The article is written by Shaivi Shah, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from Lawsikho.com. Here she discusses “chit funds”.

What are Chit Funds? 

As per section 2(b) of the Chit Fund Act, 1982 [hereinafter referred to as “the Act”], a chit fund is defined as follows-

“A chit fund is a type of rotating savings and agreement among different persons i.e. friends, relatives, neighbours and family members to subscribe a certain sum of money for a specified period of time.” 

Chit funds are often microfinance organizations. They are collective instruments and are also known as Chitty, Kuree, chit, etc. It is noteworthy to mention that there are over 10,000 registered chit funds in India. Generally, chit funds have two active different roles or designations within them. Such roles or designations are those of member and participant. Under a chit fund agreement, a certain amount of money is deposited on a regular basis by the different members and after the gap of a specified period of time the amount is returned to the subscribers with interest. Chit fund helps in collecting the small savings of a number of individual members which ultimately cumulates or turns into a big amount.

Chit Fund Business Model

The business model on which the operation of a chit fund company runs involves the floating of a chit fund scheme, finding potential members, enrolling members into a chit, collecting contributions, conducting chit auctions, distributing funds and maintaining books. Chit fund companies earn their cut by taking a fixed amount of the members’ total contribution as a fee for operating the chit fund scheme.

Chapter II of the Chit Funds Act, 2016 divides the chit fund business model into the following 5 stages: 

• Set – Up

This is the first phase which involves the chit fund company floating a particular chit fund scheme and enrolling members for the “chit”.

• Chit Contribution 

This stage requires the members of the chit fund to contribute their share of the money. This may be on a weekly, monthly or a quarterly basis depending on the terms and conditions associated with the chit fund scheme.

• Chit Auction 

A chit auction is conducted at this stage by the chit fund company after collecting the contributions of the members. If there is only one member who wants the auction, he/she is allowed to take it. 

• Lucky Member

This stage arises if more than one member wants to receive the chit auction for the month. In such a situation, one of the said members is randomly selected and this “lucky” member gets to take the chit. 

• Reverse Auction

This stage arises when none of the members want to receive the total chit auction for the month. A reverse auction is then held and offered to the lowest taker. 

Chit Fund registration 

As per the norm, chit fund companies are exempt from having to register themselves with the Reserve Bank of India despite being a form of a non-banking financial company. The reason for this is that unlike other NBFCs, the funds of chit funds are regulated by their regulators instead of the RBI. The ideal way that has been recommended to register a chit fund is for the promoters of the chit fund company to initially incorporate a private limited company. The said private limited company should be incorporated with the objective of operating a chit fund business. Once the aforementioned steps are completed, the chit fund company should apply to the Chit Fund Registrar of the State to obtain registration as per section 4 of the Act. Only once this registration has been obtained, can the company be allowed to operate as a chit fund. 

Section 4(3) of the Act mandates that such registration of the chit fund company will not be granted in the following cases:

1. The person or entity in question has been convicted of an offence and imprisoned for the same under the Actor any other legislation that governs chit funds.
2. There has been a default in the payment of the necessary fees or the filing of a particular statement.
3. The person in question was convicted of an offence involving moral turpitude and was sentenced to imprisonment for the same. An exception will arise if 5 years have elapsed since the imprisonment of the person in question. 

Documents required to start a Chit Fund

The documents required to start the chit fund will be those related to the directors as well as the registered office of the company. 

The following personal documents of the directors will be required:

1. PAN Card details 
2. ID proof (Voter ID card, passport, Aadhar card, driving license)
3. Address proof (Latest bank statement, electricity bill, mobile bill, telephone bill)
4. Passport size photograph

The following documents pertaining to the registered office will be required:

1. Latest electricity bill
2. Rental agreement (in case the premises is rented) and a NOC from the landlord
3. Sale deed (in case the property is owned)

Taxability of Chit Funds

The income derived from chit funds are neither said to be taxable or tax deductible, however, this question is considered to be lodged in a grey area. While chit funds are growing in terms of their prevalence, the taxability of the income derived from them continues to be considered as murky water. The general position in this regard is that the income derived from chit funds is not taxable. However, should the member choose to show the money received from the chit fund in question as a loss, then such dividend earned from chit funds would have to be shown as revenue income in the tax filings of the member. If shown as such, the income will be taxable in accordance with the provisions of the Income Tax Act, 1961 in this regard. 

Benefits of a Chit Fund

The chit fund system has a number of built-in advantages that it offers to its members. These include, but aren’t limited to, user-friendly services, tax-free income, easy accessibility, no periodic investment hikes, absence of latent costs, exit options with nominal charges, etc. 

