be deceived , let it therefore be deceived ”. (Winkler 1933 as quoted in Kindlberger 2000).
All Ponzi schemes collapse in the end once the money leaving the scheme becomes greater than the money entering it. Stock Guru was no different.
To conclude, any investment scheme promising more than 15% return a year has to be a very risky proposition. It may not always be a Ponzi scheme, but the chances are that it is more often than not.
The article originally appeared on www.firstpost.com on November 15, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])