Working of a Chit fund
With respect to the recent panic about chit fund fraud by Pearl, what exactly is a chit fund? is it legal? if yes, how is fraud usually committed through such an arrangement?
As per the Chit Fund Act, 1982, Chit means a transaction under which a person enters into an agreement with a specified number of persons that every one of them shall subscribe a certain sum of money by way of periodical installments over a definite period and that each such subscriber shall, in his turn, as determined by lot or by auction or by tender or in such other manner as may be specified in the chit agreement, be entitled to the prize amount. In this process, a group of people get together and pool in resources every month and one of them will get the entire amount collected depending upon his bid. Suppose 10 people get together and contribute Rs.1000 a month. The total amount collected will be Rs. 10000 (10 people x Rs.1000) in one month. In tis month all the 100 people will get together and bid for the this Rs. 10,000 and then person who bids the lowest will get the money. So if person A bids for Rs.9000 B bids for 8000 and C bids for 7000, then C will be entitled to take the cash home that month. Now since C's bid is for Rs. 7000 he will take only that money home after deducting the operational charges. The balance amount (Rs. 10000-Rs. 7000) which is the difference between the amount collected and the amount given to C is Rs. 3000. This amount will be distributed equally among the remaning subscribers. Therefore after the entire process, C contributes Rs. 1000 and takes back Rs. 7000 (he will have to pay the organizers for the operational charges). The remaining contribute Rs. 1000 and get back Rs.333 each. This process ensures that every person saves a certain amount every month and in case of an emergency a subscriber can procure cash the way C did by bidding he lowest amount. The management of the money for chit funds is now done by many companies and the subscribers deposit the money to these compnaies. Over a period of time with interest rates decreasing in Banks, these chit fund companies tried to attract more and more investors with the promise of high interest rates. Quite often these compnies were unable to flfill the promise and could not repay the due amount and often could not return the principla amount itself. Due to the lack of awarness and the urge to earn big people from the lower income group have been manipulated to subscribe to these schemes. There have been instances where the money collected from these people has been used for illegal purposes by the company while the original subscribers get nothing. It is because of this, SEBI has been very cautious about the functioning of these companies.