A list of the benefits of chit funds is further elaborated as follows:

1. Chit funds can be used by their members for the dual purposes of a borrowing mechanism as well as their designated usage as an investment. Should a member find themselves in need of funds, they are free to draw money from the chit fund. If there is no such need, the chit fund could continue to serve as an investment for the member.
2. The interest rates are generally determined by the members themselves by reaching a mutual consensus among each other. Such interest rates are variable for each auction.
3. The money that is being borrowed by a member during a time of need is basically being drawn out against his/her own future contributions. 
4. In chit funds, money can be withdrawn by members on the basis of personal sureties as well, unlike the stance followed by banks and NBFCs which compulsorily require tangible securities. Thus, the borrowing mechanism of chit funds is less rigid as opposed to other institutions.
5. The cost of intermediation in chit funds has been recorded to be the lowest as opposed to other financial institutions.

Process of a Chit Fund

The process of the chit fund has been listed below as follows:

1. Chit funds have a number of members enrolled in them which contribute a specified sum of money at regular intervals as determined by the chit fund company for the period of the chit fund scheme. 
2. The money so collected at every interval is then put up for auction to all the member of the chit fund. The chit fund company organizes the auction and all the members have the opportunity to bid for the total money collected, also known as the pot. 
3. The process of bidding requires the bidder to forego some part of the collected money in order to claim it. The bidder who is willing to forego the most money, subject to a cap of 30% of the pot for the same, gets awarded the collected money. 
4. The amount which is remaining or the amount that has been foregone by the winning bidder is then distributed among the rest of the members as the dividend receivable by them from the chit fund scheme. The same is not given to the members in tangible monetary terms, but is rather deducted from their upcoming instalments, i.e., the members will have to pay a reduced amount as their instalment at the next interval. 
5. After the auction, it is binding on the winning bidder to continue to pay the rest of the instalments for the entire period of the chit fund scheme. 

The same process is repeated until all the members have had the opportunity of collecting the pot and a member who has taken the money once will not be permitted to bid in an auction thereafter. If in a particular interval, there is no bidder at the auction, a member is chosen by lucky draw and he/she gets the entire sum of the collected money after a deduction of the organizers charges. 

Saradha Chit Fund Scam

The Saradha Chit Fund Scam was a major financial scam carried out by the founder of the Saradha Group, Sudipta Sen. The scrutiny, suspicion and negative connotation attached to chit funds comes primarily as a response to this scam. The scheme basically entailed taking money from lakhs of investors from all over the country by promising exorbitant returns. Agents were recruited to rope in more and more investors by giving them a commission as high as 30%. In 2009, the SEBI confronted the Saradha Group for the first time, however, in response, the group added 200 new companies to their structure with the purpose of perplexing the SEBI as to where to consolidate the blame. In another bid to throw off the SEBI from its trail, the Saradha Group tried to disguise its ponzi scheme as a chit fund as these fall under the jurisdiction of state governments and not the SEBI.

Eventually, investors were scammed of nearly 4,000 crore rupees and after causing unimaginable political chaos in West Bengal, the company collapsed in 2013 with Sudipta Sen being arrested in Kashmir. A PIL was filed in the Supreme Court thereafter and in 2014, the Supreme Court transferred the case to the CBI. The case is still ongoing and unresolved, however, it is owing to the widescale chaos cause by this financial crisis that the regulations regarding chit funds were revised, a central Act was introduced and measures were made more stringent. 

Regulation of Chit Funds 

The Supreme Court of India, in the case of  M/s Shriram Chits and Investment (P.) Ltd. v. Union of India has defined chit fund agreements as special contracts and has hence deemed them to fall under the concurrent list, i.e., they can be legislated upon by both, central and state governments. While certain states have enacted their own legislations to govern chit funds that fall within their territory, the Finance Ministry has enacted the Chit Fund Act, 1982 as a central legislation. Under this act, the central government has the authority to notify the central Act in different states on different dates as and when deemed necessary by it and upon doing so, if a state act is in place, it would be repealed. The Reserve Bank of India can provide guidance to state governments on regulatory aspects like creating rules or exempting certain chit funds while the SEBI, despite being the regulator of the securities market and consequently regulating collective investment schemes does not have any authority to regulate chit funds. 

Conclusion

While chit funds have had their share of bad press and negative publicity, if invested in correctly, they can provide a good return. They serve the dual purpose of being an investment as well as being a means to borrow money on a rainy day, and hence, cater to the requirements of the working class adequately. Investors will, however, be required to carry out their due diligence on chit funds to check their legitimacy before investing to avoid any sort of foul play being carried out with their money. However, this is the case with most investment instruments, and owing to the new and stricter regulations surrounding chit funds, they seem to be safe enough to invest in.

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