How Indian companies engage in diversion of funds, and how to spot/avert it

“Companies turn sick, lenders turn sick, but promoters rarely do”-Prithvi Haldea

The inspiration of this blog post came from the above quote of Prithvi Haldea, who also wrote an interesting article on the topic (http://www.primedatabase.com/ie_ph_59.asp). The observations here from my own observations, and a variety of credited sources.

1.      Examples

a.      Satyam:-By creating 6000+ fake salary accounts, Raju apparently(since case is still murky and sub judice) diverted those ‘salaries’- Rs 6000 crores to group companies for purchasing land in Hyderabad. Now, those companies have filed counter suits(!) for getting 'their' intercompany loans back, and the issue is subjudice.

b.     SEBI IPO order Dec11:-Several companies were found misusing or diverting issue proceeds.Besides banning promoters of seven companies, the regulator also suspended three BRLMs from undertaking any new share sales.These include PNB Investment Services, the merchant banking arm of state-owned Punjab National Bank ,Atherstone Capital and Almondz Global Securities. The methods of fund siphoning included inter-corporate deposits, and diversion of IPO proceeds from what was stated in the offer document

c.     Banks:-An oft cited reason for default is poor loan monitoring thus allowing borrower to siphon away the funds.

d.      Vanishing Companies:-The post IPO crash of many companies seems to indicate that the companies remain but their funds vanish into thin air. Be it the plantation companies of the 90s, realty companies of the 2000s or the private wealth management firms/retail recently, some sector or the other invariably destroys shareholder funds.

2.      Checks and balances(including RBI six-step approach to prevent fund diversion)

a.      Monitor fund utilization-mandated for IPOs over certain limit, extended by SEBI to cover warrants money/preferential issues as well. In Apr-11, the MCA has  given ROCs a comprehensive check list of the areas they need to check  on end use of IPO money

b.     meaningful scrutiny of the periodical progress reports/periodical scrutiny of accounts

c.      regular visits to assisted units and inspection of securities charged/introduction of stock audits

d.     initiation of prompt action if warranted, including withdrawal loans

e.      examination of all aspects of diversion of funds during internal audit

3.      Red Flags for investors

a.      Large cash balances not reflecting requisite interest income.

b.     Investments in group companies/associates later written off/’under court dispute’

c.      Long outstanding intercompany loans/deposits/advances

d.     Large amount of IPO proceeds as ‘General Corporate Purposes-these can be more easily diverted without issues

e.      No Quotations obtained for equipment/purchases-this may mean management is not serious about the purpose.

f.       No Lender appraisal of the Project-this may mean 'lemons' problem

g     M&A advisory fees disproportionate to market standards(for example the Japanese company Olympus paid its M&A advisor 33% of a deal value, the deal was later found to be without commercial rationale)

h    Very large note disclosing related party transactions-more the merrier does not hold!