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.

Ensuring Corporate Compliance

Coming from a Stetson Professor is this paper entitled 'Educating Compliance' which beautifully sums up the issues relating to ensuring compliance of law from the corporate entities. Taking note of the problem that to speak of the conviction of corporates is rather absurd and that 'it is the individuals within the corporation ... which qualify for the legal fiction for criminal prosecution', the author argues "that pitting the corporate entity against the individual is a bizarre construct for achieving compliance". 

The author has sought to argue against the 'reactive model' which "looks at punishing misconduct to achieve compliance with the law", to argue that by "focusing more resources on the front end and using a pro-active model to achieve compliance would keep the corporate structure whole and yet also provide a sound basis for eradicating corporate criminality". In short, the author has argued that with the government taking an interactive part to this end, corporates can be educated to keep in place an internal program which ensures that the company carries on its business in a manner which is complaint with the law by building a system in place to this end. The author advances the case of pro-active efforts to achieve compliance by using "corporate guidelines that provide a reward to companies that have effective programs and court decisions that emphasize the need to have compliance measures in place to avoid civil suits." 

Though written in the typical perspective of the United States law, the paper provides insights into the effects of proactive measures to ensure due-diligence on increased compliance by the corporate entities. The potential benefits of such an approach, the author describes in the following terms;

If the pro-active model is successful, government costs should be reduced in that fewer investigations and prosecutions would be necessary. A pro-active model also has the entity and individuals in the company working together to assure compliance. Unlike a reactive model that attempts to secure compliance after misconduct through either rehabilitation or deterrence, the corporation and its employees are not pitted against each other as they try to obtain the best benefit for the entity. Finally, government sponsored education allows the government to reap the benefit of better evidence against a company or individuals within the entity when the company fails to comply with the law. 

From a pure economic perspective, another argument of note is the fact that "The government expends enormous resources prosecuting corporate criminality. It can prove equally, if not more so, expensive to the corporation that needs to defend itself against these actions and accompanying civil actions that may accrue from a prosecution or the corporation's entry into a deferred or non-prosecution agreement" to argue that "In these days of limited resources, one has to wonder if a pro-active model might provide a better method for achieving corporate compliance. Reaching out and educating corporations as to what will be considered unacceptable conduct can allow corporations to formulate better compliance programs."

In all, the paper proves to be a recommended reading for those interesting in this aspect of corporate governance. Have a look.

Satyam: A test for Serious Fraud Investigation Office (SFIO)

1. Today, when SATYAM is the buzz-word of corporate talks and a rejuvenating revival of corporate governance being hailed as the need of the hour, the institution which should have been in the lime-light is M.I.A. The need for a specialized, equipped and pro-active investigator incumbent upon unearthing the manipulations and frauds in the Indian corporate markets is not new. The matter was raised right at the time when Harshad Mehta became a house-hold name. The Securities and Exchange Board of India (SEBI) was brought to fore as the market-regulator in 1992 and given wide powers to call for records and take action against erring listed-companies, but the ensuing corporate frauds nonetheless put in clear terms the need for a specialized investigating agency and not just the entrustment of the investigative functions with the market regulatory.

2. The lack of effective enforcement and foresight in corporate regulation became particularly evident in the aftermath of the Ketan Parakh episode which expose the fallacies and misguided temperaments of the existing agencies. The Report on ‘Corporate Audit and Governance’ submitted by the Naresh Chanda Committee [click here for perusing the Report] brought to fore this urgent need and it was on these lines that the Central Government approved the establishment of a new investigative agency, meant to specialize in corporate frauds which was rechristened as the ‘Serious Frauds Investigation Office’. [Click here for the official notification to this effect.]

3. A Charter was unveiled on 21.08.2003 to put on record the official duties, functions and responsibilities of the SFIO. This Charter of 2003 stated that “the responsibilities and functions of the SFIO will include, but not be limited to, the following;

(a) The SFIO is expected to be a multidisciplinary organization consisting of experts in the filed of accountancy, forensic auditing, law, information technology, investigation, company law, capital market and taxation for detecting and prosecuting or recommending for prosecution whitecollar crimes/frauds.

