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The battle against fraud

Suman Layak        Print Edition: March 18, 2012

Even a bowl of fruit may not be as innocuous as it looks. A team from Ernst & Young was visiting a client company and counselling employees on ethics and corporate gifts, when one employee asked: "Can I send a bowl of fruit as a corporate gift?" and followed it up with: "Does it matter if the bowl is made of gold?"

Ethics in Indian companies have more often than not been a grey area, as the question suggests. Is such a bowl a bribe, after all? The ground is shifting, and in more ways than one.

Since the Satyam scandal, independent directors have been nudging companies to probe fraud

Companies are becoming more aware of fraud, independent directors on company boards are increasingly conscious of their responsibility, and fraudsters are getting cleverer.

Marking these changes, E&Y has drawn up its first survey of fraud in India, titled Fraud and Corporate Governance: Changing Paradigm in India, to be released in March this year.

E&Y does a global survey every year, but this is the first time it has done one focused exclusively on India. Business Today got a sneak peek at the survey results.

A recurring theme in the findings is the willingness of those at the top to sweep things under the carpet. Only 35 per cent of survey participants say their employers take legal action against fraudsters.

The rest are likely to seek a resignation and let it go. The survey says: "Companies typically prefer to avoid reporting any economic offence to a regulator because of a perceived threat to their reputation."

Arpinder Singh, Partner at E&Y and head of their fraud-related services, says: "Indian CEOs do not believe business can be done without paying bribes. Therefore they do not put in policies and controls. Their approach is one of not wanting to know what goes on in their company."

On the subject of corporate fraud, R. Narayanaswamy, who teaches finance and control at IIM Bangalore, says: "The Indian laws are often stronger than US laws. The problem here is weak enforcement."

The E&Y survey gives some indication of how common fraud is in corporate India.

 For more details of the survey, go to www.businesstoday.in/fraudshow
Three out of five respondents say their companies have suffered fraud in the past year. Of these, two-thirds say the fraud was exposed by a whistle-blower - someone who spoke up, either directly to the top management or through a whistle-blowing mechanism that allowed him or her to remain anonymous. E&Y's own forensics team, too, says that 35 to 40 per cent of cases they are called in to investigate are exposed by whistle-blowers within the company.

In July 2008, forensic experts at the top four audit and accounting firms had told BT that whistle-blowing mechanisms hardly work in India (see businesstoday.in/corpfraud).

But things are changing. Many Indian corporations today use the services of companies such as Global Compliance and EthicsPoint. These companies act as third-party operators that handle whistle-blower calls and ensure the anonymity of callers.

E&Y's Singh says that although things are better than three or four years ago, when detection of fraud due to whistle-blowing was negligible, there is still a long way to go.

The Securities and Exchange Board of India mandates a whistleblowing mechanism in Clause 49 of the listing agreement. The provision has been around since 2003, but it has not been effective.

The Public Interest Disclosure Bill, 2010, has increased awareness about whistleblowing and the need to protect whistle-blowers. Still, there is plenty of room for improvement in other mechanisms intended to prevent or detect fraud.

 REGULATORY LANDSCAPE

-PUBLIC INTEREST DISCLOSURE (PROTECTION OF INFORMERS) BILL, 2010: Limited protection for whistle-blower; largely leaves out private sector

-PREVENTION OF BRIBERY OF FOREIGN PUBLIC OFFICIALS AND OFFICIALS OF PUBLIC INTERNATIONAL ORGANISATIONS BILL, 2011: Criminalises bribe offers from foreign public officials

-THE PREVENTION OF CORRUPTION AMENDMENT ACT, 2011 (PROPOSED AMENDMENT TO PCA, 1988): Adds teeth to punish use of influence on government officials

-COMPANIES BILL, 2011: Serious Fraud Investigation Office gets powers to probe companies

-DATA PRIVACY LAWS: Protect personal information, especially personal financial information

-COMPETITION ACT: Prevents abuse of dominant positions; 2002 Act amended in 2007


IIM Bangalore's Narayanaswamy has a story to share about independent directors. "I am a director on the board of one company, and before a committee or board meeting, I struggle with a 200-page agenda," he says.

