India - Corporate Frauds – Emerging Legal Architecture & Judicial Trends.

Legal News & Analysis - Asia Pacific - India - White Collar Crime

13 October 2020

 

Corporate scandals and frauds in India are as old as the hills. The 1950s witnessed the infamous LIC/ Mundhra scam, which was the first major financial fraud of the independent India. Frauds continued with an alarming regularity thereafter in every decade – the infamous Harshad Mehta, Ketan Parekh, Sahara, and Satyam scams are just a few of them. These frauds were investigated by the law enforcement agencies under the relevant provisions of the Indian Penal Code, 1860 (IPC). The Companies Act, 1956 did not have any separate definition of ‘fraud’. Legally, it was not necessary to have a separate one as Lord Macaulay’s IPC adequately dealt with all such crimes. The Companies Bill, 2008 was the original legislative proposal to replace the Companies Act, 1956 basis Dr. J.J. Irani Committee Report (Irani Report). The Irani report did not have any recommendation for a provision like Section 447 dealing with frauds. It seems the intervening major corporate scandals of 2007-08 led the Parliamentary Standing Committee to recommend two new legislative changes:
 

  1. Separate definition of fraud under Section 447 of the Companies Act, 2013 (the Act) and
     
  2. Creation of the Serious Fraud Investigation Office (SFIO) under Section 212 of the Act to investigate those frauds.
     

Section 447 of the Act is an amalgam of several sections of the IPC including Section 405 dealing with Criminal Breach of Trust, Section 415 dealing with Cheating, Section 463 dealing with Forgery and Section 477A dealing with falsification of accounts.
 

Definition of Fraud under Section 447 of the Act
 

Section 447 of the Act starts with words “without prejudice to any liability including repayment of any debt under this Act or any other law” which means without affecting adversely any other legal proceedings. In the context of the said section, it signifies that the proceedings initiated under Section 447 of the Act will not be barred provided they do not adversely affect an action or a proceeding relating to any liability. This includes repayment of debt initiated under any other provision of the Act or any other law for the time being in force.
 

As per the explanation, the various elements in relation to fraud include:
 

(a) any act, or
 

(b) omission, or
 

(c) concealment of any fact or
 

(d) abuse of position
 

committed by any person or any other person with the connivance in any matter, with the intent to deceive, or to gain undue advantage from, or to injure the interests of the company or its shareholders or its creditors or any other person, whether or not there is any wrongful gain or wrongful loss.
 

The term ‘intent to deceive’ has been judicially examined from the perspective of Section 463 of IPC. It was held in the case of Vimla v. State[1] that the idea of deceit is a necessary ingredient of fraud, but it does not exhaust it. The expression ‘defraud’ involves two elements, namely, deceit and injury to the person deceived. Injury is something other than economic loss that is deprivation of property, whether movable or immovable or of money and it will include any harm whatever caused to any person in body, mind, reputation or such others. A benefit or advantage to the deceiver will almost cause a loss or detriment to the deceived. Even in those rare cases where there is a benefit or advantage to the deceiver, but no corresponding loss to the deceived, the second condition is satisfied.
 

Section 447 of the Act has been invoked in a few recent corporate scandals which are still at different stages of trial. Given that it is a relatively new provision, there are no direct pronouncements on this provision so far either by NCLT or the High Courts or the Supreme Court (SC).  This provision has been invoked by the SFIO in a few recent corporate scandals.

 

The Act has introduced stringent punishment for the persons who are found to be guilty of fraud. Fraud, if it involves an amount of at least INR 10 lakh or 1% of the turnover of the company, whichever is lower, is an offence punishable by imprisonment not less than six months and can go up to maximum of 10 years. The provision for fine cannot be less than the amount of fraud and may extend up to three times the fraud amount. However, if the fraud in question involves public interest, the term of imprisonment shall not be less than three years.

 

The offence under Section 447 of the Act is cognisable, non-bailable and non-compoundable.
 

Section 446A of the Act lays down five factors to be considered by the Court while deciding the amount of fine or imprisonment under the Act: (a) size of the company; (b) nature of business carried on by the company; (c) injury to public interest; (d) nature of the default; and (e) repetition of the default.
 

