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Tuesday, April 30, 2013

Investigating ponzi schemes: A malady

by Shubho Roy.

What has happened?

SEBI was investigating Saradha for more than 3 years before the deposit schemes of the company collapsed (See here). Saradha seems to have used two methods to delay the investigation:

  1. When SEBI asserted its authority to stop Saradha group from collecting money, Saradha challenged the jurisdiction of SEBI in district courts. It quickly got orders to prevent SEBI interfering in its businesses. These orders were eventually overturned by the High Court.
  2. When SEBI requested information from Saradha about their schemes and investors, Saradha responded by providing large volumes of documentation without specifically answering SEBI's questions. This slowed down the entire investigation.

Why is this a problem?

In those three years Saradha took on new depositors and collected money from existing ones. All this money is now lost. Two years of investigation were required to stop what seems to be a run of the mill ponzi scheme. The tactics employed by Saradha are not new. They are similar to those employed by Sahara in delaying investigations in the OFCD schemes and in many other white collar crime investigations. The disturbing fact is that they seem to succeed time and again. While SEBI has wide powers of entities registered with it, if someone does not register with SEBI, the system of enforcement of laws changes completely. The current system requires SEBI to approach the local courts for prosecuting violations of the SEBI Act which constitute an offence. Moreover, SEBI cannot directly appoint lawyers for prosecuting the offences and must rely on the state government prosecution machinery to get criminal prosecution started.

The source of these difficulties

The present system suffers from a number of weaknesses, two of the most important are:
  1. The normal court systems do not have the time or expertise to enforce violations of investment and securities laws. This leads to confusing orders which sometimes exceed the jurisdiction of the courts. Even in the case of Saradha, the High Court set aside the orders preventing SEBI from exercising its powers over Saradha, noting that the courts were out of jurisdiction when they prohibited SEBI. However, High Court orders take time, and in this time period the operator of the ponzi scheme can continue to collect money or misappropriate the money already deposited. Expertise in deciding jurisdiction and applicability of SEBI laws is also not available in most normal district courts. It will be extremely expensive and wasteful to train all district judges in securities laws for the once-in-a-decade case in financial laws.
  2. The use of state public prosecutors for violations of financial laws is problematic for two reasons. First, the normal public prosecutors office is flooded with normal criminal cases like theft, murder, etc. A complex financial law case will never be the priority of the normal public prosecutors office. Second, the average public prosecutor who is extremely busy with the daily load of run of the mill criminal cases is not trained investment and securities laws. Just like district judges, it is not cost effective to train all public prosecutors in securities laws.

How would this work under the IFC?

The Indian Financial Code, drafted by the Financial Sector Legislative Commission, addresses these issues in the following ways:
  1. The whole system of investigation is formalised under an investigator appointed by the regulator. The terms of reference for the investigator, the system of investigation and the time for investigation has to be written down at the onset. Since all incomplete investigations will require extensions, there will be system of raising alarms for an unusually long investigation. See draft clause 394 of the IFC.
  2. The code allows the investigator to apply for a warrant for the search and seizure of documents. The investigator does not have to go to the area where the scheme is operating. He can apply for a warrant with the magistrate where the head office of the regulator is situated. This allows the government to create a special magistrate's office. This magistrate can be trained in issues of finance and fraud and be a proper judicial check for warrants. See draft clause 396 of the IFC.
  3. The code also allows the financial agency to make an order preventing transfer of any money or assets pending an investigation if there is a reasonable fear that the assets of clients are at risk. Any violation of such orders is also punishable by imprisonment up to five years. See draft clause 398 of the IFC.
  4. The code empowers the central government to set up special courts to try cases involving the violation of investment laws. This allows for far quicker and more efficient disposal of cases. These courts will be district courts and follow all due process of law required under the Evidence Act and the Criminal Procedure Code. However, unlike general criminal courts, judges in these courts can be experts in securities and investment laws. See draft clause 417 of the IFC.
  5. Finally the code envisages that the financial sector regulator appoints its own lawyers to prosecute cases of criminal offences. These lawyers will have the same powers as a prosecuting lawyer under the criminal procedure law. Since most financial regulators have legal officers on staff today, this allows specialised expertise to head the prosecution of these crimes rather than a generalist public prosecutor.

The strategy used in the IFC is similar to that used in securities laws in the U.S., where dedicated federal court benches are used to prosecute securities frauds. Even in India, special courts and prosecutors have been created for the CBI and for prosecution of offences under the Prevention of Corruption Act. The longer a ponzi scheme lingers the more victims it accumulates. The Indian Financial Code provides a system to effectively shut down schemes like these and a specialised criminal law system to prosecute violators.

