Rebooting Economy XI: Why are private companies so prone to financial frauds?

Rebooting Economy XI: Why are private companies so prone to financial frauds?

Apart from rise in financial frauds in private companies in India, recent years have also witnessed a rise in the role of shell companies and tax havens in their operations, raising further concerns about illicit operations

Wilful default is quite common to Indian private enterprises. A large part of borrowings is then written off with public money Wilful default is quite common to Indian private enterprises. A large part of borrowings is then written off with public money

On July 22 while India was recording new highs - in COVID-19 case and death counts and in the height of the Ayodhya's latest Ram temple from 161 ft in its 1988 design to 181 ft - a new watchdog of corporate governance made its debut.

On that day, the National Financial Reporting Authority (NFRA), regulator of auditing, announced debarring former Deloitte India CEO Udayan Sen for seven years and imposed a penalty of Rs 25 lakh for "professional misconduct" as Engagement Partner (EP) in auditing and certifying financial statements of the scam-hit IL&FS Financial Services (IFIN) for 2017-18.

The NFRA order said Sen went by the company's attempt at "fraudulent presentation of financial statements" relating to net-owned funds (NOF) and capital adequacy ratio (capital-to-risk assets ratio or CRAR), adding "the fact that the company had ceased to comply with the stipulated NOF/CRAR norms was deliberately misstated". It found the IFIN had incurred losses in 2017-18 which was "turned into a reported profit".

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It concluded: "the statutory auditor (Sen) had been totally compromised".

The IFIN is a subsidiary of the Infrastructure Leasing and Financial Services (IL&FS), a non-banking or shadow banking company which collapsed in 2018 under its own financial misconduct. Banking regulator RBI found it had not disclosed bad loans for four years and initiated bankruptcy proceedings.

The government had sought a five-year ban on the IL&FS's statutory auditors - Deloitte and a KPMG affiliate, two of the Big 4 audit firms, others being PwC and Ernst & Young - for allegedly aiding and abetting the financial fraud.

On April 22, 2020 the Mumbai High Court ruled (though video conferencing) that (a) the Ministry of Corporate Affairs (MCA) and National Company Law Tribunal (NCLT) can't take action against the audit firms of the IL&FS and (b) quashed criminal complaint filed by the Serious Fraud Investigation Office (SFIO), calling it "bad in law" and "non-application of mind".

The court said though the Companies Act of 2013 provided for removing auditors that (Section 140(5)) wouldn't apply to auditors who have resigned.

The new regulator NFRA has filled a legal void. It was set up in 2018 under the Companies Act of 2013 (five years later).

Will it make a material difference to financial frauds by setting the standards? That is highly unlikely.

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Here is how.

Secret behind corporate frauds: Built-in conflicts of interest

The Satyam Computers scam was a watershed moment for India that led to the NFRA. It thoroughly exposed what is wrong with auditing.

A private company, the Satyam Computers unravelled in January 2009 when the man responsible for its phenomenal success and eventual overnight collapse, B Ramalinga Raju, wrote to market regulator Securities and Exchange Board of India (SEBI) detailing all its murky financial deals. Even then, the SEBI took 5 years to investigate and pass its orders.

Raju had been an icon of private sector success (IT sector) and the toast of Indians until then.

The SEBI's 2014 order reproduced Raju's confession letter which revealed: (i) "non-existent" bank balance which "resulted in artificial cash and bank balance going up by Rs 588 crore in second quarter of FY09 (ii) "non-existent" accrued interests of Rs 376 crore (iii) "understated liability" of Rs 1,230 crore (iv) "overstated debtors position" of Rs 490 crore etc. Raju said this had been going on for seven years.

Here is a dead giveaway. Any student of chartered accountancy (CA) doing "articleship" would have detected the company's frauds simply by matching its claims on bank balances with actual bank statements.

The following table (taken from the SEBI order) gives the gap between the company's claims and actual bank statements regarding its fixed deposits as on September 30, 2008.

