One of the factors that cause stress to the private equity (PE) industry across the spectrum is poor corporate governance and an increasing susceptibility to frauds.
The recent statement by the Union finance minister in the Lok Sabha may bring cheer to PE investors. The minister told Parliament that the ministry, in order to tackle the spiralling rate of frauds, has instituted a Market Research and Analysis Unit to check for financial scams and administer market surveillance on defaulting companies. Further, responding to the investors? needs, the concept of ?early warning system? is being developed to trigger alerts for potential fraudulent activities in a company. These steps will certainly go a long way in ensuring optimism within the PE sector.
A few weeks ago, as per media reports, Bain Capital, one of the well-known PE houses, has dragged EY to a US court, alleging that the auditing firm had knowingly validated and misrepresented false financial statements of kidswear company Lilliput, prompting the PE firm to invest in the company. Bain Capital further asserted that the remuneration of EY was based on inveigling investors to infuse sizeable capital in the company.
Such an exhibition of sharp practice is certainly not the first. TPG?s proposed buyout of Vishal Retail stared hard at a negative fallout in 2010, following apprehensions over the latter?s fudged and misrepresented accounting books. In yet another unfortunate episode, Morgan Stanley PE?s investment into Biotor Industries has gone sour. It was then revealed that directors of Biotor had submitted forged financial documents, causing a massive loss to the PE fund. Similarly, ICICI Venture and Premji Invest were also caught in a snafu, with private equity players sniffing out financial malpractices by promoters of Subhiksha Trading Services.
Such affairs have compelled PE investors to stretch themselves a bit, so that they comprehend the exact behaviour of their portfolio companies. Anyhow, their worry still lies in the approach. Since PE companies are typically minority shareholders, promoters are inclined to deal with such investors not as collaborators but merely as a ?money pool?. Which is why PE funds, on various occasions, have failed to keep a tab on the performance of portfolio companies, and consequently been exposed to financial frauds!
However, in this context, the Companies Act, 2013, seems to offer huge respite to the investors. Section 447 of the new Act provides for an all-inclusive definition of fraud. Fraud, as per this definition, constitutes an act, omission (of any act), any concealment of fact, or even abuse of position. Interestingly, to prove any financial sting in a court of law, one would have to prove the element of mens rea; that the act was an intentional one, regardless of whether any wrongful gain or loss ensued from the transaction.
Even more, to avoid promoters being let off easily because of limited liability placed on certain officers or employees, the new Act extends the ambit of culpability by inserting the word ?person? in Section 447. Accordingly, the said provision would have a bearing on any person who is related to affairs of the company and is guilty of committing fraud. The new law, with Section 448 in place, specifically tightens the noose on auditors who knowingly endorse misleading financial statements, untrue returns, reports and certificates. Likewise, it is advisable for auditors to take heed of Section 147 that specifically makes auditing firms and their partners liable, jointly and severally, for abetting, colluding or double-dealing in any manner whatsoever.
The concept of class action suits, as dealt with in Section 245 (yet to be notified), will further fortify shareholders? interest, following which PE investors will be able to sue promoters and auditors for any financial subterfuge. In fact, stringent penalties may also act as a fresh deterrent. All forms of fraud in the new Act attract the same punishment: imprisonment, ranging from a minimum of 6 months (or 3 years if public interest is involved) to a maximum of 10 years. This is in addition to levying of a fine proportionate to the amount involved in fraud or even thrice that much (on a case-to-case basis), eventually making the committal of fraud a non-compoundable and a serious offence.
All these protective measures are likely to be welcomed by the PE firms, which generally break out in cold sweats whenever a fraud in target companies is detected post investment. While such investors have extended highly critical capital in nurturing entrepreneurs and augmenting businesses, it is only logical to note that better corporate governance has, of late, emerged as an impactful factor in evaluating targets by PE players.
With these proactive measures, implementation of the new Act and better due diligence, one certainly expects fraud to be finally knocked out.
(With contributions from Abhilaksh Gaind)
The author is a partner with J Sagar Associates, Advocates and Solicitors. Views are personal