Vivek Kaul
Dr K M Abraham of Securities Exchange Board of India (Sebi), in his June 23, 2011 order, against two Sahara group companies, Sahara India Real Estate Corporation Limited and Sahara Housing Investment Corporation Limited, had alluded to the possibility of a Ponzi scheme.
In his order Abraham had said “The Learned Counsel, at one point in the submissions before me, mentioned the fact that there are no investor complaints at all, from any investor in the OFCDs (optionally fully convertible debenture) raised by the two Companies. Going by the history of scams in financial markets across the globe, the number of investor complaints has never been a good measure or indicator of the risk to which the investors are exposed. Most major ‘Ponzi’ schemes in the financial markets, which have finally blown up in the face of millions of unsuspecting investors, have historically never been accompanied by a gradual build up of investor complaints.”
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. (For a more detailed and historical treatment of Ponzi schemes click here).
So does that mean that Sahara is a Ponzi scheme where money is simply being rotated? While there is not enough information available in the public domain to come to this conclusion nevertheless several interesting points can be made.
One of the characteristics of a Ponzi scheme is that the scheme appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors. The optionally fully convertible debentures that the two Sahara group companies issued to raise money from nearly 3 crore investors do fall into this category of investment which sounds genuine enough and at the same time is obscure enough to prevent any scrutiny by investors. Further, Sahara raises its money from the lowest strata of the society, a lot of whom do not even have bank accounts. So the chances of questions being asked are very low.
Another characteristic of a Ponzi scheme is that the operators of the Ponzi Scheme persuade the investors to roll over the profits into the next investment cycle. So the returns remain on paper. Since the money remains with the operator the Ponzi scheme keeps running.
This is exactly what was done by a host of Non Banking Financial Corporations (NBFCs) in the nineties. Billboards promising exorbitant rates of return started showing up all over small town India. Money from the later investors was used to pay off the earlier investors. In many cases, once their investments matured, the investors were persuaded to reinvest the principal and interest on the investment back into the scheme.
This seems to be true in case of Sahara by their own admission. As their spokesperson recently told the Business Standard “Right from last 30 years, we have observed that our field workers try their best to pursue the depositors/investors to reinvest in some other scheme of the group because they get their livelihood from that since they earn commission on it. They always impress and hold their introduced depositor/investor by giving best human service throughout the tenure of the scheme.”
Most of the Ponzi Schemes start with an apparently legitimate or legal purpose. 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 Stockguru claimed to be making money by investing in the stock market.
Similarly Sahara is into a variety of businesses from running hotels to making films and television serials and building homes, which are all legitimate. The money raised by Sahara supposedly finances these businesses. What is questionable however is that are any of these businesses making money? Also has all the money that has been raised put to use?The film business of the company has been scaled down majorly over the years. The listed businesses of the group can’t be said to be doing terribly well either. Very little financial information regarding the group is available in the public domain to perform any reasonable financial analysis on it. (You can access some financial information regarding the group here).
Brand building is also 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.
Sahara is the official sponsor of the Indian cricket team. Given this the entire Indian team has been advertising the new Q shop venture of the group. So who are investors more likely to believe while parting with their hard earned money? Sachin Tendulkar, cricketing great and a Member of Parliament, or dull advertisements put out by SEBI asking investors not hand over their money to Sahara Q shop?
In an advertisement headlined “Don’t be forced, don’t be misguided” the Securities and Exchange Board of India (SEBI) had asked investors “not to yield to any pressure from any person, including Sahara or its agents, for converting or switching their existing investments in the bonds to any of the other schemes like Q-shop, etc.”
Sahara also owns the Pune IPL team. It also has a stake in an F1 racing team Sahara Force India, whose other high profile owner is Vijay Mallya.
A final point to remember about Ponzi schemes is that the finally become too big and collapse under their own weight. Let us say someone decides to start a Ponzi scheme with the intention to defraud people.
He gets 100 members to start with and each one of them contributes Rs 10,000 to become a member of the scheme. The members in turn are promised Rs 50,000 back in a period of one year. Given that the scheme is a Ponzi scheme, there is no business model to generate returns and give out the Rs 50,000 promised to each investor. So the guy running the Ponzi scheme has to take the money being brought in by the newer investors to pay off these original investors.
