LEGAL ASPECTS OF CORPORATE FRAUD IN INDIA

Company Law, Contract Law

LEGAL ASPECTS OF CORPORATE FRAUD IN INDIA

July 8, 2024

Authored By – GAGANPREET KAUR GILL, CHANDIGARH UNIVERSITY
Edited By – Rajarshi Tripathi

INTRODUCTION

In the corporate sphere, the issue of corporate fraud poses a pervasive and intricate challenge, casting a shadow over the integrity of businesses worldwide. The web of illicit financial transactions represents a significant threat to corporations and their stakeholders. This ultimately erodes shareholder trust, depletes investment capital, and damages the company’s brand reputation.

This article provides a comprehensive analysis of corporate fraud within the Indian context. It delves into the nuances of corporate fraud, including its evolution, types, indicators, and categories. Furthermore, the discussion encompasses past notable examples of fraud that have occurred in India, as well as the evolving regulatory landscape with respect to such practices.

Keywords:- Corporate law, fraud , Whistle blower protection , offence , company

MEANING OF FRAUD

The term “Fraud “ is defined under Section-17[1] which means means and includes any of the following acts committed by a party to a contract, or with his connivance, or by his agent, with intent to deceive another party thereto of his agent, or to induce him to enter into the contract:—

(1)” the suggestion, as a fact, of that which is not true, by one who does not believe it to be true;

(2) the active concealment of a fact by one having knowledge or belief of the fact;

(3) a promise made without any intention of performing it;

(4) any other act fitted to deceive;

(5) any such act or omission as the law specially declares to be fraudulent”. Illustration– “A sells, by auction, to B, a horse which A knows to be unsound. A says nothing to B about the horse’s unsoundness. This is not fraud in A”.

Moreover,according to the Contract Act, a contract obtained through fraudulent means is considered voidable at the option of the party whose consent was obtained by fraud. Section- 19 of the Contract Act establishes that if a party enters into a contract due to fraudulent misrepresentation, the contract is deemed voidable and the non-fraudulent party can choose to void the agreement. The concept of fraud goes beyond just deceit, as was established in the case of Dr. Vimla v. Delhi Administration (1962). The court held that the notion of fraud encompasses more than just deception and can include other unfair means used to obtain consent.

MEANING OF CORPORATE FRAUD

Corporate fraud refers to intentional acts of deception committed by a company or its representatives for the purpose of financial or personal gain. These fraudulent activities undermine the trust and integrity of the corporation and can have serious legal and financial consequences. Some common examples of corporate fraud include: Financial statement fraud, Misappropriation of assets, Insider trading.

At its core, corporate fraud involves the willful misuse of a company’s resources or the breach of fiduciary duties for illicit personal or organizational gain. Combating such fraud is crucial for maintaining public trust and the integrity of the corporate system.

EVOLUTION OF CORPORATE FRAUD

India has a long history of grappling with corporate fraud, dating back to the surge of companies and financial dealings that accompanied the country’s industrialization and economic reforms after independence. This growth, unfortunately, created fertile ground for deceitful activities.

One of the earliest and most infamous scandals was the Harshad Mehta securities scam of the early 1990s. This intricate scheme involving banks, brokers, and financial instruments ultimately triggered the collapse of the Indian stock market and severely damaged the nation’s financial system. The Mehta case exposed glaring weaknesses in India’s regulatory framework, making the need for stricter oversight and enforcement painfully clear.

Subsequent years saw a string of high-profile corporate fraud cases in India, including the Satyam Computer Services scandal, the Kingfisher Airlines debacle, and more recent incidents involving companies like IL&FS and DHFL. These cases revealed deep-seated problems: inadequate corporate governance, feeble internal controls, and troubling collusion between businesses, financial institutions, and regulators.

The Indian government and regulatory bodies like the Securities and Exchange Board of India (SEBI) and the Ministry of Corporate Affairs have taken action in response to these challenges. They have enacted and strengthened various laws, regulations, and enforcement mechanisms. The Companies Act, 2013, the Prevention of Corruption Act, and the Insolvency and Bankruptcy Code all aim to establish a more robust legal framework to combat corporate fraud and promote greater transparency and accountability within the corporate sector.

However, recent cases serve as a stark reminder that the fight against corporate fraud in India is far from over. Continued vigilance, more vigorous enforcement, and a holistic approach that tackles the underlying systemic issues are all essential. As India’s corporate landscape continues to transform, its legal and regulatory framework must also adapt to ensure the integrity and stability of the nation’s business environment.

TYPES OF CORPORATE FRAUD

Corporate fraud, a pervasive threat, manifests through diverse methods, each posing distinct challenges for organizations and stakeholders. Let’s delve into the key categories and tactics employed by perpetrators:

1.Misappropriation of Asset

This encompasses a range of deceptive activities, including:

Payment Fraud: Dishonestly diverting funds through unauthorized transactions.