Standard of Proof
 

Section 447 of the Act provides for a maximum imprisonment for 10 years. The standard of proof is ‘beyond reasonable doubt’. Recently, the SC in the matter of Latesh v. State of Maharashtra[2] explained the term ‘reasonable doubt’ as “a mean between excessive caution and excessive indifference to a doubt, further it has been elaborated that reasonable doubt must be a practical one and not an abstract theoretical hypothesis…
 

Conditions for Grant of Bail
 

Section 212 of the Act provides for investigation into affairs of the company by SFIO. Section 212(6) of the Act provides that a person accused of offence covered under Section 447 of the Act shall not be released on bail till the following conditions are satisfied:
 

  1. the public prosecutor has been given opportunity to oppose his release and where the public prosecutor opposes the application,
     
  2. the court is satisfied that there are reasonable grounds for believing that he is not guilty of such offence and that he is not likely to commit any offence while on bail. (Twin Conditions)

 

The Twin Conditions are almost impossible to satisfy – they are identical to the conditions under Section 45 of the Prevention of Money Laundering Act, 2002 (PMLA) for grant of bail to an accused. In a landmark judgment delivered by the SC in Nikesh Tarachand Shah v. Union of India[3], Section 45 of the PMLA was struck down as unconstitutional for being violative of Articles 14 and 21 of the Constitution. Surprisingly, despite the striking-off of an identical section, not only are arrests being made under Section 447 of the Act but bails are also denied using the Twin Conditions[4]. It is interesting to note that the SC in SFIO v. Nitin Johari[5] cancelled the bail granted by the Delhi High Court and took a view that economic offences constitute a class apart and need to be visited with a different approach in the matter of bail.
 

Section 212(14A) introduced by the Companies (Amendments) Act, 2019 provides that if the SFIO report concludes that a fraud has taken place in a company due to which, any director, KMP or other officers have taken undue advantage or benefit in the form of asset, property or cash, then the Central Government can apply to the NCLT for appropriate orders for disgorgement of such asset, property or cash and also hold them personally liable without any limitation of liability.
 

Under the PMLA, it’s a Scheduled Offence
 

Section 447 of the Act has now been included in the list of scheduled offences under the PMLA[6]. This means that handling of proceeds from corporate frauds will now be a money laundering offence. Under the PMLA, Enforcement Directorate has the power to attach and confiscate property determined to be “proceeds of crime” within the meaning of Section 2(1)(u) of the PMLA. However, the unintended consequence of the amendment will be that innocent parties may be questioned about their dealings with a company where fraud is discovered and potentially having their personal assets seized or directors arrested.
 

Reporting Duty of the Auditors
 

Section 143(12) of the Act casts an obligation upon the auditors of companies to report to the Central Government about fraud or suspected fraud committed against a company by its officers or employees. In 2016, the ICAI has published a detailed Guidance Note on Reporting on fraud under Section 143(12) of the Companies Act, 2013 for the guidance of the auditors. Further, if the auditor does not report a fraud as provided above with an intention to deceive the regulators, the auditor can be deemed to have committed a fraud himself and be removed under the provisions of Section 140(5) of the Act.
 

Latest Developments
 

SEBI has amended the SEBI (LODR) Regulations, 2015 with effect from October 08, 2020 to provide that in case of initiation of forensic audit, (by whatever name called), the following disclosures shall be made to the stock exchanges by the listed entities:
 

  1. The fact of initiation of forensic audit along-with name of entity initiating the audit and reasons for the same, if available;
     
  2. Final forensic audit report (other than for forensic audit initiated by regulatory / enforcement agencies) on receipt by the listed entity along with comments of the management, if any.
     

This new requirement to report is without any materiality thresholds, which could cause high level of anxiety to the Audit Committee and Boards as any such disclosure could have a profound impact on the stock price of the company. In addition, a speculative reporting by the media may also create panic among the investor community.
 

Concluding Thoughts
 

Several recent corporate frauds seem to have alarmed the law makers and the regulators. Tightening of Sections 447 and 212 of the Act, coupled with the inclusion of fraud as an offence under the PMLA, has alarmed the Audit Committees and the Corporate Boards. Stringent conditions for the grant of bail, provisions for disgorgement of assets, claw-back of remuneration and unlimited personal liability of directors have further damaged the frayed nerves of independent directors. Regulators and the law enforcement agencies are increasingly becoming prosecution focused. SEBI’s new requirement of reporting to stock exchange, even a commencement of forensic audit, may create further complications every time a whistle blower complaint is received by the Audit Committee. Independent directors now prefer to undertake a comprehensive due diligence of compliance and the governance standards of a company before accepting new board positions. India Inc. is slowly adapting itself to the new normal.
 

 

For further information, please contact:

 

Bharat Vasani, Partner, Cyril Amarchand Mangaldas

[email protected]

 

[1] AIR 1963 SC 1572.

[2] (2018) 3 SCC 66.

[3] (2018) 11 SCC 1.

[4] There are 145 Writs Pending before the SC to deal with a fresh challenge to the constitutional validity which is being heard by another Bench of the SC.

[5] (2019) 9 SCC 165.

[6] This was added pursuant to the amendment was made in the Prevention of Money Laundering Act, 2002 by the Finance Act, 2018.