Ponzi Schemes and SEBI Circular on Mutual Funds

A recent news-item on The Mint intrigued us in writing this post. It refers to the Circular SEBI/IMD/CIR No 18/198647/2010 issued by the Securities and Exchange Board of India (SEBI) on 15th March, 2010 which requires Mutual Funds to seize from utilizing the 'Unit Premium Reserve' from being distributed as dividends to the holders of these Funds. Even though the Circular does not state so, in our view the Circular is a conspicuous attempt on the part of SEBI to avoid occurrence of Ponzi Schemes and thus this post.

Before we come to the Circular, let us examine what actually Ponzi Schemes mean. The US counterpart of SEBI, the Securities and Exchange Commission  (SEC) defines such schemes in the following terms;

A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity. 

It further states that "the schemes are named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. At a time when the annual interest rate for bank accounts was five percent, Ponzi promised investors that he could provide a 50% return in just 90 days. Ponzi initially bought a small number of international mail coupons in support of his scheme, but quickly switched to using incoming funds to pay off earlier investors." 

While the SEC claims that it investigates and takes enforcement action against schemes of such nature so as to protect the innocent investors, it is fair enough to admit the recent scam by Bernard Madoff who shot to limelight last year as being the master-mind behind one such widely instituted scheme. The chronicles of Charles Ponzi and Bernad Madoff are noted in detail on their exclusive wikipedia pages and thus we will restrain from repeating it except noting the fact that even the existence of such schemes was known well in the 1920s, they came back to haunt the market regulators even till date. 

There are other attempts to define Ponzi schemes but then we will pass them by only giving references [e.g. #1 from investopedia; #2 from moneyterms],  to conclude that the thrust of such schemes is that they dupe the investing world by offering money to the older subscribers by paying them the sums received from newer subscribers and thus are able to operate simply on flows of money from investors without actually having a business/trade to invest the money in. 

So what does the SEBI Circular do? It concludes from an interpretation of regulatory requirements that "Unit Premium Reserve, which is part of the sales price of units that is not attributable to realized gains, cannot be used to pay dividend." This Unit Premium Reserve is actually the excess amount collected by the funds from the investors at the time of investing in as much as the sale price of the units is higher than the face value of these units or simply, selling the units at a premium. Now in terms of the Circular SEBI has declared that the Unit Premium Reserve has to be credited to a separate account shall not be utilized for the determination of distributable surplus to the unit-holders. 

If the fact is correct that Mutual Funds are indeed utilizing the unit premium to declare dividends, in our view is nothing but an apt following of the concept underlying ponzi schemes where the intent is to lure a new investor by giving dividends to an existing investor where in turn these dividends are sponsored by the new investor. Thus the SEBI circular seems to be on the correct legal plane as one of the functions of SEBI under the SEBI Act, 1992 it to act towards investor protection and ensure that correct practices are breed within the market players. Though the mutual fund units are not ‘shares’ and are “securities” like shares in terms of section 2(h) of Securities Contract Regulation Act, 1956; the interpretation assigned by SEBI seems to be  akin to Section 78 of the Companies Act in terms of which the utilization of premium collected on issue of shares is not allowed to be distributed as dividend. One may also be intrigued to note that SEBI is the authority (and not the Institute of Chartered Accountants of India) which frames accounting standards for Mutual Funds. Thus the SEBI Circular can been seen to be in line with the objective to end any accounting mis-treatment of such amounts towards bringing true, fair and uniform reporting across the mutual fund industry.

The market, however, seems to hold a contrary view. The news article clearly cites various players in the industry alleging this to a potential set-back for the industry and that why the SEBI has awaken now to take action when such practices have been vogue in past as well. We do not have an answer to these claims except to retort with by stating that better late than never. We are only hopeful that the issue would be considered in correct perspective and implemented in full letter and spirit. 

Acknowledgment: As usual, the work will be half done if we fail to acknowledge the inputs given by our dear friend and close follower of this blog, who prefers to be un-named. 

Post Script Rejoinder

After having written the original post we were pointed out of a subsequent order passed by a Whole-Time Member of SEBI in the matter of Credent Industries where the Member in para 13 has observed inter alia as under to hold that the accused were operating a Ponzi Scheme.

13. Further, the preliminary findings of SEBI points out that Credent/Mr. Amaranjay Kumar is operating a "Ponzi Scheme" which is a fraudlent investment operation that pays returns to its existing investors from the money paid by subsequent investors, rather than any actual profit earned.