Accounting Fraud: Manipulating financial records to create a false impression of an entity’s financial health.

Schemes to Inflate Share Prices: Employing misleading tactics to artificially boost a company’s stock value, often to deceive investors.

2.Unauthorized Asset Acquisition:

This involves the illegal appropriation of various assets, including:

Physical Goods: Theft of tangible assets belonging to an organization.

Intellectual Property: Misappropriation of intellectual property rights such as copyrights or patents.

Exploiting Assets Through Dummy Payments: Utilizing fictitious payments to gain unauthorized access to an entity’s assets for personal gain.

3.Corruption:

Corruption encompasses a web of deceitful practices, including:

Fraudulent Payments: Making or receiving illicit payments to achieve an unlawful objective.

Bribery: Offering or accepting bribes to public officials or private individuals to influence their actions.

Aiding and Abetting: Assisting others in committing fraudulent activities.

Politically-Motivated Fraud:Utilizing political influence to shield fraudulent activities.

4. Dominant Forms of Corporate Fraud:

While corporate fraud encompasses a vast array of tactics, some forms are more prevalent than others. These include:

Financial Fraud: Deception involving the manipulation of financial records or the misappropriation of funds.

Asset Misappropriation: The unauthorized seizure of an organization’s assets for personal gain.

Employee Fraud: Dishonest activities perpetrated by employees within an organization.

Vendor Fraud: Deception committed by a supplier or vendor in a business transaction.

Customer Fraud: Deceitful actions by customers aimed at gaining an unfair advantage.

Investment Fraud: Misrepresentation of information or fraudulent practices related to investments.

These prevalent forms of corporate fraud often involve a combination of deceptive practices such as:

Theft of various assets, including money, tangible property, or sensitive information.
Misuse of accounts for personal gain.
Procurement fraud involving manipulation of procurement processes.
Payroll fraud involving the manipulation of employee payroll records.
Misrepresentation of financial data through accounting manipulation.
Inappropriate journal entries used to conceal fraudulent activity.
Suspense account fraud involving the misuse of suspense accounts for fraudulent purposes.
Submission of false expense claims for personal gain.
Fabrication of employment credentials to gain unauthorized employment.
Bribery and corruption to influence business decisions or gain an unfair advantage.

By maintaining vigilance and implementing robust internal controls, organizations can significantly mitigate the risks associated with these prevalent forms of corporate fraud.

LEGISLATIONS THAT DEALS WITH THE CORPORATE FRAUD IN INDIA

THE COMPANIES ACT, 2013 provides laws for punishment related to an individual who commits fraud against the company. [1]

SECTION OF COMPANY ACT DEALS WITH CORPORATE FRAUD

Section 447: Punishment for Fraud[1]

Where the offense of fraud, as established under Section 447 of the Companies Act 2013, has been carried out. The person who has been found guilty of committing such fraud shall be:

Imprisoned for a period that may extend to ten years but not less than six months, and

Shall be liable to pay a fine that may extend to three times the amount involved in the fraud but not less than the amount involved in the fraud.

Forgery (Sections 448, 449, & 450)

These sections address forgery offenses committed against a company. Section 448 specifically deals with creating or altering company documents to contain false or misleading information. Those found guilty of such forgery can be imprisoned for up to seven years and fined ₹5,000. In some cases, the fine may be tripled the amount involved in the fraud.

Liability for Fraudulent Conduct (Section 542)

Section 542 deals with the consequences of fraudulent business practices during company liquidation. This section holds those managing the company personally liable for any debts or liabilities arising from such fraudulent conduct.

Thus, Companies Act aims to ensure the accuracy of information submitted and deter fraudulent activities.
Penalties for false statements and forgery can include imprisonment and fines.
Company managers can be held personally liable for debts resulting from fraudulent business practices during liquidation.

2. PMLA TARGETS CORPORATE FRAUD AS MONEY LAUNDERING

THE PREVENTION OF MONEY LAUNDERING ACT (PMLA) treats corporate fraud as a serious offense. It applies when fraud is committed to conceal criminal proceeds or gain benefits from them. PMLA’s Section 3 defines money laundering broadly, encompassing acquisition, possession, or any act that disguises criminal proceeds. Section 4 prescribes penalties for money laundering, including imprisonment for 3 to 7 years and a fine.

3.SEBI: SAFEGUARDING INDIA’S SECURITIES MARKET

Established in 1992, THE SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI) Acts as a watchdog, vigilantly monitoring fraud in the securities market. SEBI’s key functions include:

* Protecting investors

* Educating investors about the market

* Overseeing intermediaries

* Facilitating the smooth operation of the market

* Regulating business practices

SEBI enforces various regulations to deter fraudulent activities. For instance, Section 12A prohibits manipulative practices and insider trading, while Section 15E penalizes asset management companies for non-compliance with regulations. These measures promote a fair and transparent securities market in India.