Now every investor has been promised Rs 50,000. To enter the scheme Rs 10,000 is required. Hence to get Rs 50,000 to pay off one original investor, five new investors have to be roped in. Each one of them pays Rs 10,000 each and thus Rs 50,000 is raised to pay off the original investor.
The point to note here is that the Rs 50,000 that each original investor gets is basically the money being brought in by five new investors. Hence, the money gained by the original investors is basically the money brought in by the five new investors. And that is what makes a Ponzi scheme a zero sum game. The original investors gained only because the latter investors were willing to pay. No new wealth has been created.
This also means that to pay off the 100 original investors 500 new investors need to be brought in.
So that’s the first level of the Ponzi.
What happens next?
After the original lot has been paid off, the 500 investors who entered the second level of the Ponzi need to be paid off, to keep the scheme going. To pay off each of these investors five new investors are required, which in total means 2500 investors. If the fraudster running the Ponzi manages to get 2500 or more investors, the scheme continues.
Let us say the fraudster manages to get 2500 investors and each of these investors pays Rs 10,000. The money thus collected is used to pay off the 500 investors of the second round. In the third round 2500 investors have to be paid, for which 12,500 investors need to invest money in the Ponzi scheme.
If the scheme continues successfully by the ninth round nearly 19.5 crore new investors need to be brought in to keep the Ponzi scheme going. India’s population as per the latest census is around 120 crore. This means that for this hypothetical scheme to continue nearly 16% of the population of India needs to invest in it.
So any Ponzi scheme if it becomes sufficiently big has to collapse because the number of people required to keep it running it simply way too big. One way to avoid this to keep get investors to reinvest their money back into the scheme and live to fight another day.
But all Ponzi schemes collapse in the end under their own weight. A mutli level marketing(MLM) kind of Ponzi scheme is a very good example of a Ponzi scheme that ultimately collapses under its own weight.
In an MLM scheme a company appoints independent distributors, who are not employees of the company. The products of the company are sold to the distributors, who not only sell these products to make a profit, but also appoint more distributors and so the cycle goes on.
The company goes about appointing distributors but the catch is that the products the distributors buy rarely get sold and is just there to build a façade of a business model.
A major part of the commission earned by a distributor comes from appointing new distributors to the company, and thus creating a new level. And so the scheme goes on, with newer levels being created. 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.
Like any other Ponzi Scheme there are only a finite number of people who can enter the scheme. So after some time the number of people required to keep the scheme going becomes very large and the scheme goes bust.
As Debashis Basu wrote in a recent column in Business Standard “Now they(MLM schemes) come under the garb of selling you some expensive products or some vague services: gold coins (Gold Quest), lifestyle products (QNet), surveys (Speak Asia), and so on. So, at any time, they have the fig leaf of providing some “value”. Even Amway, Oriflame and Tupperware rely on a model with recruitment and ever-expanding chain. For those at the end of the chain to get some crumbs and to sustain the whole chain, products have to be hugely expensive. Even then, most people make no money. New recruits are shown a dream — what people in the second link of the chain have achieved. But they are not told that no one beyond the top two or three layers really makes any money.”
While Ponzi schemes keep going bust newer ones keep coming and taking their place. This is sad because for the economy as whole, they are undesirable. Every time a Ponzi scheme is exposed, the confidence of the investor in the financial system goes down. Investors become reluctant to part with their money. This in turn hampers the ability of the capitalist system to raise capital for newer ventures.
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 economist Charles Kindleberger wrote in his all time classic Manias, Panics and Crashes “There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”. In a country like India where the per capita income is low the chances of people falling for Ponzi Schemes continue to remain high.
The only way out of this menace is by punishing people who run Ponzi schemes quickly. Rather than assuming investors are knowledgeable about investment opportunities, and instead of providing investors with more information about particular investments, disseminating information about investments gone awry may be a better bet to control this problem.
As Basu writes in his column “The ministry of finance and financial regulators may like to believe that they oversee the financial sector well. They are really deluding themselves. The money people lose in pyramid schemes is a few times the size of equity mutual funds or life insurance plans, on which millions of words are written and thousands of regulatory man-hours are spent. And all the literacy workshops funded by the government and industry would seem such a joke if pyramid schemes are allowed to flourish.”
Hence, its time the government woke up to this and did something about this menace, starting by punishing some of the big boys.
The article originally appeared on www.firstpost.com on December 12, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])