Financial Times

Financial scandals : Who takes responsibility?

By Prabath Jayakody

It’s just few years since the occurrence of one of the biggest ever financial scandals in Sri Lankan history, the collapse of the Pramuka Bank, which led to thousands of depositors being helpless and desperate after being deprived of monies deposited with the bank. Immediately after the collapse of the bank, there was a serious discussion as to who was responsible for the mismanagement of the bank.
There was widespread criticism of the manner and the extent of the process of supervision conducted by the Central Bank of Sri Lanka (CBSL) over the operations of banks and financial institutions of the country. Besides, the public perception of the effectiveness of statutory audits carried out by leading audit firms was also affected by the incident at that time.Another unfortunate incident has taken place now, just a few years later, which has resulted in similar implications on the society as in case of the one mentioned earlier.

The main difference between the two cases is that the Pramuka Bank was an approved Savings and Development Bank, which had been authorized by the CBSL to accept deposits from the general public whereas in the most recent case (Sakvithi Group Case) it has been an unauthorized unit which had obtained deposits from the public and its officials then disappeared. While the depositors of Pramuka Bank are still striving to recover from the desperation caused by that collapse, thousands of complaints have begun to occupy the complaint books of the Police Department from another set of desperate depositors. Once again the role and the responsibilities of the CBSL has been the subject of widespread discussion in society while similar discussion is taking place with regard to the responsibilities of the national media.

CBSL and the Financial Sector Stability

As per the revised objectives of the CBSL, it’s specifically entrusted with the preservation of the financial sector stability of the country. In order to ensure such financial stability, the CBSL needs to maintain closer and continuous scrutiny and supervision over the various institutions, which are engaged in diverse financial operations such as accepting deposits from the public, lending(loans and advances), leasing and hire-purchasing, foreign exchange transactions, etc. This process of supervising and controlling the financial activities within the country is facilitated by a large number of laws (acts and statutes) whereas the CBSL itself has been vested with the authority to issue directives over such financial activities. The CBSL is the main institution, which is statutorily established, resourced and authorized to supervise, investigate into and control the financial operations within the country. For this purpose, in order to determine the urgency and the degree of supervision that such activities deserve, the CBSL may consider the materiality of the activities in terms of their nature and size, taken either as a single unit/transaction or collectively, and the nature and magnitude of the likely implications on the financial stability and law and order within the country.

As in many other sectors, there can be both legal as well as illegal (unauthorized) parties operating in the financial sector and engaged in various financial activities such as accepting deposits, lending, leasing and hire-purchasing and foreign exchange transactions.

Police had to create special sheds to take down statements of those deceived by the Sakvithi group

All finance companies are required to register with the CBSL in order to accept deposits from the public. Thus, it’s inferred that if any party accepts deposits from the public without being registered, that party is carrying out an illegal operation. Thus, if such party is engaged in any form of advertising, promotion or makes an offer to the general public via mass media or any other form to take part in such activities, the law-enforcing agencies and supervisory bodies should be able to initiate legal action against such illegal operations. Thus, when Sakvithi Group published such advertisements in newspapers, investigations should have been conducted in an effective and efficient manner. If these companies had been incorporated as public or private limited companies with the Registrar of Companies under the Companies Act, then the founders of the companies need to have specified their objectives in their Memorandum of Association, which constitute the activities that they have been incorporated to carry out until they are duly amended. By reference to these documents the legality of their operations could have been questioned.

However, the problem arises if they obtain the money from the public in some other form rather than deposits. The two sources of finance that are available to a company are either share capital or debt capital although their terms and conditions and their distinction can be more complex in practice.

Thus, if a company offers to invest money under a profit-sharing arrangement, this should constitute the issue of shares, which means that such investors should be registered as shareholders of the company. Even though a company is free to borrow from outside parties, such companies should not be allowed to use the term “deposits” and “Profit-sharing” in offering for such debt so that such debts are provided subject to the generally accepted principles and legal provisions relating to debt financing. In such cases these companies will have to issue either debentures or such other form of debt instruments with floating or fixed charges over their assets under competitive market conditions with lenders being able to take legal action in the event there exists a trend of interest in default. This would assist in deterring innocent parties being caught in terms like “deposits” and “profit-sharing” used in fraudulent and misleading advertisements.

