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Why scams occur? - Views on News from Equitymaster
 
 
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  • Apr 5, 2001

    Why scams occur?

    What is shocking about the fact that scams occur is not that the scams occur, but that our learned politicians in New Delhi and the regulators in the Reserve Bank of India and SEBI are shocked that they occur at all!

    A "scam" is something illegal, a way in which an objective is achieved by a determined party who, since they are determined to achieve their objective, will find a way to reach that objective – by hook or by crook – irrespective of what the law says. In many cases a "scam" or an illegal act occurs because it is not legal. If it were legal, a "scam" would not occur although share prices could still decline and people could still lose money on their investments.

    If I am an investor with an ambition to make a lot of money on the stock market, I have the option of using my money to make more money or, as is often the case, I don’t have that much money of my own and look around to see whose money I can use to make money for myself. When looking around to see how I can make money, I have options:

    1. I can borrow money from my friends and people who trust me – good for some money but not good for the grand ambitions I have,

    2. I can go to the bank and borrow money legally from them – but there are controls by the Reserve Bank of India and reporting systems that I have to adhere to for declared borrowings,

    3. Use the badla market or the forward trading market to fund my positions in shares – but this leads to an exposure as the financiers can squeeze me if they know I am in trouble

    So, what do I do? I do a "scam". I find a friendly banker or a friendly company or a friendly mutual fund manager (if I am a really generous person, I get all three on my side) and get them to give me the money in some sly fashion (loan to a company, that company gives another loan to another company) and use that money in the stock markets. If the share markets go in my direction and in my favour, that means I have made a profit that allows me to pay off (no puns intended in "pay off") the loans I had taken. The books are all squared up and we all make money and enjoy life. The problems always occur when the grandiose plans get bigger in size and scale and, somewhere down the line, the share prices move against the bet I have taken and causes panic amongst my lenders. Seeing a decline in share price, they may try to cover it up for a while, but ultimately the game has to end and – as we have seen in 1992 and in 2001 – the stocks hit the floor and the scam hits the fan (pardon my Queen’s English).

    Now why did this scam occur? Because the regulators have placed controls on who is eligible for money and how much of it. The ration mentality of the regulators has not changed despite the reforms of Rajiv Gandhi, Rao, and Vajpayee. The regulators are still controlling the one last – but essential – ingredient of a modern financial market: monetary flows. Why should a bull or a bear have to do a scam to raise money to act out his stock market ambitions? Why not allow that bull or bear to float a mutual fund and raise money from any investor who believes in that bull or bear – rightly or wrongly? Imagine the Mighty Mehta Fund or the Khatarnak Ketan Fund or the Daboo Dayal Fund each one filing a prospectus and raising money from investors who believe in the stories they are being told. If SEBI allowed this free raising of money, there would be no scam as all the bulls and bears would have their money power from those who wish to give it to them. Under the present rules and guidelines, the scamster bulls and bears still get their money from small investors, but those small investors don’t know that they are the donors of the money – as the depositors of Bank of Karad in 1992 and Madhavpura in 2001 have found out.

    SEBI’s present rules say that to start a mutual fund you need to have Rs 10 crores in capital. This SEBI says is to protect small investors? Oh, yeah? How many of you feel protected by the existing mutual funds out there? They all have Rs 10 crore in capital. Have they been exempt from the madness and the chaos of this "scam"? Just because you have Rs 10 crores in the bank does not mean that you are honest or that you have the interests of the shareholders at heart. The amount of capital one has to start a business has little relationship to the objective of that business. And why do you need Rs 10 crores to start a mutual fund anyway? The idea of a mutual fund is to raise money from other investors and manage money for them!

    SEBI has had this minimum capital rule for nearly 10 years. And the RBI has been policing money flows to stock markets for decades. Yet scams occur. Precisely because these artificial barriers fail to allow the market to decide what is in its best interests. If the Daboo Dayal Fund had raised Rs 100 crores and if I had invested all that money in a list of D-10 shares and if that money had now turned into Rs 10 crores, how many more funds do you think I could launch in future and how many more investors would give me money in future? Ask Morgan Stanley how much money they have collected since the launch of their fund in India in 1994? Sure there would be a loss of Rs 90 crores to the sacred "small investor" that SEBI and RBI are always protecting, but consider that an expensive lesson for those "small investors" who will save their future money flows by not giving me any of that. In "scams", there is a new bank manager, a new mutual fund official who is willing to give away someone else’s money (without their permission, their consent, or their knowledge).

    SEBI and RBI are busy building dams and preventing the voluntary free flow of money across the economy. Yes, there need to be controls on how much money a bank should lend to brokers, and yes there needs to be a control on how mutual funds invest but the easiest way to break a desire to cheat is to let the market decide who is worthy of getting money and who is not – that Rs 10 crore limit is a fiction created by SEBI and protects only the richer companies and creates less competition for them. It is a joke. Even in USA or UK, there is no such ridiculous requirement to launch a fund. There are rules as to how you can manage the money raised from investors, but there is no Rs 10 crore capital adequacy norm. And if someone does something wrong, they are punished. Frankly, the only thing between a Daboo Dayal Fund and you is an inappropriate SEBI regulation that forces your money to find its way into some laloo share via a conniving bank official. That, to me, is a "scam".

     

     

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