(b) The SFIO will normally take up for investigation only such cases, which are characterized by –
i) complexity and having interdepartmental and multidisciplinary ramifications ;
ii) substantial involvement of public interest to be judged by size, either in terms of monetary misappropriation or in terms of persons affected, and;
iii) the possibility of investigation leading to or contributing towards a clear improvement in systems, laws or procedures.

c) The SFIO shall investigate serious cases of fraud received from Department of company Affairs. SFIO may also take up cases on its own, subject to para (d) below. The SFIO would make investigation under the provisions of the Companies Act, 1956 and would also forward the investigation reports on violations of the provisions of other acts to the concerned agencies, for prosecution / appropriate action.

d) Whether or not an investigation should be taken up by the SFIO would be decided by the Director SFIO, who will be expected to record the reasons in writing.”

This Charter also stated that “SFIO is expected to be set up as a modal office with state of the art facilities” and “it may outsource work to professional agencies, on case to care basis”.

4. From these it appears reasonably clear that all complex matter involving corporate frauds and requiring expertise for investigations would normally be taken up by the SFIO. In this background, let us see the role of SFIO hitherto in the SATYAM fiasco, if fiasco it is.

5. The facts that can be culled out from the downride SATYAM has been facing in the last month are as under;
- Its CEO Mr. Ramalinga Raju is accused to have siphoned off amounts to the tune of thousands of crores of Rupees from the company accounts. [Therefore corporate fraud]
- The balance sheets of the Company have been said to be fudged to the extent that even the auditors have issued a disclaimer that the audited balance sheets may be considered unaudited. [Therefore failure of statutory audit requirements]
- Some of the auditors involved in checking / verifying / auditing its affairs have been arrested and are being examined at their own end towards their involvement (in terms of illegal gratification or otherwise) in the fudging of statutory records [Thus professional negligence and malpractices]
- The employee pay-rolls are said to be inflated and investment lists of the company said to be based on fraudulent and forged documentation [Thus a mass fraud on the investors and overall other stake-holders]

6. Moreover, this fraud is said to have been perpetrated for more than five years and rapidly increasing in dimensions until the bubble burst. In these circumstances, it definitely seems to be a case in which SFIO should be involved and should proceed with its examination. In fact, one look at the SFIO’s website would also tell that the amount of stakes involved in the fraud is the key and foremost criteria for SFIO to come into action. [check question no. 1 at this link]

7. But surmises apart, what has SFIO done till now? News reports [1] [2] show that unlike SEBI, which got permission from the Supreme Court to quiz the accused, SFIO is yet to pursue the denial of its investigating powers before the lower courts. In the matter which involves billions, delay of hours itself (not even days and months) is crucial to obtain information and evidence before they are destroyed by the interested parties. This lethargy, therefore, reflects well upon the diligence and role of SFIO. It seems that the SFIO is yet waiting for the Government to arm it with ammunition in the form of personnel and resources to carry out its role at a point when a lot of water has already flown down the bridge.

8. On a philosophic note, it is important to remind ourselves that the existence of a democratic society is based on one fundamental principle; Rule of Law. This axiomatic principle has been incumbent upon the functioning of all the three wings, viz. the legislature, executive and judiciary and the manner in which governmental action is undertaken. Of this one important facet is that ‘justice must not only be done but must also seem to be done’. The stakeholders, not only of Satyam bus also of this country, can they not expect the supposedly primer and specialized agency to take lead in this issue and settle the controversy to rest?

9. In this scenario one can only hope (and hope and hope) that the wrong-doors would be meted with justice and faith in the system (which may perhaps be too high to think) be restored to a level where one would be deterred of the consequences (and not just think twice) of impugning such a fraud with the citizens of the country on a whole. And more importantly, this delivery of justice be timely and actually compensatory (if not economically, at least morally) to the persons who have been effected by this fraud and not just a battle worn for the sake of academic discussion and statistical purposes.

10. Perhaps the Supreme Court was right to observe that ‘even God cannot save this country’.

Shareholders v. Stakeholders: The changing paradigm in corproate governance

ORIGINS OF CORPORATE LAW

The paradigms of corporate law have always been fascinating and intriguing for various reasons. Their origin is equally interesting. Formation of companies was initially due to the need for funds from various sources, which were neither forthcoming from the hitherto existing business structures like the partership concerns nor were available on loan for the ideas were either too risky or not the returns promised were not very profitable. This can hardly be understood today unless one imagines the business atmosphere of 15th and 16th century wherein it the domestic trade requirements had been satiated, the only means to expand was to look for other places in the world; just the time when explorers like Vasco-Da-Gama, Amerigo Vespucci, Christopher Columbus and others had just come back from their risky voyages and told their inhabitants of the United Kingdom that there were people outside Europe as well and they needed to take initiative and expand there as well.

