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.