4.INDIAN PENAL CODE

Section 409: Criminal Breach of Trust by Public Servant or by Banker, Merchant or Agent

This section applies when someone entrusted with property, like a public servant, banker, merchant, or agent, dishonestly disposes of it for themselves or someone else. In the context of corporate fraud, this can be relevant in cases where:

Company Directors or Employees Embezzle Funds or Assets: “If directors or employees entrusted with company funds or assets misuse them for personal gain, it can be considered a criminal breach of trust under Section 409.”

Section 420: Cheating

This section deals with deceiving another person by fraudulent means and inducing them to deliver property or take an action that results in a disadvantage. In the context of corporate fraud, Section 420 can be applied in cases where:

False Financial Statements Mislead Investors: “If a company publishes misleading financial statements to attract investors, causing them to invest in the company and suffer losses, it can be considered cheating under Section 420.”

Both sections address fraudulent acts involving entrusted property or deception for wrongful gain.
They can be applied in various corporate fraud scenarios depending on the specific nature of the deception or misuse of property.

For a more comprehensive legal framework on corporate fraud, other laws like the Companies Act, 2013, and the Prevention of Corruption Act play a crucial role. These establish stricter oversight and penalties specifically targeting corporate wrongdoings.

CASE LAWS

M/S. Satyam Computer Services Limited vs Directorate Of Enforcement(2009)

This case involves the high-profile Satyam Computer Services fraud, which was one of the largest corporate scams in India’s history.

KEY FACTS:

– Satyam Computer Services Limited was an Indian IT services company that was found to have engaged in massive financial fraud, including inflating revenues, profits, and assets, as well as fabricating bank statements and invoices.

– The fraud came to light in 2009 when the company’s founder, B. Ramalinga Raju, confessed to the scam in a letter to the company’s board of directors.

– The Directorate of Enforcement (ED), the law enforcement agency responsible for investigating financial crimes, initiated proceedings against Satyam and its executives for various offenses under the Prevention of Money Laundering Act (PMLA).

KEY ISSUES ADDRESSED:

1. Applicability of PMLA: The Supreme Court had to determine whether the Satyam fraud case was covered under the PMLA, even though the predicate offense (i.e., the original crime that generated the laundered proceeds) occurred before the PMLA came into effect.

2. Scope of ED’s Powers: The court examined the scope of the ED’s powers in investigating and prosecuting cases of corporate fraud, especially in relation to tracing the proceeds of crime. 3. Burden of Proof: The court deliberated on the burden of proof in PMLA cases, particularly regarding the ED’s responsibility to establish a direct link between the predicate offense and the proceeds of crime.

JUDGMENT:

– The Supreme Court held that the Satyam fraud case was indeed covered under the PMLA, as the offense of money laundering continued even after the PMLA’s enactment.

– The court upheld the ED’s powers to investigate and prosecute the Satyam case, emphasizing the need for effective enforcement mechanisms to tackle corporate fraud.

– Regarding the burden of proof, the court ruled that the ED must establish a direct nexus between the predicate offense and the proceeds of crime, rather than relying on presumptions.

Thus, Satyam case highlighted the importance of robust legal and regulatory frameworks in addressing corporate fraud and the critical role of enforcement agencies in investigating and prosecuting such financial crimes in India.

Punjab National Bank vs. Union of India Thr. Its Secretary (2022)

This case is a follow-up to the previous landmark judgment by the Supreme Court in the Punjab National Bank (PNB) fraud case, which involved the issuance of fraudulent Letters of Undertaking (LoUs) to the diamond merchant Nirav Modi.

KEY FACTS:

– After the initial PNB fraud case, the bank filed a fresh petition seeking further directions from the court regarding the role and accountability of the Reserve Bank of India (RBI) as the banking regulator.

– PNB argued that the RBI’s failure to put in place adequate supervisory mechanisms and internal controls contributed to the massive fraud that led to a loss of over ₹13,000 crore for the bank.

KEY ISSUES ADDRESSED:

1. Regulatory Oversight and Accountability:

– The court examined the extent of the RBI’s responsibility in ensuring the integrity and stability of the banking system.

– It scrutinized the RBI’s role in monitoring and supervising the operations of banks, particularly in relation to the issuance of LoUs.

2. Duty of Regulatory Authorities:

– The court reiterated its earlier stance that regulatory authorities like the RBI have a fundamental duty to safeguard the financial system and cannot absolve themselves of responsibility.

– It emphasized the need for robust regulatory frameworks and effective oversight mechanisms to prevent the recurrence of such large-scale frauds.