It was in this scenario that those who longed to take initiative and march out to the newly discovered worlds found other people with funds but not too enterprising who could lend them out to them on otherwise not so commercial viable rates but only because of the promise of getting a share in the profits. And thus the shareholders in profit were born, not the ones which acted upon the business ideas but merely contributed capital and allowed others to pool in their spirit and enterprise and take a share in the profits earned on a whole by these enterprising man investing the capital generated by these shareholders. No wonder 'share' is understood as 'a share in the share capital of the company' which in a disillusioned sense would mean 'a portion of contribution (and entitlement to reward) in the common pool of resources of the company'.

This arrangement for pooling in capital was legally recognized when the Crown started issuing 'Royal Charters' (though initially on a selective basis), giving the common pool a separate legal identity and giving it various features (like, limitation of each individual's liability, etc.) and slowly we had a generalized law with benchmarks following which any group of two or more people could form a company. In this feature what was novel was the presence of entities which owed their existence to legal fiction. Originally this was something peculiar for though the bulk (and in some cases entirely, as it happened in Soloman v. Soloman & Co.) of resources were contributed and majority of functions were performed by a group of closely related individuals, still they were fictionally divested from the enterprise because of an artificial distinction made in law. Later, however, with more and more instances being recorded of companies with shareholders who were unknown to each other and were related only because they owned a share in the company, the things came to be understood differently, and the modern day company was born.

SHAREHOLDER MODEL

The above sketching of the historical evolution of company law would the essential and close linkages between a company and shareholders. On these lines, it was essentially understood and presumed that the company acted in the best interests of the shareholders i.e. the contributors to the capital stock and that the company's directors owed (in some qualified sense) a fiduciary duty to the shareholders, in whose interests they acted and sought to maximize the returns to their wealth. This belief was, however, shaken when a lawyer and an economist argued over the essential premises on which companies operated and surveyed the existing state of affaris in the 1930s and based upon their findings and arguments, published a book titled "The Modern Corporation and Private Property". These two; Adolf Berle and Gardiner Means, shook the notions of the contemporary understanding of the masses as regards the working of the corporations and the dive station of ownership from management of the corporate capital stood exposed.

This led to a wide spread debate on governance; corporate governance that is. Having witnessed that corporate heads did not actually and at all times, think in the best interests of the shareholders, theories began to be developed and regulation strengthened to ensure that the Directors performed the functions for which they were appointed by the shareholders i.e. maximizing shareholder's wealth. In the late 1990s, the debates on good governance versus bad governance stole the lime light and were perhaps the only topics for discussions and studies across almost all jurisdictions in the world. Studies were conducted and reports issued on the ways to ensure good governance in the helm of corporate affairs and to detach the director from acting in his own interests to make way for the resources of the companies to be used in the most efficiently possible manner. The Report of the Cadbury Committee stands out the most amongst these various initatives. [click here for the entire report] The strengthening of regulations on insider trading etc. were also the other outcomes of this increasing hue and cry for good governance.

STAKEHOLDER MODEL

The above narration would clearly reveal that the entire spectrum for corporate governance were the shareholders. All questions in management were to be decided on the sole basis that whatever was best for the shareholders was to be adopted. This came to be recognized as the 'shareholder model' when societal concerns were sought to be matched with the increasingly rising profits of the corporations. Issues such as 'Corporate Social Responsibility' i.e. a corporation owes a responsibility to the society in which it operates and therefore has to act upon it, etc. came to be raised and were being argued vigorously in the early days of the 21st century.

The basis for the argument was that since the corporation made profits by exploiting the resources it took from the society, it had a responsibility to return a share of profits it made from such exploitation back to the society instead of all being offered to a handful of shareholders. Further the notion that corporations could work only because the law granted it privilege to do business in its own name and such could not have been possible had no such privilege being granted, therefore the corporation owed a responsibility to share the benefits it derived from such privilege with the post-holders of law, which applying a welfare-state concept meant, that the corporation was obliged to share the benefits of corporatization with the society on a whole.

This was the beginning and essence of the 'stakeholder model' which meant that the corporation had to act in the best interest of not the shareholders alone but of the stakeholders on a whole; wherein stakeholders was a term used to collectively refer to all those who owed/owned an interest (stake) in the functioning of the corporation. Therefore, for illustration, the stakeholders of a corporation operating in a village would mean all the villagers (for they suffer from the pollution created by the corporation), the village administration (for they were responsible for the disturbance created by the corporation in the normal functioning of the villagers), the employees of the corporation (for they contributed to the well-being of the company and therefore are entitled to share proceeds from the benefits earned by the company from their sweat and toil), etc.