How did a battery of chartered accountants (CAs) from the Big 4 giant PricewaterhouseCoopers (PwC) miss it, assuming that "articleship" students failed the test of due diligence? Was it an oversight?

Here is another example. The company claimed a cash balance (on September 30, 2008) of Rs 1,782.60 crore in the Bank of Baroda's New York office while the bank statement said it was Rs 50.72 crore.

No way such mismatches could have gone undetected for seven consecutive years.

How did it happen then?

The first answer is the structural design of financial reporting. It is a self-certifying exercise. A private company hires and pays an audit firm for certifying its books of accounts - a clear conflict of interest.

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"He who pays the piper calls the tune" is an age-old maxim. Instead of changing this rule of the game it has been perpetuated to the advantage of private entities like Satyam Computers. Interestingly, the SEBI asked Raju and his associates to "to disgorge the wrongful gain" of Rs 2,353.46 crore earned through insider trading and/or pledging of shares that the CAs would have detected instantly.

Second, the Big 4 themselves have complex organisational structures aimed at subverting Indian laws and regulatory mechanisms. To expect them to ensure integrity of financial reporting of their clients would be naive.

They were once the Big 5. The fifth, Arthur Andersen, collapsed after its client and the then darling of Wall Street, Enron Corporation, collapsed overnight in 2000 when its financial accounting turned out to be built on fake holdings, fake profits and off-the-book accounting. Enron had set up the Dabhol mega power plant (Maharashtra), now being run by public sector units NTPC and GAIL.

Third, the Big 4 audit firms facilitate financial flows to tax havens through shell companies for tax evasion purposes by shifting revenue and profits of their clients.

Before providing evidence for all of this, here is about the Satyam Computers' auditor.

One of the Big 4, the PricewaterhouseCoopers (PwC) audited its accounts. SEBI banned it for two years in 2018 (9 years later). A few months later, in September 2018, the Securities Appellate Tribunal (SAT) quashed it saying (i) there is no evidence of wrongdoing or collusion on part of the PwC (ii) SEBI has no jurisdiction and (iii) banning an audit firm is the "sole prerogative" of the Institute of Chartered Accountants of India (ICAI).

The ICAI is a statutory body set up in 1949 as the self-regulatory watchdog of CAs but has been ineffective, just like the Press Council of India, the self-regulatory watchdog of journalists.

Secret of financial and auditing frauds in India: Unregulated Big 4

To its credit, the ICAI did seek regulatory authority over the Big 4 during litigations that led to a Supreme Court order in 2018 directing the government to frame an appropriate law.

The case pertains to allegations of multiple transgressions by the Big 4, commonly referred to as Multinational Accounting Firms (MAFs), and their Indian associates. In all, 171 such firms were under scrutiny.

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The apex court order said: "...having regard to the statutory framework under the CA Act, current FDI Policy and the RBI Circulars, it may prima facie appear that there is violation of statutory provisions and policy framework effective enforcement of which has to be ensured."

It directed further investigations by the Enforcement Directorate (ED) and framing of appropriate law observing that the "accounting firms could not be left to self-regulate themselves". The charges against them were brought after a series of enquiries by the ICAI and ED's investigation into illegal remittances.

The charges are very serious: (i) violation of the Chartered Accountancy (CA) Act of 1949 that prohibits foreign chartered accountancy firms (companies or partnerships firms) from working in India without reciprocity with the country of their residence (ii) no regulatory control as management and audit firms (MAFs) are not registered with the regulator ICAI (ii) profit-sharing and capital contribution (including for buying Indian CA firms) by violating the FDI policy prohibiting FDI in accounting, auditing, book keeping, taxation and legal services and not seeking RBI's prior approval (iii) entered India for consultancy services but transgressed into taxation, auditing, accounting, book keeping and legal services (multiple conflicts of interest) (iv) not disclosing details of operations and (v) their partnership firms in India are "merely a face to defy the law" that calls for "lifting the corporate veil".

