Analytical Speaking

VINOD KOTHARI & COMPANY

Collective Investment Schemes or How

Gullible Investors continue to lose money

Vinod Kothari
[email protected]

Nidhi Jain
[email protected]

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Disclaimer:
This write up is intended to initiate academic debate on a pertinent question. It is not intended to be a
professional advice and should not be relied upon for real life facts.
 Collective Investment Schemes or How Gullible Investors continue to lose money
VKC

Analytical Speaking

At one point of time, it was plantation companies raising money from investors for teak
trees in unseen remote place of Madhya Pradesh. Then there were kind of ponzi
schemes pretending like purchase and sale of assets but essentially giving investors
money for money. Of late, several property companies, mainly from the NCR region,
have been widely advertising offering “guaranteed returns” to investors for investment
in properties. SEBI has reportedly sprung in action against one of these, but that is only
one. Daily newspapers from Delhi are full with ads of property companies offering
secured, guaranteed returns on properties. In fact, one of the leading property
companies, promising to build another Connaught Place, has advertised in all India
newspapers inviting contributions from investors to invest in properties. This has
brought to focus the seldom-noticed provisions about “collective investment schemes”.

The lure of easy money has always been strong enough, and surprisingly, well-reasoned
people are very easily taken by promises of making a decent return backed by secured
investments. It is not that regulators have not warned investors enough; it is also not
that in the past, investors have not suffered. In fact, the operators of the scheme know
that it is a short-lived schemes; the investors also know it is risky investment, but some
how, interest has such an intoxicating impact on people that every now and then, one
such scheme succeeds in attracting investors. And if person succeeds, it is then the
demonstration effect – if the next-door uncleji has invested money and earned 18%,
why would I not do it? Or, if Bobbyji has raised crores of money out of nothing and is
leading a lavish life, why wouldn’t I do it?

The modus operandi is simple – a property company or a property developer will invite
people to invest money in land/plots/flats or simply to-be-constructed properties.
Sometimes, the land/plots/flats are for real; sometimes, they are not. Assuming they
are for real, an investor becomes the investor or allottee of the plot or land, with an
agreement to execute conveyance whereby at some time in future, the plot or the
property will be transferred to the investor. Actually, however, the investor never
intends to buy the plot or property in question – he simply intends to invest money. So,
after a fixed term, say a year, the investor surrenders his right to get the property, and
gets back money with a promised rate of return.

This write up examines the legalities of schemes such as above.

 Collective Investment Schemes or How Gullible Investors continue to lose money
VKC

Analytical Speaking
Regulations on collective investment schemes:

A Collective investment scheme (CIS) is regulated by section 11AA of the SEBI Act,
according to which a scheme or arrangement where contributions, or payments made
by the investors are pooled and utilised with a view to receive profits, income, produce
or property, and are managed by a manager on behalf of the investors is a CIS. Investors
do not have day to day control over the management and operation of such scheme or
arrangement. The law states several exceptions to the definition of CIS, such as NBFC
deposits, public deposits u/s 58A of Companies Act, chit funds, Nidhis etc. Notably,
mutual funds are also excluded from the definition. Also note that a portfolio
management scheme is not covered by the scheme as there is no pooling of money.

The key words in the definition are “pooling of investors’ money” and distancing of
ownership and management of the funds. In other words, if the money raised from
investors for sharing of profits or returns is commingled, there is CIS. The investors are
passive investors; they are not managing their own money. So, the three critical
features of a CIS are:

(a) pooling of money;

(b) entrustment of money to someone such that the investors are not the ones who are
managing their own money; and
(c) sharing of returns from a specified investment.

CISs need to be registered with SEBI. A copy of the offer document of the scheme has to
be filed with SEBI – same as in case of IPOs and FPOs. The scheme also needs rating.
Besides there are several very stringent requirements – someone who is in a hurry to
collect public money will surely not have the patience to comply with the regulations.

Regulatory history of collective investment schemes:

The CIS Regulations were made after plantation schemes had robbed a good amount of
public money and the government came under severe critique. SEBI appointed this
committee under the Chairmanship of Dr. S. A. Dave. The Dave Committee submitted its
report in December, 1998 and the CIS regulations by way of notification by SEBI came in
October, 1999.
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Analytical Speaking
There are several rulings on the issue of registration of the existing CIS floated by many
companies. There are hundreds of companies that had not applied for registration
under the Regulations and had not wind up its CIS to repay investors in accordance with
the Regulations and hence barred by SEBI from operating in the Capital market for few
years (in many cases for 5 years). SEBI has requested the respective State Governments
to initiate civil/criminal proceedings against the entities for apparent offences of fraud,
cheating, criminal breach of trust and mis-appropriation of public funds. It has also
requested DCA to initiate winding up of the entity u/s 433 of the Indian Companies Act
to repay investors and has launched prosecution against the entity and its directors u/s
24 and 27 of the SEBI Act, 1992. As on 31st March, 2011, there are 552 companies
against which prosecution cases were launched for violation of CIS Regulations.