3. Remedial Measures and Reforms:

– The court directed the RBI and the Union of India to consider implementing comprehensive reforms in the banking and financial sector to address the underlying issues that enable corporate fraud.

– It suggested measures such as enhancing the RBI’s regulatory powers, strengthening internal controls within banks, and improving coordination between various enforcement agencies.

JUDGMENT:

– The Supreme Court upheld its earlier position and held the RBI accountable for its failure to discharge its statutory duties effectively. – The court directed the RBI and the Union of India to take immediate steps to implement the necessary reforms and strengthen the regulatory framework to prevent and address corporate fraud in the banking sector. Thus, this case reinforces the Supreme Court’s emphasis on the critical role of regulatory authorities in ensuring the integrity and stability of the financial system, and their responsibility in preventing and addressing corporate fraud in India.

EFFECT OF CORPORATE FRAUD ON BUSINESSES IN INDIA

Corporate fraud can have extensive and wide-ranging impacts on businesses, including:

Financial Losses: Fraudulent activities can result in direct monetary losses through the “theft of funds, misappropriation of assets, and revenue manipulation”. These losses can “undermine profitability, impair liquidity, and jeopardize the financial health of the organization”.

Reputation Damages: Corporate fraud “tarnishes the reputation of the company, eroding trust and credibility among customers, investors, suppliers, and other stakeholders”. Once a company’s reputation is compromised, it may struggle to “regain trust and loyalty, leading to loss of business opportunities and market share”.

Legal Consequences: Fraudulent actions often “lead to legal investigations, regulatory penalties, and litigation, resulting in significant legal expenses, fines, and settlements”. These “legal battles can drain resources, distract management focus, and damage the company’s standing in the eyes of regulators and the public”.

Operational Disruption: Fraudulent schemes can “disrupt normal business operations, causing chaos, confusion, and inefficiency within the organization”. “Investigations, audits, and remediation efforts may divert resources away from core business activities, leading to productivity losses and operational setbacks”.

Employee Morale: Corporate fraud “undermines employee morale and trust in the organization’s leadership”. Employees may feel “demoralized, disillusioned, and disengaged, leading to increased turnover, decreased productivity, and a toxic work environment”.

RECENT AMENDMENT IN REGARD TO CORPORATE FRAUD IN INDIA

The Securities Exchange Board of India has introduced new provisions in the Listing Obligations and Disclosure Requirements Regulations, 2021. These amendments aim to “enforce higher disclosure and standards of corporate governance in public listed companies”.

The key change In this amendment is the mandatory “disclosure of fraud, default and arrests”. Listed entities are now obligated to report any “fraud or defaults by the company or subsidiary and any fraudulent activity, default, or arrest of its promoter, director, key managers or any senior management”, regardless of whether these incidents occurred in India or abroad. This new compliance mandate is intended to “increase international security requirements”.

According to Regulation 30(6), a listed company must “disclose to the exchange all the material information at the earliest and should not take more than 24 hours from the occurrence of the event or information”. If the information is not disclosed within this timeframe, the company must provide an explanation for the delay.

These disclosures must be made within specific timelines, depending on the nature and origin of the event[1]

– “Within 30 minutes the decision from the board of directors meeting with respect to the event should be disclosed.”

– “Within the next 12 hours after the event or information occurred should disclose from which listed entity it originated.”

– “Within 24 hours from the occurrence of the event, in cases when it did not originate from within the listed company.”

CONCLUSION & COMMENTS

Corporate fraud remains a pervasive challenge in India, despite the nation’s evolving legal and regulatory framework. While recent amendments like the mandatory disclosure of fraud by listed companies are a positive step towards greater transparency, a holistic approach is needed to effectively combat this menace.

This multifaceted approach should encompass:1.Strengthening Regulatory Oversight: Regulatory bodies like SEBI and the RBI must enhance their supervisory mechanisms and enforcement capabilities to deter fraudulent activities.

2.Promoting Robust Corporate Governance: Companies must prioritize robust corporate governance practices, including strong internal controls, ethical leadership, and a culture of compliance.

3.Enhancing Whistle-blower Protection: Robust whistle-blower protection mechanisms are crucial to encourage internal reporting of suspected misconduct.

4.Public Awareness Campaigns: Educating the public about the red flags of corporate fraud can empower them to make informed investment decisions and hold companies accountable.

5.By implementing these comprehensive measures, India can create a more robust and ethical business environment, fostering trust and confidence among stakeholders and ensuring the long-term stability and growth of its corporate sector.

REFERENCES

Books / Commentaries / Journals Referred

Company law book by Avatar Singh

Online Articles / Sources Referred

Cases Referred

M/S Satyam Computers Services vs. Directorate of Enforcement(2011).
Kingfisher Airlines Ltd vs. Union of India (2015).
Union of India vs. Infrastructure Leasing & Financial Services Ltd (2022).

Statutes Referred