There is no sign of any such law regulating the Big 4 until now.

Preponderance of corporate frauds in private sector

How do private companies fare vis-a-vis public companies in corporate frauds?

The data is difficult to come by but a series of corporate frauds in India in recent months and years reveal that private enterprises dominate (though their victims are more often public sector banks).

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The list of high-profile private entrepreneurs turning fugitive is long: Nirav Modi, Mehul Choksi, Vijay Mallya, Jatin Mehta (Winsome Diamonds), Sandesara brothers (Sterling Biotech) and many more. In April 2019, the ED told a special court that 36 businessmen who have criminal cases pending against them fled India in recent years.

Besides, there are plenty of private entrepreneurs in India who are accused of fraud and are facing investigation: Rana Kapoor (Yes Bank), Rakesh Wadhawan and son Sarang Wadhawan (HDIL and DHIL), Chanda Kochhar (ICICI-Videocon scam), just to name a few.

In a joint study published in May 2020, the Universities of Toronto, California and Chicago found that in the US "11.2% of large publicly-traded US firms on average are engaged in corporate fraud". The study did not disclose relative incidents of frauds in public and private sector enterprises, but an idea can be gleaned from another study.

The study was of 2000 by three other US universities: Texas A&M University, Sam Houston State University and University of Texas. They contacted members of the Association of Certified Fraud Examiners to study corporate frauds. Out of a total of 2,471 cases they received, 611 (25%) related to government-run units and 1,860 (75%) private-run.

What about India? There is no study that looked beyond a sample size of 100 fraud cases to rely on.

Tax evasion, shell companies and tax havens

The real attraction of the Big 4 is not the quality of auditing.

A 2012 joint study by the UN Global Compact-TARI-Indian Institute of Corporate Affairs (IICA) found that the presence of Big 4 firms made no difference to the incidents or detections of frauds, thereby ruling out quality issues. It concluded that "number of frauds in our study is equally distributed among firms audited by the Big 4 and Non-Big 4 auditors..."

A series of recent financial scams involving the Big 4 - from the Satyam Computers (PwC) to IFIN (Deloitte and KMPG), National Spot Exchange Limited (NSEL) scam (Ernst & Yung) - makes it clear.

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The Big 4 are popular for tax evasions. Their connections with tax havens are well known. Investigations into the Panama Papers and Paradise Papers revealed such murky deals at length. Many Indians figured in the first. Prof. Ronen Palan of University of Birmingham and his co-authors of 2010 book 'Tax Havens: How Globalization Really Works' pointed out that the Big 4 were "the very heart" of the gigantic offshore/tax haven world "without which, all this would be impossible". (For more read 'Taxing the untaxed VII: Who supports tax havens and how do they flourish? ')

A 2018 global, firm-level study found "clear evidence of a strong correlation between tax haven use and the use of Big 4". It was a joint study led by the UK's Aston University which found the Big 4 associated with at least 2.9% higher growth rate of tax haven subsidiaries.

It is a different matter that some of the private enterprises, like the Lehman Brothers, linked to the US sub-prime crisis and whose collapse triggered the global panic leading to the 2007-08 Great Recession, was registered in an internal US tax haven - Delaware.

Tax evasion is quite rampant in private sector.

In December 2019, a UK-based transparency campaign group Fair Tax Mark published an investigative report showing that the top six global private companies, Google, Amazon, Facebook, Apple, Microsoft and Netflix, described as the Silicon Six, avoided paying $100 billion tax between 2010 and 2019.

According to OECD-G20's anti-tax avoidance initiative (BEPS), tax avoidance by private companies amounts to $240 billion every year. A 2019 study by the International Monetary Fund (IMF) said the non-OECD countries were losing 1.3% of their GDP or $200 billion of revenue every year to profit-shifting (to tax havens) and the OECD countries about 1% of GDP or close to $450 billion. (For more read 'Coronavirus Lockdown XII: Why the wealthy should be taxed more')

Shell companies have emerged as the conduit for such illicit financial flows for private companies. In August 2017, the Indian government announced that 300,000 shell companies had been identified for tough action, of which 175,000 had already been struck off with a single stroke.

