India Can't Clean up its Financial System Without Breaking the Business-Auditor Nexus

On June 11, the ministry of corporate affairs (MCA) moved the National Company Law Tribunal (NCLT) with a 214-page petition to bar Deloitte Haskins & Sells (Deloitte), statutory auditors of IL&FS Financial Services (IFIN) and BSR Associates (a part of the KPMG network in India), for five years for colluding with management to bury serious issues of round-tripping money and ever-greening loans by buying the auditors’ silence through consulting assignments and worse.

The complaint is against Deloitte, its chief executive Udayan Sen, partner Kalpesh Mehta and BSR’s partner Sampath Ganesh.

A whistle-blower’s letter, first published in Moneylife on April 10, was the basis of a quick investigation by the Serious Frauds Investigation Office (SFIO) leading to this petition being filed in record time.

Hopefully, it will lead to far better outcomes than in the past, if the judiciary cooperates and does not allow lawyers to game the system with endless adjournments.

SFIO has, correctly, targeted statutory auditors first. While it is true that the Reserve Bank of India (RBI), lenders (including mutual funds – MFs), rating agencies and others have failed in their responsibilities, statutory auditors are the first watchdogs that failed to bark. The others, to an extent, can hide behind audit reports being a true reflection of the organisation’s finances, to justify their own complicity.

When Ramalinga Raju of Satyam wrote his famous confession in 2009, he also threw the marquee audit firm, Price Waterhouse & Company (PWC) under the bus. But, although PWC was a controversial and repeat offender, the Securities and Exchange Board of India (SEBI), under two chairmen, allowed the investigation to drag on for nine years. It handed a two-year ban and disgorgement order only in June 2018. This order also did not affect its on-going audits. Is it any surprise that Deloitte thought nothing of colluding with the failed IL&FS group until it led to a systemic panic?

Also read: What Triggered the Downfall of IL&FS?

But this is not the only instance. Quick and decisive action by the MCA is throwing up a lot more dirt, probably because auditors realise that the government is serious this time. I am just putting together revelations in the past few weeks alone, which show how the rotten, business-auditor nexus has attained grotesque proportions and inflicted a massive cost on the financial system. Here are a few examples.

PWC vs Reliance: On June 11, the shares of Reliance Capital and Reliance Home Finance, both from the beleaguered Anil Dhirubhai Ambani Group (ADAG), which has already been exposed for various collusive deals, collapsed on the news that PWC had refused to sign the accounts and resigned with immediate effect.

The ADAG companies reacted with the usual bluster and threatened legal action against the auditor. PWC’s decision to walk out happened after the REDD exposure about the ‘box system’ used by DHFL and Reliance Capital to circumvent rules and well after the MF industry’s controversial lending to these groups had caused panic among investors.

Reliance has said it will finalise its accounts with the other auditor, Pathak HD & Associates, whose term remains valid. So far, all regulators are silent, while NAVs (net asset values) of some debt schemes went into a vertical fall. Now, in a sensational new development, PWC has written to MCA that it has been threatened and intimidated by Reliance Capital.

Infibeam Avenues vs SRBC & Co LLP: On June 11, while ADAG was hogging the headlines, Infibeam Avenues announced that its decision to ‘terminate’ SRBC & Co LLP, its joint statutory auditor, was approved by the MCA. The audit firm, which is part of the Ernst & Young (E&Y) group, was accused of having leaked unpublished price-sensitive information and had earlier denied the charges.

Also read: PWC Quits as Statutory Auditor of Anil Ambani-led Reliance Capital, Reliance Home Finance

It is not clear if this will lead to further regulatory action, but the allegation reveals another venal side of the business-auditor nexus. Every major corporate development indicates information leakage as evident from stock price movements. Moneylife regulars would have read our many exposés of this problem.

Eros International Media Ltd and Hindenburg Research: This case erupted on June 6 when the rating agency CRISIL suddenly downgraded Eros by ten notches. The agency, apparently, woke up just as Hindenburg Research, a US-based forensic financial research firm, and an admitted short-seller of the stock in the international markets, was getting ready to put out an explosive research report.

Its deep audit of this New York-listed Indian company exposed how the audit committee of Eros, as well as its statutory auditors, have ‘failed to raise the red flags’, despite enough holes in the company’s functioning. It also says that Eros’s “bankers seemed more interested in generating fees through debt & equity offerings than in performing credible underwriting” and that the “complex international structure made it too challenging for regulators to enforce.” The Indian auditor of Eros International is Chaturvedi & Shah, which has an association with the Reliance group since the 1980s. Mukesh Ambani controls a 5% stake in Eros.

Eros’s advances had surged 207% and receivables shot up 66% in 2017-18. When Hindenburg Research examined Eros’s claim about not being able to collect trade receivables (largely unsecured), it found that these receivables, largely, did not exist. The forensic investigation also went deep into its subsidiary companies to expose how it used a web of shell companies to round-trip money to promoters. The auditors clearly looked the other way, despite years of warning signs.

“We think Eros’s collapse is an egregious failure of its auditors, Grant Thornton, to apply even basic scrutiny to the company’s financial condition,” it says in a scathing indictment. This is stunning because Grant Thornton did a terrific forensic audit for IFIN (of the IL&FS) group in what is called Project Icarus. Its findings have helped SFIO in that investigation. So far, no regulator has reacted to this.

The Hindenburg investigation has, finally, proved long-standing rumours that Indian companies have been using small and unknown auditors to sign off on subsidiaries and shell companies that were used to route and round-trip money for promoters. Hindenburg Research exposed, with photographs, how Eros Television India Pvt Ltd’s audit firm was housed in a slum rehabilitation building with barely one tablespace.

The report concludes, “Eros’s unravelling is like the obvious ending to a cliché movie.” I would say that Eros is just one of the scenes in this movie; the dirt that has spilt out in June alone suggests that it is the audit industry’s credibility that is unravelling even more rapidly.

The question then is: Where are we headed from here? Remember, RBI has already barred SR Batliboi & Company from handling audits of commercial banks for one year. This seems like a slap on the wrist, but actually causes a major upheaval for the firm, since clients forced to move on for lapses in the statutory audit may not, necessarily, return after a year.

With PWC, Deloitte, Grant Thornton, SR Batliboi (of the Ernst & Young group) and BSR (part of the KPMG group) under a cloud, all the big global names of the audit world have been hauled up for serious lapses. It has already triggered media reports projecting a gloom and doom scenario for India, if all major audit firms face punitive action.

This is a fake fear-scenario propagated by the big four and their powerful lobbying machinery working through mainstream media. Every major upheaval creates an opportunity for growth. Remember, the Deloitte whistle-blower was an insider. Such people need an opportunity to become independent and grow.

In 1992, several lawyers told me how their business quadrupled after the Central Bureau of Investigation (CBI) and banks went on a spree of filing litigation, because the government failed to separate civil issues from criminal fraud and settle the former out of court. Today, many of them are considered marquee law firms.

Companies will be governed dramatically better if managements fear statutory auditors. The government failed to send a strong signal to multinational audit firms after the Satyam scandal. It would have ensured a clean-up long before our bad loans ballooned to Rs 10 lakh crore and several major companies went bust.

The timing is just right again because several disparate events have converged simultaneously. Fortunately, MCA has acted firmly, decisively and quickly with IFIN. Let’s hope the momentum continues.

This story was originally published on Moneylife and has been republished with permission.