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Ideas & Debate

How pyramid schemes grew deep roots

Victims of pyramid schemes fill claim forms, in
Victims of pyramid schemes fill claim forms, in March, issued by a task force formed by the government. A new report blames regulators and security agencies for the mushrooming of pyramid schemes. /Chris Ojow 

Regulators have a tendency to lag behind innovators in financial activities, as indeed in many other areas. They are jolted into action only when something goes wrong. Perpetually underfunded and incapacitated in terms of human resources, they sit pretty comfortable as rot takes over.

Nothing illustrates this so well than how the sub-prime mortgage crisis developed and the pyramid schemes that have robbed mostly poor Kenyans of their lifetime savings.

And the rot in the stockbrokerage has exposed the weak underbelly of regulation of capital markets — which has eaten badly into investors’ confidence in stock.

Even as investigations into pyramid schemes in Kenya go on, there is doubt as to whether the state can compensate investors for what they lost in the schemes.

And the state should be asking whether it should be responsible for the greed of investors who take unreasonable risks.

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A new report from the Ombudsman places blame on, among others, Kenya’s regulators and security agencies for escalation of pyramid and related schemes.
In the US, regulators did not discover that one David Madoff was running a ponzi scheme.

Investors were promised and some indeed received returns of over 100 per cent. Even 950 per cent returns is reported to have been given within just a month.

In Kenya, pyramid schemes promised investors over 100 per cent returns in a few weeks, which was used to lure them into “investing” even bigger amounts that would later turn out to be a nightmare.

In recent boom years of the stock market in Kenya, investors got returns, but there is no particular year when they even reached 100 per cent. In 2006, investors got a 42-per cent return while in 2005 they received 34 per cent.

Why would anyone expect such huge returns in money-doubling or tripling schemes? Kenyans got easily lured when they were told that they could make more than they were making in the initial public offers (IPOs) that started very well with the KenGen issue.

For example, Deci, a pyramid scheme, had operated in Kenya for three years and there were reported cases of people who had benefited immensely. Indeed, a researcher went about investigating and found a good number of beneficiaries. But that was before the pyramid could no longer be sustained.

Retail investors who thought that the stock market could be used as a pyramid scheme in its initial stage have of course been disappointed.

They must live with the bulls and bears and this is a situation you will find throughout stock market history not only in Kenya, but also in other countries.

There were those who thought that the high returns could be replicated every year. They may not have had the benefit of history of stock markets in Kenya or even elsewhere in the world.

In the early 1990s, the Nairobi Stock Exchange was extremely small in size with hardly any activity. But by 1994, activity had risen dramatically and in that year, the NSE index rose to over 5,000 points —the highest level by then.

And there were those who wanted even higher returns promised by pyramid schemes. And they moved there.

In the US, some of those who benefited are under siege. Indeed, press reports indicate that trustees are asking 223 investors to return as much as $735 million or face legal action. These are those who benefited before the Madoff scheme collapsed.

Are those who benefited from the pyramid schemes in Kenya going to return the money or assets they have accumulated as a result of the schemes?

And how are they going to determine who benefited? Are there still some pyramid schemes in Kenya after the discovery of many that closed down? It is no longer so clear.
If you go around churches today, you will hear of one sort of scheme or the other.

There are those that do not enrol members who are not “saved” or are not part of the congregation.

And if you talk to members you will hear of many success stories— but those are the ones used to lure an unsustainable number of beneficiaries. It may start harmlessly as a merry-go-around, graduate into a savings scheme with trustees for the cash, then a loan scheme.

Higher returns
The savers are encouraged to save more because they are supposed to receive even higher returns. Thus it becomes some sort of credit and savings scheme with expected dividends – you can easily confuse it for a Sacco.

Thus it becomes so convoluted that an ordinary person is not able to distinguish it from a normal Sacco with realistic returns.

And it is not just Sacco-like organisations that behave this way. There are organisations that sprout purporting to do legitimate business but go around looking for shareholders to put in their money.

The shareholders genuinely believe that the organisation will make money and therefore they buy a stake but as soon as the money is surrendered, the promoters disappear into thin air, never to be seen again though rumour may be heard that they in this or that town.

You may occasionally hear that they have moved to southern Sudan, Uganda, Dubai or to the US or even to eastern DRC.

This is not very different from a borrower who takes a bank or Sacco loan and then takes the next flight out of the country and does not intend to ever repay the loan.

Some even start off as genuine business but when business becomes tough they look for short-cuts to get out of the financial rut. Sasanet appears to have begun as a serious genuine ICT-related business but somewhere along the way, things went wrong and it became a pyramid scheme.

In the US, it has since come to light that the Securities and Exchange Commission is developing a regulatory package to respond to weaknesses exposed by the Madoff scandal.

In Kenya, it is not clear whether anybody has contemplated that a scheme such as that of Madoff can be carried out in Kenya by sophisticated conmen who managed to fool even fund managers.

There are brokers who style themselves as magic stock pickers — they can create a portfolio with stocks that can only bring you profit.

One genuine investment banker keeps telling me that if he really could predict what will happen to the stock market, he would no longer be working but would be in his yacht enjoying the pleasures of the world.

There are really no miracle workers in the stockbrokerage industry contrary to the claims some people might make. But how long will the regulators and security agencies remain asleep?

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