Mitigating fraud and corruption risks in transactions, Bangalore

“It is just as difficult to detect an official’s dishonesty as it is to discover how much water a swimming fish drinks.”                                                    

          – Chanakya in Arthshastra

Fraud and corruption has been part of economy and organization from centuries. These incidents have become more visible with the wider media attention and greater demand for more transparency from stakeholders. India is not unaffected by fraud and corruption and has been ranked 94^th in corruption index by Transparency International. Saket Bhartia, Associate Director, Ernst and Young shared his perspective on fraudulent activities and fraud investigation at the Speaker Event organised by IAIP at Bangalore on February 2nd 2013. He cited examples of recent cases which shook the foundation of some of the biggest names in the world and in India. He informed participants that organizations lose about 5-6% of revenues due to these activities. These activities have strong correlation with market uncertainty and increase with uncertain market conditions. Though sometimes scale of fraud is very low but it may greatly impact the perception about organization and may harm image of organization. He gave an example of one of the IT giant of country where vendor were carrying out a recruitment fraud within the campus of organization and asking for money from candidates. Interviews were held in the office space allocated to that vendor to perform their tasks. The vendor misused the space and unrestricted access to bring bad name to the organization. Though neither organization nor any of its employee were involved in this fraudulent activity but it certainly were a blot on the goodwill and reputation of the organization. Bhartia shared a survey by E & Y on Technology fraud, which revealed that 74% of respondents strongly perceive IT fraud as a serious risk and 1/3^rd of respondents were unaware of the IT ACT of 2000.

Bhartia shared a psychological theory based on behavioral studies on fraudster which examines the main driver behind committing fraud. This theory conceptualizes the fraud triangle consisting of an Opportunity, Pressure and Rationalization. He pointed out that when there is lax in monitoring, an opportunity arises. This opportunity coupled with pressures from job related functions or systematic causes lead people to rationalize fraudulent behavior. Understanding the triangle and mitigation of risks, utilizing systems is a key to reducing fraudulent practices.

According to speaker, 10-15% of employees in an organization are principled and good, another 10-15% are sometimes highly susceptible to committing fraud and the rest 70-80% are in the middle. Managing this large chunk of employees is the biggest challenge as they are fence sitters and can be affected by any component of fraud triangle. He examined that 10-15% who are highly susceptible cannot be stopped by any kind of mitigation system, these people will find out the way out to commit a fraud.

Foreign investors usually make use of metrics provided by organizations such Transparency International to assess the corruption risk of their potential investee markets.  The speaker noted Data or information theft, IP infringement, Bribing or Corruption, Fraud by senior management, Vendor fraud or kickback and Regulatory non compliance as five key areas where frauds takes place.

Bhartia provided participants with some basic steps to assess risks related to fraud and corruption at pre-investment stage and post investment stage. At Pre-investment stage an investor should focus on detailed background checks on target and its promoters, review of corporate governance, fraud risk diagnostic to identify red flags, building appropriate protection in the investment/shareholder agreement etc.  Post investment investor should ensure appropriate corporate governance/fraud risk management framework at the investee company, red flags/fraud indicators, review internal and other audit reports and stay attentive of evasive and inconsistent responses of query.An investor should be wary of the tone at the top of firm, implementation of promises and a whistle blower mechanism among other things.

Bhartia shared a recent trend in private equity investments where deals were being called off due to possible fraud and corruption risks. Foreign firms have also started assessing their operations in India and have become very vigilant. With the increasing level of frauds, private equity firms who were focused on valuations in the beginning have switched over risk management of their investments.

Bhartia highlighted overstatement of assets, understatement of liabilities and inflation of income as key areas where most fraudulent practices take place within an organization. It is always better to double check “too good to be true” situations and be on the lookout for the following red flags. Red flags could be:

• Significantly different operating margins
• Changes in key management personnel
• Frequent changes in MIS/Reporting formats
• Failure to rectify repeated weakness in controls reported by internal auditors
• Large number of related parties- Employees or Vendors
• No independent review and approval for transactions related to promoters/CEO
• Evasive & inconsistent responses to queries from investors & directors

The speaker identified few reasons for increasing levels of corrupt practices such as lack of political will, vast differences in per capita income, absence of single window solutions for investors, lack of political stability, delays and lack of co-ordination in judicial process etc.

Contributed by: Abhimanyu JL and Deepak Mundra, CFA

Photo courtsey: Abhimanyu JL