Always avoid companies that promise assured returns that are too good to be true.
Fraudulent companies provide counterfeit instruments. A recent trick: Issuance of preference shares under the promise of exorbitant returns.
Following a few incidents, investors have been cautioned against putting money in cumulative convertible preference shares (CPCs) and cumulative redeemable preference shares (CRPs) issues that don't have regulatory approvals.
Seashore Securities mobilised Rs 503 crore (Rs 5.03 billion) from 76,758 investors by issuing CRPs. Securities and Exchange Board of India (Sebi) has ordered the company to stop raising money and prevented the sale of its assets.
The preference shares of Seashore Securities came with a promise of 24 per cent annual dividend. These were redeemable six years after the allotment.
After few years of operation, the company defaulted on payment of interest and winded up its operations, following which investors lodged complaints.
Investors' associations said there's little investors can do to get their money back as private firms are allowed to raise funds using preference shares if they comply with the rules and regulations.
"As there's little awareness about preference shares, operators take advantage of the investors using little-known financial instruments like these," said Hinesh Doshi, vice-president of the Investors' Grievances Forum.
He explained that companies raise money using preference shares at a fix rate of interest. When firms declare dividends, these investors get first priority over equity shareholders. But the structure can differ depending on the type of preference share used.
For example, it can be cumulative or non cumulative, redeemable or non-redeemable, convertible or non-convertible. In CPCs, which Sebi has warned against, the dividend is paid to shareholders until a fixed date after which the investment is converted into equity capital of the company.
In the case of CRPs, investors get their money back at the end of the tenure.
"If the company goes bankrupt, preference share holders are given priority over equity shareholders but only after the payment of debt and other liabilities, which is not safe enough for investors," Doshi said.
Hemantsingh Jhala of All-Gujarat Investor Protection Trust said that there's little regulators can do about these companies until they default. These firms come under the regulation of ministry of corporate affairs (MCA) and registrar of companies (RoC).
"As long as they comply with MCA's guidelines, the regulator cannot initiate action," said Jhala. It's only after they default and investors complain that the probe starts. Sebi comes into the picture when these organisations raise money using instruments that comes under its purview.
If you come across a preference share scheme, the first thing to do is look at the rate of dividends.
"Always avoid companies that promise assured returns that are too good to be true. No one can give 18 per cent and 24 per cent fix annual returns," said Suresh Sadagopan, a certified financial planner.