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A few months later, when private sector financial fraud cases stumbled out, namely the PNB (Modi and Choksi), PMC (Wadhawans' HDIL and DHFL), IFIN, Yes Bank (Rana Kapoor) and ICICI-Videocon (Chanda Kochhar) scams, hundreds of shell companies flooded out. The ICICI-Videocon scam revealed a loan was given to a firm in tax haven Cayman Islands. (For more read 'Taxing the untaxed IX: Is India blissfully ignorant to the menace of shell companies? ')

A 2019 IMF-University of Copenhagen study found $15 trillion of the total $40 trillion FDI channelling around the globe is "phantom" FDI structured to avoid corporation tax. The phantom FDI works out to be 37% of the total FDI and equals the combined annual GDP of economic powerhouses China and Germany. Surely, this is not the handiwork of public sector players. (For more 'Taxing the untaxed VI: What are tax havens and why they matter to India ')

Diluting bankruptcy law to save private enterprises

Former RBI Governor Urjit Patel, who had resigned in 2018, recently came out with a book, 'Overdraft: Saving the Indian Save', revealing how the Indian government diluted the Insolvency and Bankruptcy Code (IBC) to help loan defaulters.

His book says after the dilution the time-bound threat of insolvency application isn't credible anymore and that the victory over crony capitalism is at risk. Except for a few public sector enterprises like the Tamil Nadu Generation and Distribution Company, Northern Power Distribution Company, Burn Standard and Company and Hindustan Paper, most of the companies facing bankruptcy proceedings are private ones.

Patel revealed pressures to dilute the bankruptcy application. That it came from private entities is evident. The officiating Finance Minister Piyush Goyal's famous statement of February 2019 that "law cannot be blind, wherein in 90 days arithmetically it becomes a non-performing asset (NPA)" came in his address to a private industries' association.

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In its financial stability report released on July 24, 2020, the RBI has warned that the gross NPAs in Scheduled Commercial Banks (SCBs) could rise from 8.5% in March 2020 to 14.7% by March 2021.

On July 27, HDFC Chairman Deepak Parekh asked the RBI governor not to extend moratorium on loan repayments, pleading that borrowers who have the ability to pay are taking advantage and not paying.

Wilful default is quite common to Indian private enterprises. A large part of borrowings is then written off with public money.

In any case, private sector has been thriving on large public hand-outs and public bail-outs. Therefore, dilution in the IBC is not such a good idea. (For more read 'Rebooting Economy IX: Why is private sector dependent on public money in times of crisis? ')

That is not all.

Growth of private sector in India, particularly the spectacular growth of some industries, owes it to "cronyism" during both the licence-permit era of pre-1991 and the liberalised era of post-1991. This is state-capture wherein the state works for private companies.

Then there is regulatory-capture, wherein independent regulators do the bidding of private sector. The coal and telecom (spectrum) scams demonstrated both.

More often than not, state-capture and regulatory-capture come at the cost of public sector growth (telecom, for example).

The coronavirus pandemic-induced economic slowdown has made no dent in such cronyism.

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Eminent scholar Noam Chomsky was scathing in his comment, during an interview on July 24, 2020, on how the top private corporate giants in the US are enriching themselves with President Donald Trump's help.

He said, "They're just running wild, using Trump and the administration or using the cover of the pandemic to increase their dedication to enriching the very rich and the corporate sector who are, of course, eating it up. They love it."

For anyone to argue that the private sector is inherently more efficient than the public sector is not just facile but without merit. This is reflected in studies comparing efficiency of the two sectors.

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Published on: Jul 29, 2020, 6:52 PM IST
Posted by: Manali, Jul 29, 2020, 6:52 PM IST