Dynamics Of Fraud Control

Corruption is the abuse of entrusted power for private gain and encompasses corrupt practices in both the public and private sectors. It is imperative to curb the corruption in India and the Legislature has innovative means to do so. Various corporate and fiscal laws in India (i.e., Income Tax Act, Customs Act, Central Excise Act, Companies Act, etc.) empower the regulatory authorities to scrutinise and inspect books of accounts and other records of companies. Inspections are to serve one or more of the following objects and to verify:

1. compliances by companies under the various fiscal acts;
2. whether the company accounts represent a true and fair picture of a company’s finances and have been disclosed in compliance with the acts;
3. whether a company’s funds have been siphoned off, applied or diverted, or the company management has misused its fiduciary position for any personal advantage, in violation of the acts;
4. whether there are acts of mismanagement or oppression, which adversely affect or may adversely prejudice the interest of company stakeholders, which may merit a company to be wound up on just and equitable ground;
5. whether statutory auditors have properly carried out their duties to certify a true and fair view of the state of affairs of a company; and,
6. whether sale, purchase and transfer of current assets are at fair market value.

Fraud investigation

The investigation of companies under section 235 and 237 of the Companies Act, 1956 is entrusted to the Serious Fraud Investigation Office (SFIO) in cases where: (1) the size of the alleged fraud is estimated to be 500 million (US$10 million) or more; (2) the company is listed or has paid-up capital of more than 50 million and 20% or more of the capital is subscribed by the public; and, (3) the fraud involves widespread public concern estimated to affect more than 5,000 people.

The following are examples of the kinds of fraudulent activities unearthed by SFIO.

(i) Project financing: An Indian company overvalued second-hand plant and machinery imported from its overseas parent company to obtain higher term loans from funding institutions. The loan amount thus obtained was transferred to the parent company towards payment for the plant and machinery. The company also procured raw materials at highly inflated prices from its parent company and thereby siphoned off working capital funding as well.

(ii) Negotiable instrument: An Indian company raised sale and purchase bills, showing trading of diamonds among its various group companies in a circular manner, i.e., company A selling to B, then B selling to C and C selling back to A. In the process, no goods were transferred. Bills were discounted with banks, and the company received huge amounts of rupees as advances from banks against the bills.

Initially the company repaid the amounts specified in the discounted bills after the prescribed period. However, after some time, payment was stopped. The main promoter, who was controlling all the affairs of the company, fled the country, and the company stopped functioning, resulting in huge amounts of bank funds becoming non-performing assets.

(iii) Falsification of financials: A company filed accounts showing losses or nominal profits with the income tax department and accounts showing huge profits with ROC and stock exchanges. This was accomplished by overvaluing stock in the accounts that were filed with ROC and stock exchanges in an accounting year other than the financial year. Sales with large profit margins were recorded in the months that were included in the accounting year used for the accounts filed with ROC and for the purposes of investors or other stakeholders.

The company also adopted different accounting methods/systems for the purposes of company law and income tax law. Accounts filed with the income tax authorities always showed losses but the accounts filed with ROC always showed profits. These methods were adopted to project a misleading picture to the public while at the same time avoiding the payment of income tax.

(iv) Capital market: A company adopted a dubious method of creating equity capital by circulation of cheques through the bank accounts of its associate companies, without having any funds in those accounts and with no actual flow of funds to the accounts of the company.

Whatever money was shown to have come in, cheques in equivalent amounts were issued in favour of the companies from which the cheques were received, mostly on the same day or within a couple of days. The mere debit and credit entries in the bank accounts were used for creating equity capital.

The annual report (2010-11) of the Ministry of Corporate Affairs stated that nearly 70 billion in equity "was created by swapping equity shares of the company against preference shares of associate companies at an exorbitant premium. These companies did not have backing of any assets or significant levels of performance to justify high premium."

Promoters often take advantage of manipulated financial performance, selling their shareholding in a company at manipulated prices to make illegal gains from the share market and later repurchasing them at reduced prices by reversing the process in the subsequent period, thus maintaining their control of the company.

Pacts and codes

An integrity pact is an agreement between a government agency and the bidders for a public sector contract, establishing mutual rights and obligations and providing that neither side will pay or offer bribes, collude with competitors to obtain contracts or engage in such abuses while performing their duties.

To combat corruption in public contracting, the Shipping Corporation of India entered into a memorandum of understanding with Transparency International India to implement an integrity pact programme in 2009; Indian Oil Corporation adopted an integrity pact in 2008; and Hindustan Petroleum Corporation implemented a pact for contracts above 10 million (US$190,000) in 2007.

Code of conduct create an ethical environment in organisations. The preparation of such code is mandated by clause 49(I)(D) of the Listing Agreement regulated by the Securities Exchange Board of India, although their implementation is left to the organisations. For example, clause 5 of the code of conduct for Tata companies aims at eliminating all forms of bribery, fraud and corruption, and requires full disclosure before any gift is given or taken. Clause 4 of the Indian Oil code of conduct sets ethical standards for all employees.

UK and US based entities having established offices in India, whether in the form of joint ventures / wholly-owned subsidiaries or Indian Companies whose securities are listed in the US or UK stock exchanges, should ensure due compliances of the UK Bribery Act and US Foreign Corrupt Practices Act, in a global effort to combat corruption in the corporate setup.

Whistle blowing

Whistle blowing refers to disclosing wrongdoing in an organisation to help safeguard the rule of law. Employees of companies and organisations are encouraged to report corruption that they discover through their work, although this may cause risk to the job and even the life of the whistle blower. In India, no law specifically protects whistle blowers and witnesses. Section 5 of the Prevention of Corruption Act, 1988, provides powers to a special judge, including awarding a pardon to a person who makes full and true disclosure of an offence. Section 24 of the act provides protection to bribe-givers from prosecution if they provide all details of the bribe and the recipient.

Annexure I-D of clause 49 of the Listing Agreement provides for a whistle blower mechanism to be established by companies to enable easy detection and reporting of corruption. This provision is a non-mandatory part of the agreement. Companies such as Tata Motors Finance, Maruti Suzuki India and DLF have adopted whistle blower policies.

Disclaimer–The views expressed in this article are the personal views of the author and are purely informative in nature.