Why collective investment schemes are hard to regulate

For the last few years, the Securities Exchange Board of India (Sebi) has been coming down hard on companies running collective investment schemes (CIS). These schemes, much in the news since the Saradha scam, are those in which people invest to create a pool of money which is then utilised to realise some income for the investors, or acquire some produce, or some properties which are then looked after by a manager of behalf of the investors.  In other words a property is owned by an individual, but is maintained jointly with the manager. A mutual fund is also called a collective investment scheme.

SEBI introduced regulations for CISs in 1999. But so far only one company - Gift Collective Investment Management Co has registered with it as a CIS after complying with the regulations. This is a Gujarat government PSU which is building the International Financial City in the Ahmedabad-Gandhinagar region.

Data presented in Parliament in March this year show 669 companies were probed by SEBI for violating CIS regulations . Between them these companies had collected Rs 7,435 crore. Of these, 552 companies were prosecuted and convictions were secured in 124 cases. Another 75 wound up their business and refunded money to their investors.

So how were so many CISs functioning without SEBI's approval? "People are playing with the loopholes in the system," says Sandeep Parekh, Founder of financial sector law firm Finsec Law Advisors. "Even if the intention is not to cheat, many do not want to comply due to regulatory hassles as well the cost of compliance." P.R. Ramesh, Senior Consultant at Economic Law Practice, another Mumbai-based law firm, agrees. "More often than not the idea is to beat the norms," he says. "Though requirements for running a CIS are simple, they include such checks and balances that almost no ponzi scheme is possible. For instance, they require CISs to have Rs 5 crore of net worth and to be close-ended funds. Schemes also have to submit to rating."

If SEBI has not been able to prevent the proliferation of unregulated CISs, it is because it does not have the teeth or the infrastructure to do so. Its staff and number of offices is severely limited, nor are its orders binding like those of courts. Most of the time it starts probes only after it has been tipped off by some enforcement agency. In the case of Saradha Realty, for example, SEBI got a reference in April 2010 from the Economic Offences Investigation Cell in the West Bengal government. Again, whenever SEBI has asked companies running CISs or related schemes to refund money to investors, the latter have contested the order in court saying passing such orders was beyond Sebi's legal authority.

Take the case of the Jaipur-based CIS Pearl Green Forest Ltd (PGFL). In 2002, SEBI pulled up the company and ordered it to return the money it had collected, but PGFL went to court and it was only in March this year, the Supreme Court finally decided SEBI did have the right to issue the order it had. "The other problem is delay in decision making," says Parekh of Finsec. "SEBI needs to speed up its adjudication process. There has to be a central data information cell which is connected with all the law making agencies, there has to be coordination between them. There should be an investors' charter. It has been seen in the past that agencies like to pass the blame from one to the other."

Banks too can be blamed for the malpractices CISs get away with. "In many ways this is a failure in the banking system," says Ramesh. "If banks had been alert in monitoring the money coming into an account they could have nipped this in the bud." Why was no alarm raised when crore of rupees were coming into certain accounts every day? One reason cited is the poor surveillance system in banks at the district levels as compared to the cities.

Those running CISs need to themselves realise the need to be transparent and to comply with laid down norms. "Compare this section to the Alternative Investment Funds, the private equity and venture capitalist players, for whom SEBI has set guidelines as well," says Ramesh. "Some 47 entities have registered with it. They want to comply. It is only if your business is shady, you will not come forward to accept regulation."

One consequence of the Saradha saga has been that the entire CIS sector is being viewed with suspicion. Various agencies are vying with one another to punish the guilty and claim the credit. Politicians too are fishing in the muddied waters for their own interest. The worry is that, after the initial clamour, the basic causes that lead to scams like Saradha will neither be acknowledged nor addressed.