In case of Suman Motels Ltd. vs SEBI on 13 January, 2003 (2003 42 SCL 433 SAT), it was
held by the Securities Appellate Tribunal (SAT) that the order of SEBI directing the
Appellant to refund the money to the investors was in no way faulty. The Appellant
Company cannot claim that it is not required to comply with the requirements of the
Regulation and the Respondent (SEBI) entrusted with the duty of enforcing the
Regulation should not enforce the same.

On 23.1.1998 SEBI decided to undertake a special audit of those CIS which had
mobilized an amount of more than Rs. 5 crores from the public, which included M/s
Paramount Bio-Tech Industries Ltd. It was informed that a sizeable portion of the
amount mobilized has been paid for commission expenses and the agencies were of the
opinion that these companies were deploying the funds received from the public for
non banking financial companies, real estate etc. The Allahabad high Court in case of
M/S Paramount Bio-Tech Industries Ltd. vs UOI on 25 November, 2003 (Civil Misc Writ
Petition No 51911 of 1999) dismissed the petition when the petitioner company
questioned the framing of the regulation by SEBI, by stating that the facts of the case
reveal that the respondent (SEBI) is only regulating the investments to protect the
interest of the investors who invest in various securities/bonds in the nature of
Collective Investment Schemes. In their opinion Parliament and SEBI have the legislative
competence to frame the Act and Regulations.

The Punjab & Haryana High Court in the case of P.G.F. Ltd. vs Union of India on 30 July,
2004 (2005 124 CompCas 201 P H, (2004) 4 CompLJ 288 P, H), held that in this case, a
transaction for purchase of agricultural land in the name of several investors was found
to be a CIS, but then the facts of that case clearly indicate that the entire transaction of
 Collective Investment Schemes or How Gullible Investors continue to lose money
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Analytical Speaking
purchase of land was running as a sham. It was not proved whether land was actually
bought at all, or registered in the name of the so-called investors. Hence, that case is not
of precedent value for the Scheme. Decided that the transaction that was alleged as a
CIS as, though in the guise of purchase of agricultural land, it was actually a pure money
circulation scheme and it was a sham.

Deposit schemes or collective investment scheme:

If, in the grab of so-called investment schemes, what is being raised is a pure deposit,
then RBI regulations are applicable. The definition of "deposit" is provided under
section 45I(bb) of the Reserve Bank of India Act, 1934, that includes and shall be
deemed always to have included any receipt of money by way of deposit or loan or in
any other form. Hence, money for money transactions is deposits – that is, if against
money, the CIS offeror offers repayment in form of money, that is a deposit. Acceptance
of deposits is regulated under sec. 58A of the Companies Act, and in case of NBFCs, by
sec. 45I (c) of the RBI Act. Further, as per section 45S of RBI Act, no individual or a firm
or an unincorporated association of individuals shall accept any deposit.

By combined reading of the above provisions, it is clear that a company accepting

deposits would have to comply with the provisions of RBI guidelines issued in this
behalf.

Muddle of regulations

The unfortunate part is – it is not clear who will regulate such schemes? First of all,
deposits come under RBI purview, and CIS comes under SEBI purview. Sometimes,
money is raised by strange instruments like preference shares or debentures – which,
arguably, is not a deposit at all – hence, it comes MCA. There is no reason why there
should have been distinct regulators, but given that there are, at the first stage, no one
is sure as to who is to take action against a scheme whereby gullible investors’ money is
being sucked off. In this unclear role, regulators keep waiting for years before they jump
in action. By this time, the problem would have already become a crisis.

Another curious hole in the regulatory scheme is LLPs. No one knows why LLPs were
needed in the country at all, but as they stand, LLPs are neither covered by the RBI Act,
nor by the Companies Act, nor by the SEBI Act. So, technically, an LLP may keep raising
 Collective Investment Schemes or How Gullible Investors continue to lose money
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Analytical Speaking
deposits or investments, and still be outside any of the relevant laws. This is a major gap
in the regulatory structure, but we would, as we always do, keep waiting for years
before we would jump in action.