The supervisory arms of the CBSL should be strengthened further with improvements to their investigative methodologies and related legal provisions, if needed, so that they will be able to take legal action and other remedial measures to safeguard the wealth of depositors/investors while the investigations are in progress without having to wait till the investigations are completed, if it appears that a fraud or misappropriation is taking place or likely to take place and hence, the money of depositors is at risk. Additionally, this machinery should enable the speedy and timely exchange of relevant information amongst the CBSL, Department of Inland Revenue (DIR) and other law-enforcing agencies in respect of all the financial institutions including finance companies and leasing companies. For example, if a finance/leasing company appears to be understating its actual tax liability (VAT, ESC and Income Tax), then the DIR needs to urge the CBSL to conduct rigorous investigations into the financial statements and other periodic reports produced by those companies and question the validity of the audit opinions expressed by the auditors of such companies, if needed. However, the effectiveness of this task would be heavily dependent on the effectiveness of the arrangement within the CBSL to supervise the performance of its supervisory functions with regard to financial operations including finance and leasing companies.

It seems that there exists a substantial knowledge gap within the society with regard to the capital and money markets of the country including the equity and bond markets (shares/debentures/government securities, etc), derivative markets (foreign exchange, interest rates, etc), other safer investment opportunities available (eg. Unit trusts) and regulatory provisions regarding these operations. Thus, the CBSL should take initiatives to implement, on a continuous basis, programmes to raise public awareness of these areas with the cooperation of other supervisory bodies such as the Securities and Exchange Commission of Sri Lanka. The younger generation of the country needs to keep abreast of these developments with a reasonable awareness of the capital market operations and the regulatory framework through universities, other professional students and upper school students. Regional seminars should also be held for taxpayers in collaboration with the DIR. Government employees, pensioners, private sector employees and Sri Lankans employed overseas can also be specifically targeted either through regional seminars or posted leaflets in addition to general mass media awareness-raising.

It may also be possible that money laundering takes place through investments in these companies as some of this money comes from illegal sources and with a view to avoiding taxation.

Thus, if such companies are allowed to operate (even with the ability to promote their activities through powerful media), it implies that no effective machinery exists for combating money laundering within the economy. Such developments could have devastating impacts on the good governance of the country. It could also affect the effectiveness of the other anti-money laundering measures implemented within the capital and money markets.

It is the duty of the CBSL to establish a framework, which makes sure that fraudulent parties will not be permitted to be engaged in misleading promotion and advertising whereas they will not be able to take advantage of different terms causing definitional ambiguities for their fraudulent motives. We have to accept the fact that such measures alone would not be sufficient to eradicate all such fraudulent financial operations being carried on by individuals and various other parties in an informal manner. However, a strong legal framework and close and timely supervision will prevent organized and planned financial frauds, which spread and develop over time by attracting public attention and trust through large scale targeted propaganda. Besides, such a strong preventive mechanism will enable the law-enforcing agencies to detect such frauds and malpractices in a timely manner before they develop to cause enormous impacts on the financial system. In the Sakvithi Group case some depositors claim that they deposited in that company due to the pretended relationships that the company had with some prominent personalities in diverse fields who were thought to be respectable and trustworthy.

Role of the general public

No one can reject the fact that we have plenty of laws covering almost all the areas of human activity and involvement. Although there may have been inefficiencies and manipulations in the implementation of the legal system, we should honestly accept the fact that a great degree of protection and shelter has been provided to the general public by the legal system including the constitutional law with either deterrent or punitive effects. With regard to financial activities, the role of business and financial laws and regulations, directives of the CBSL and the role played by the CBSL itself cannot be undermined. If there had not been such supervision by the CBSL, the number and the magnitude of financial scandals and frauds would have been unpredictable.

It’s the depositors/investors, who will eventually lose their money due to these frauds. Some deposit in these companies everything that they’ve earned and saved throughout life. It’s not a viable solution to request the CBSL or the government to reimburse the money after the occurrence of such frauds as it’s not the government or the CBSL, which commit these fraudulent acts and take the decision to invest/deposit in such riskier means.

