Decoding the maze of sham deals

Max Amsterdam said “Business is the art of extracting money from another man's pocket without resorting to violence”.

The investigations into the 2G scam have revealed a trail of monetary transactions involving business houses indulging in the heady amalgam of business transactions in lieu of political favours received.

Private limited companies have been liberally used to route these transactions as public limited companies have more disclosure requirements, especially if they are listed.

It is debatable whether slush money paid through a private limited company and reflected in its books of account can be detected by an auditor and reported on. Even if reported, the information would not be in the public domain as reporting would be to the management that would anyway be aware of the transaction.

Auditors, and probably bankers, would need to go beyond accounting standards and look at the business transactions of the entity to smell a rat. A sum of Rs 200 crore moving from a realty company to a vegetable and fruit company and from thereon to an entertainment company before ending up with a company that ran a TV channel has been unearthed.

Exception reporting

Forensic accounting would not be needed to prove that this amount would be the largest amount in the vegetable company's financials and should have triggered a red flag — the doctrine of exception reporting would kick in.

A strange agreement between the vegetable company and the entertainment company in which the former transferred money to the latter in lieu of the latter acquiring a 49 per cent stake in the former was touted as the reason for the exchange of money — the exact reverse of what would occur in a normal acquisition though it is stated that this agreement was never validated.

Time would reveal how the entity that ran the TV channel was able to conceal this amount in its balance-sheet as stated by the CBI. It is not surprising that the entire money trail was reversed through the same conduits once the scam came to light though it has proved to be a case of too little too late.

Public Deposits taken are subject to Section 58A of the Companies Act, 1956 and are subject to limits and disclosures. Inter-corporate deposits between private limited companies was invented to avoid the rigours of the Section. As long as a residuary object in the Memorandum and Articles of Association permitted lending and borrowing of funds, these deposits were freely traded at terms and conditions mutually agreed upon.

Inter-corporate loans

The company that ran the TV channel had taken funds at interest rates of below 10 per cent when it had bank borrowings at rates 4 percentile points above this. Despite taking shelter under the residuary clause, the charges framed against these entities include the fact that since they were not non-banking financial companies, monies could be lent or borrowed only for the purposes incidental to the main objects of the company and these entities do not have lending of money as their main object — another indicator to the auditor and the bankers to look beyond the accounting transaction and justify it from a business perspective. Auditors would prefer to report on anything out of the ordinary just to be safe rather than sorry.

Lifting the corporate veil

Students of accounting and corporate law are taught early the doctrine of lifting the corporate veil as decided in the 1897 case of Saloman vs Saloman. English criminal law is filled with cases wherein the doctrine has been used in criminal law.

In Jennings vs CPS, it was held that “where an offender does acts in the name of a company which constitute a criminal offence which leads to the offender's conviction, then the veil of incorporation is not so much pierced as rudely torn away”. Also, where the transaction or business structures constitute a device, cloak or sham, ie. an attempt to disguise the true nature of the transaction or structure so as to deceive third parties or the courts, the doctrine would apply.

Auditors would need to use this age-old concept of company law in their auditing practices to detect sham transactions.

(The author is a Bangalore-based chartered accountant.)

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