Prior to Companies Act 2013, fraud was largely seen as a broad legal concept. But with economic crime assuming newer and bigger forms, the definition of fraud in Section 447 of the 2013 Act has been widened to include any act, omission, concealment of fact or abuse of position to deceive, gain undue advantage from, or 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. Fraud could now include corrupt practices, deceit, conflicts of interest and bribery.

As specified under the 1956 Act, directors have to set the right tone at the top, and assume responsibility for safeguarding the company’s assets and preventing and detecting fraud and other irregularities. Additionally, audit committees have to establish a vigil/ whistleblower mechanism for directors and employees. It is interesting to note that Section 447 or related draft rules do not specify any materiality threshold for reporting fraud(s), except for the reporting by the auditor.

The new law also permits reopening account books and voluntary revision of financial statements or the Director’s Report, with the approval of the National Company Law Tribunal, if fraud is suspected. When there is financial restatement due to fraud, any excess remuneration paid can be recovered from past or present managing director or whole-time director, manager, or chief executive officer. Many sections in the new Act deal with fraud, including incorporation of a company, revival and rehabilitation of sick companies, and winding up. Until now, auditors did not have to legally determine whether fraud has occurred or not, and had to primarily report material fraud related to fraudulent reporting and/ or misappropriation of assets.

There is now onerous responsibility on auditors to act as whistleblowers by reporting directly to the Central Government if they have reason to believe a fraud is being, or has been committed against the company by its officers or employees. “Materiality”, according to the draft rules, refers to frauds happening frequently or frauds involving (or likely to involve) not less than 5 per cent of the net profit or 2 per cent of the turnover in the preceding year.

The Serious Fraud Investigation Office (SFIO) is now a statutory body with power to arrest for offences specified as fraud. The penalties are not compoundable, and are more severe now. Moreover, stringent prosecution is prescribed for companies, involved officers, audit firms, their partners and experts. Punishment can include imprisonment ranging from six months to 10 years; and fine not less than, and up to three times the amount involved in the fraud.

The National Financial Reporting Authority is meant to regulate auditors, and has extensive powers to investigate professional or other misconduct by any member or firm of chartered accountants.

Shareholders and deposit holders can also initiate class action suits against the company, its officers and auditors for failing to protect their interests.

While the provisions have been made stringent and are expected to act as a deterrent, there are several challenges involved too. These include the need to educate and train independent directors and audit committees; set up robust internal controls to identify, prevent and report fraud; use of information technology for monitoring; use of internal audit to strengthen internal control systems; strong code of conduct and ethics policies; and auditor’s reporting of fraud and the extent of intimidating liability prescribed for the auditor.

Arvind Nath Associate Director contributed to the article.

The author is Partner, Price Waterhouse

Related Topics