Those, who deposit their money in such companies just for the purpose of earning higher returns than the general bank deposits should understand the basic principles behind the behaviour of financial markets as the lack of knowledge will by no means preclude them from being cheated and from losing. Banks and other financial institutions invest the money you deposit with them in various means. Some of it is lent back to private individuals and institutions for financing their short- and long-term investments while another part is invested in other means such as government securities, shares of companies and debentures, etc in return for a dividend or an interest in consideration of the risks associated with such investments. From this return on their investments, they have to pay out the interest due on the funds provided by depositors, which have been used to invest. Thus, it’s essential that they will earn a higher return on their investments than that they pay on the deposits and their borrowings. Some of these companies are said to offer Rs. 3000 to Rs. 4000 per month for each Rs. 100,000 investment, which effectively amounts to a return of 3-4% per month, which means an annual return of about 36-48% in simple terms. In some cases this is said to be much higher than this. To pay you such a higher return they need to earn a much higher return than this on their investments. A rational investor, therefore, needs to consider a number of possibilities against this backdrop.

Those companies should have highly profitable investment opportunities, which may not be open to the general financial market and may not be subject to competition where they can continue to earn such higher returns, which is almost unlikely to happen. However, a serious doubt arises with regard to the validity of this possibility as it’s irrational for these companies to borrow (deposits/loans) at such higher costs(eg. 50%) provided that they can obtain funds at much lower and competitive rates of interest(eg. 25%) from the banking system. Thus, it would be sensible to look at some other possibilities too.
Banks and other financial institutions would be refusing to lend money to these companies either because of their failure to prove the viability and growth prospects of their business activities and/or they may not have sufficient assets to support their borrowings (as security/pledges/collateral on such loans). This may be a reason why they turn to you!

Such companies may be utilizing these funds for carrying out various illegal operations such as under-world activities, terrorist activities, drug dealings, human smuggling, etc where they can earn higher returns. However, if you invest your money in such companies, the risk (financial and otherwise) you take is much higher, which could even damage your reputation. Besides, you would be indirectly financing such unlawful operations, which will be harmful to society.

They would be operating with a deliberate fraudulent motive with a view to raising as much money as possible from the public and then halting the operations at some point possibly fleeing from the country to avoid any punitive measures.

Therefore, when you are offered higher returns than the general financial markets, it would be advisable to look at those possibilities with caution. The possibility of recovering your money would be very low once such incidents take place even if the responsible parties are taken into custody. Effectively the risk that you take in investing such companies would be much higher even than that you would have taken if you had commenced your own business. Why do all these people and businesses make this much effort to remain profitable, if there exist such unbelievably high-margin investment opportunities?
It should also be remembered that whatever the legal provisions we implement, these culprits will find ways and means of circumventing such provisions for their survival and benefits and hence, it is your vigilance and awareness, which will protect you and your wealth.

Role of the media

Generally, it would not be practical to expect the media institutions to verify the validity of the huge range of advertisements published in their newspapers as they may not have the resources and technical capability to do so whereas they are not even bound by law to do so. However, in respect of financial operations of the country we need to look at this from a slightly different perspective.

Most fraudulent financial institutions build up the trust on them and attract depositors/investors through newspaper advertisements showing rosier prospects to innocent people with no knowledge of the behavior of financial markets. Such fraudulent propaganda on financial operations, when backed by media, will usually result in exponential implications on society and the stability of the financial system of the country. On the other hand the collapse of the financial system and the public trust thereon will cause severe repercussions to the entire society and the economy as a whole.

Thus, it’s vital for the smooth functioning of the financial system that all media institutions will make sure that they only publish advertisements of those financial institutions, which are registered with the CBSL and authorized to carry out the operations addressed by such advertisements.

Even though it’s not the responsibility of the media institutions to check on the validity of what these companies do, no media institution is permitted to publish advertisements offered to buy illegal drugs. Likewise, if an organization is not explicitly authorized to carry out a particular financial operation, no media institution should be allowed to publish advertisements, which promote such activities either directly or indirectly.

In consideration of all these factors, developments and arguments, we need to arrive at the conclusion that preventing such financial frauds or scandals will need the vigilance and corporation of all the parties including the supervisory bodies, owners of funds, media institutions, law-enforcing agencies and the general public. If urgent action is taken to establish such a strong mechanism and constructive financial culture within the country, we may be able to avert such calamities in the future.

(The writer has a background in Finance, Audit and Risk Management).

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