This sudden increase in the number of people and also the various classes of people to whom the corporation owed a responsibility meant that a significant amount of time and resources had to be diverted by the corporate managers to initiatives and activities which would not have opted for without such a responsibility and thus were at first evasive to such philanthropic concerns. Thus various countries sought to influence the corporate management's behaviour through legal means such as granting tax incentives, dealing only with such corporations which acted upon such shareholder models for government procurement, etc. Further, with the popularization of the movement of Corporate Social Responsibility (or CSR), the corporate management on their own thought wise to devote some portion of their resources (the proponents of CSR would argue that the proportion of these resources are still meager) to the well being of the general folk. However the issue (despite being a relatively new one) is very contentious and has seen an amazing response from the scholarly and academic mainstream.

Thus one may find that corporate governance has really come a long way and shows enormous potential to assume other significant issues within its fold, increasing the tension and paradigm of areas for corporate management to focus upon. The era of shareholders dictating terms to the corporate management has long passed with now most legal regimes making it mandatory for corporate management to follow extensive reporting requirements on the actions and efforts on their part in furthering the social cause and taking care of the stakeholders.

For further reading, I would recommend;

1. Government of UK's website on Corporate Social Responsibility and update on CSR
2. Nottingham University Business School's International Centre for CSR

PSUs & Clause 49: The unaddressed anamolies

The chairman of SEBI M. Damodaran released a statement on 3^rd January, 2008 stating that public sector companies will also have to comply with Clause 49 of the listing agreement for stock exchanges. Clause 49 of the Listing Agreement was added as late as in 2000 after the recommendations of the Kumarmangalam Birla Committee on Corporate Governance constituted by the Securities Exchange Board of India (SEBI) in 1999 and has been subject to amendments and revision ever since.

In 2002 the Narayana Murthy Committee was constituted by the SEBI to assess the adequacy of current corporate governance practices and to suggest improvements. Based on the recommendations of this committee, SEBI issued a modified Clause 49 on October 29, 2004 (the ‘revised Clause 49’) which came into operation on January 1, 2006.

The Clause 49 of the listing agreement stipulates that 50% of the boards of listed companies should comprise of independent directors in case they have an executive chairman and one-third in case of an non-executive chairman, which in turn promotes the original intent of Clause 49 by protecting the interests of investors through enhanced governance practices and disclosures. The stated clause aims at a corporate governance requirement which needs to be met by all listed companies, in all Indian Stock Exchanges, including the NSE and BSE.

But, Mr. M. Damodaran’s claim that PSUs are not exempt for not complying with Clause 49 of the Listing Agreement, looses weight as one systematically examines the revised Clause 49 which the SEBI announced vide its circular no. SEBI/CFD/DIL/2004/12/10 dated October 29, 2004 which has acted as an amendment to Clause 49 of the Listing Agreement.

The starting paragraph of the circular itself states that the revised clause 49 shall apply to all the listed companies, in accordance with the schedule of implementation given in the revised clause 49 however for other listed entities, which are not companies, but body corporates (e.g. private and public sector banks, financial institutions, insurance companies etc.) incorporated under other statutes, the revised clause will apply to the extent that it does not violate their respective statutes, and guidelines or directives issued by the relevant regulatory authorities.

Therefore, it is hard to imagine, with such a provision in the revised agreement, on how the original intent of the entire basis of the formation of Clause 49 would be upheld, as any PSU which is a body corporate, would only be required to seek refuge under their statutes against the implementation of Clause 49 in their respective companies. Such, an exclusion also includes the directives issued by the relevant authorities, which in turn means that any directives issued by the regulatory authorities, would have more binding value over the body corporate, rather than the compliance with Clause 49. Such, exemption clauses like the one in Clause 49, only gives both the private as well as the public sector units, a loophole in the regulation which can be exploited. Then what purpose does the law serve, if it provides a shield that can be used, against its own implementation at the time of need?

Clause 49 acts, not as a regulatory measure imposing the ideal of corporate governance and transparency in the operations of various organizations, but in turn has been turned into another piece of law, which would not be able to implemented effectively and efficiently, due to the gaping hole by which, most of the body corporate can escape. It in effect merely becomes a skeleton legislation which, could in turn only be abused and not effectively used.