The loss of critical savings by many have raised demands for retribution. A hurried response to such demands can bring in laws which dilutes the principle of `innocent until proved guilty' or reduce the procedural and evidentiary standards. The Code scrupulously avoids this by placing the power of issuing warrants and convicting offences on the same standards as envisaged in the laws of evidence and criminal procedure. However, it addresses the problems of a slow judicial system and dedicated expertise in resolving financial crimes.


  1. Although I agree that with the conclusion that special courts for investments are necessary, I find it difficult to agree with the following arguments:

    1. You say: "However, High Court orders take time, and in this time period the operator of the ponzi scheme can continue to collect money or misappropriate the money already deposited." The High Court may not quickly dispose off the entire case for good but it can at the very inception pass a stay order preventing the CIS from collecting any further money. So delay in deciding the appeal by a High Court is not a major issue here.
    2. You say: "It will be extremely expensive and wasteful to train all district judges in securities laws for the once-in-a-decade case in financial laws." Expense cannot be avoided. Setting up Special Courts is also very expensive. Training the judges and personnels for such courts is expensive too.

    Better judges, lawyers as well as Court infrastructure are necessary. The existing subordinate judiciary lacks these attributes. Thats why we need special courts for investments.

    1. Dear Pratik,

      The High Courts should not be issuing stay orders unless a clear case
      is established by the regulator. The general principle in law is that
      a judicial precedent is not overturned. I would like to point out that
      the lower court had issued an order, a High Court (rightly) will not
      overturn it in the first hearing.

      Your point about training judges in general is valid. But that is a
      consideration for the wider agenda of judicial reforms. We have to
      weigh the costs and benefits of the judicial system of expert
      judges. The Shardha type of cases are once in a decade type of
      problem. We in India just don't have the resources to train the judges
      in financial law. If we had the resources it could be better used to
      train judges in the more common legal problems like contract
      You are right that special courts are expensive, but the question is
      one of relative costs. Training all lower and High Court judges is
      more expensive than special courts.

  2. Please note that for about last two years Saradha was following a method that may not have been stoppable easily under IFC also. They were taking deposits in their real estate firms and showing them as advance booking amount for flats and plots with full co-operation of depositors. The agreement had a clause that in case buyer did not want to buy said property for any reason, he was entitled to a full refund with 24% p.a. interest. On paper, this is not a financial dealing, not a deposit. It is just a standard real estate purchase with a good and fair refund clause.

    Also, there are similar schemes in other sectors also. In Sangrur distt, there is a engg college which is run by relative of MLA, which is saying pay fee of your child five years in advance. In case child does not want to study, then get full refund with 18% or 20% interest. There are commission agents who are canvassing for money and telling people quietly that this is actually a deposit scheme. There is full approval of director education and her department for scheme. It is actually a Ponzi scheme but no SEBI or anyone will come to know of it till people start losing their savings. There may be more in other parts of the country.

    India has made great progress in Ponzi schemes. This is our country’s contribution to the world of finance. Any good or service can be turn into Ponzi just by having advance payment and refund clause. What will the IFC do?

    1. The style of operation Shardha was using is not new. There is a problem
      of defining investments as a function of what the `company proposes'
      `to do with it, rather than what the person who makes the investment
      `perceives' it to be. The problem in present laws is that they are
      all written from the perspective of the company. For example, nidhi
      companies taking deposits, companies issuing fixed deposits, NBFC
      companies taking investments.

      On the other hand the the IFC takes the approach of stating that all
      investment activity is regulated. This is based on the `economic'
      perspective of the consumer. If the consumer sees it as an investment,
      then colouring that investment as a land deal will not change the
      underlying economic perception. This type of frauds are easily caught
      in jurisdictions where there is a clear investments regulator. If you
      are interested to read about the history of such cases you could look
      at the [Howey Case][] where this trick was tried in
      1946. The U.S. Supreme Court clearly held that selling land could not
      be a cover for what was essentially selling a security. In the IFC,
      UFA will be the residual financial sector regulator. If the activity
      is an financial service/product and it is not banking or payments,
      then it is under the am-bit of UFA. The UFA will be have the power to
      raid the offices of Shardha and get the offer documents. It will
      clearly show a 18-20% return that was being promised if the land was
      not taken.

      The UFA will use this in the specialised criminal court to show that
      this is a colourable exercise which has the objective of avoiding the
      law. This will also be supported by the general legal principle 'What
      the law forbids to be done directly cannot be made lawful by doing it

      This type of schemes trying to avoid jurisdictions are more than 50
      years old. Most countries have developed jurisprudence and legal
      systems to counter them. The same will happen under a principles based
      IFC which prohibits `investments'


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