"I met a gentleman who is a reputed corporate honcho, and is on the board of eight companies. I asked how he managed to handle the work load. He said often he reaches board committee meetings and is not aware or able to recall which committee of the board it is."

Narayanaswamy is working on a paper on corporate governance in India in the wake of the Satyam scandal. He says: "The media wrote a lot about how 200 independent directors resigned after Satyam. What they did not write is that around 180 resign every year. So there was nothing great about those numbers."

He says that if an independent director finds fraud happening in a company, and if investigation shows that the promoters or senior management are involved, the director prefers to serve out his or her term and leave quietly. "They neither demand action nor resign to avoid attention," he says.

Only 35% of respondents say their employers take legal action against fraud

He says that companies like Satyam Computer Services, where the promoter holds a small stake and yet controls the management, are at risk.

"This is where promoter-led fraud happens the most," he says. The E&Y survey findings corroborate this: 34 per cent of respondents say that a "weak tone at the top" is one of the main reasons for corruption.

E&Y's Singh says that since the Satyam scandal, independent directors have been nudging company boards to investigate fraud. He adds: "Any sector that has the government as a major customer is prone to bribery and corruption."

But bribery comes second, after theft of data and information, according to the findings of the E&Y survey.

The third biggest threat is vendor kickback, the fourth is fraud by senior management.

Almost a third of the respondents say they have paid bribes to retain business, and one-fourth say they have paid bribes to government officials to get things done.

The survey identifies some typical fraud techniques:

  • Procurement manager A starts a company in his wife's name. He favours supplier X, and X awards a contract to A's wife's company. The contract may or may not be fulfilled, but a payment is made against it.
  • A promoter makes a deal to buy or sell goods or services from a non-group company owned by a relative or friend. Money flows, but no services or goods are actually provided. However, turnover gets inflated.
  • Sales and purchases are made to and from the same company, just to inflate sales figures.
  • Good stock is discarded as scrap, and then sold in the grey market to generate cash. The survey indicates that the profile of fraudsters is also changing. Today's fraudsters are driven by greed, rather than need, and more concerned with maintaining their lifestyle than with anything else. They are technology savvy, and are often the go-to person in their organisation when colleagues need to solve their IT problems.

 ANATOMY OF A FRAUD

There is just one glitch in the numerous checks and balances to prevent corporate fraud: their implementation depends on the company's management.

The case of a listed manufacturing company shows how easily investors can be defrauded. The management implemented weak controls around key business functions, and kept key decision-making authority within the promoter group.

The promoters regularly entered into transactions for which invoices were faked. The company even developed software to generate fake accounting entries. Payments of fake bills were fi nanced through overdraft. In this way, money was siphoned out of the company.

Fudged inventory records were submitted to fi nancial institutions to maintain a high working capital limit. Records were regularly manipulated by entering fi ctitious inventory details into the accounting system.

By systematically overriding controls for years, the promoters infl ated the balance sheet to three times the actual size. Investigations showed that the promoters had cooked the books to:

  • Meet investor and creditor expectations
  • Retain control of the company
  • Meet targets to maximise incentives and perceived brand value
  • Window-dress accounts to obtain higher valuations at the time of exit from the company
  • Conceal the siphoning off of company resources for personal gain

While more than 80 per cent of the survey respondents say they know about the Indian Penal Code, and 70 per cent say they are aware of the Prevention of Corruption Act, only about half of them know about the United States Foreign Corrupt Practices Act, which applies to US-listed companies beyond US borders. Even fewer know about the UK Bribery Act.

E&Y's Singh says that in one case where a company promoted by a senior manager's wife received benefits, a single stray e-mail on the manager's office PC helped nail the fraud.

Forensic tools such as disk imaging are increasingly being used to detect fraud. Despite the range of technological tools available, 61 per cent of survey respondents say their companies depend on basic spreadsheets for fraud detection.

Weak enforcement of laws and the "weak tone at the top" seem to have encouraged the "bowl of gold" mindset in India. It is likely to take more than an Anna Hazare-type movement to set it right.

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