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Monday, August 11, 2014

4 ways to avoid investing in fraudulent schemes

By Uma Shashikant

What do investors want? This is a tough question to answer, though investors seem to be clear in their minds that they are entitled to good returns, preferably with no risk. Investors do not see themselves as being in a market place. They like to think that since they are the providers of money, they should be entitled to returns.

Investors would have been rational and reasonable if those who demanded and used their money were fair and ethical in their dealings. Countless frauds, misappropriation and innovative schemes have scalped investors of their savings. The regulators, who seemingly have investors' interest in mind, have been behind the curve. Borrowers and seekers of capital have a long history of coming up with clever schemes that circumvent regulations and defraud the investor. Investors, therefore, are wary, suspicious and demanding.

What should investors do even as they wait for the system to change and become more fair and equitable? How can we take the investor to the marketplace, and begin to foster responsible buyer behaviour?

First, investors should ask what the nature of their investment is. There are many names in the marketplace: contribution, share, advance, instalment, etc. There are only two things in finance: equity and debt. Either you are a lender to the company, or you are a part-owner of the business. A jewellery store that asks you to open a monthly contribution plan that helps you buy gold at the end, is borrowing money from you. The IPO that seems like the next big thing is asking you to invest in its equity and, therefore, its business.

There can be clever packaging or naming, there may be celebrities endorsing the product and there may be colourful brochures, but everything boils down to one of the two means of raising capital. If there is a promise of interest and the principal, and the scheme runs for a specific period, it is a borrowing. If there is no periodic return, but there are promises of growing the value of the investment over time, it is equity. Both are risky. Investors should be able to cut through the marketing hype and figure out the nature of the commitment. If this is too tough and complex to understand, it is better to stay away, however fancy or attractive the terms might appear.

Second, anyone borrowing public money should not be owned and operated by a closed group. Sahara is known to have set up over 4,000 establishments registered as private limited companies. This means these enterprises are owned by a small group of people, whose accountability is not to the public, but they proceeded to raise deposits from the public. Investors gave money because they were promised good returns, but how the returns would be generated was unknown, and Sahara continued to refuse to place its business activities and the profits generated from those activities in public domain.

The weak laws of the country today allow private operators to raise money from the public. Investors should refuse to park their money with private firms. A company that goes public puts its accounts up for everyone to see. Before borrowing money from the public, the firm should have risk-taking equity investors outside the promoting group that have put their money in.
Third, return is generated by the business operations and should be visible on the balance sheet. Firms have raised money by telling investors that they would invest in teak plantations, emu farms, shrimp farms, orchards and agri plots, that would become money spinners in the future. Research shows that buying behaviour is highly influenced by people than by processes. Many firms use the benefit of mascots, advertising, endorsements and brands to build credibility. Investors should take some time to ask where their money is goint to be invested and how it will generate returns. Without getting involved in such basic investigation, investors will remain gullible.

No amount of regulatory intervention to ensure that investors get the information they need will work, unless investors refuse to patronise poor-quality firms. This is a tough task for policymakers and regulators given the vast population of investors and their varied preferences. But, at a micro level, if that one marginal investor refuses to be taken in by the hype and asks for facts, it will make a difference.

Fourth, spurious capital-raising activity invariably involves highly incentivised distributors. Without high commissions, it would not have been possible for Saradha or Sahara to raise money from a large number of investors. When a simple job of providing an application form to a customer is incentivised by a large percentage as commissions, everyone and his uncle chooses to become a distributor. This large army is spread across products, regulators and regions, and is not regulated by anyone. That a distributor will bring a bad product and push it for a fat commission is a risk that investors continue to face. Killing distribution will mean that good products will not reach investors either, and also take down the good distributors.

Even as regulators struggle to fix this problem, investors can make the effort to find out what the distributor earns. This is not difficult if the investor is not too eager to sign off a 'once-in-a-lifetime opportunity' to make a fortune. Asking the distributor upfront helps, asking for time is a good tactic, and refusing to invest too soon helps. Working with someone over a long time, rather than seeking to transact with different distributors, also helps.

Regulators try to fix this problem by asking for disclosures. This does not always help, since risks can manifest much later, and firms may refuse to comply as we have seen with some of the listed firms that have turned bad. Regulators may create entry barriers for firms raising money. This works to some extent in building quality.

Investors who are aware of how markets work and, therefore, are able to evaluate the products offered to them are always better off. Rather than demand what we should get, maybe we can begin with what we should do. It is, after all, our money.

Source:-The Economic Times

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