Startups Wake Up To A Spate Of Frauds That Could Dent Their Shine

Three well-known iconic startup brands—BharatPe, Byju’s and Go Mechanic—are among the companies being investigated over the past year for possible frauds, raising questions about the manner in which many unicorns have been functioning.

In the case of BharatPe, the Economic Offences Wing's probe indicated fake invoices and fund siphoning through the company and related party transactions. Go Mechanic faced accusations of frauds, document forgery, and falsification of accounts by investors.

Whereas, the Edtech start-up Byju’s had Enforcement Directorate searches and court cases in the US to deal with.

“Unfortunately, we are witnessing a rise in the number of corporate frauds. A large number of marquee startups were found to be victims of doubtful practices or having regulatory compliance issues,” said Puneet Gupta, Managing Director at Protiviti Member Firm India.

Missing Internal Controls

A CII-Protiviti Risk Management & Internal Controls study into balance sheets of a cross-section of 150 companies found significant gaps in internal financial control (IFC) disclosure.

In the case of companies experiencing adverse events, such as confirmed or alleged fraud, accounting irregularities, or other corporate governance issues, only 19 per cent of them had an adverse comment from auditors on the health of internal financial controls, the study found.

In most of these cases, the adverse comment was made after the ‘adverse event’ was made public. In no case did the directors' report have any adverse disclosures on internal controls.

However, to the credit of India Inc., in annual reports of firms without any recent history of adverse events, only 1.7 per cent had adverse issues raised by auditors expressing concerns relating to the health of IFCs. 

As a result of the audit lapses, the NFRA is “becoming more and more concerned and may audit the functioning of some of the ‘big boys’ in auditing,” said an official at the Ministry of Corporate Affairs, who didn't want to be named.

Besides the fiduciary oversight by corporate boards, finance committees of these boards, as well as independent directors, have come up for scrutiny by the ministry.

Watchdogs Beware

“There are issues with internal financial governance, mainly on account of the composition of the boards. We often find that independent directors are either not truly independent or that they do not perform their role as a watchdog on behalf of the small shareholders,” said Swapan Kumar Sarkar, former president of the Indo-American Chamber of Commerce.

Both officials at the Ministry of Corporate Affairs, as well as professionals like Sarkar, feel that instead of just the set of post-facto regulatory controls, there is a need for better guidelines with clear rules for corporate directors so that they detect the possibility of both frauds and financial adversity.

Speaking of recent events that unfolded in a marquee startup, Puneet Gupta further pointed out that he “was surprised on why questions were not asked inside the boardroom when the close relative of a promoter was given responsibility for internal audit … various internal control mechanisms are often missing in some firms.”

As independent directors and audit committees bear a significant responsibility in areas such as risk management, internal control, and related areas, “there is a pressing need for substantial efforts in training independent directors in these domains," added Gupta.

This is more so because these directors while fulfilling their duties, may well face the risk of legal repercussions for corporate shortcomings, particularly when those shortcomings turn into criminal acts such as frauds and siphoning of funds by company promoters or executives.

“The onus, therefore, rests on independent directors to elevate their engagement, proactively educate themselves, and enhance their skills. It is crucial for them to be cognisant of their rights as well as be assertive and knowledgeable enough to pose pertinent questions,” Gupta pointed out.

Rushed Scale-Ups, Shoddy Scrutiny

The rush to scale up is perhaps more so in startups as these are recipients who get large funds in a short period of time. Moreover, they also spend large sums as they scale up to take on older brick-and-mortar competitors in a very challenging corporate frontier.

“In the rush to scale up, internal controls are often forsaken and the lines between corporate interests and personal ones sometimes get blurred. That is where oversight, as things unfold, become more important than post-facto scrutiny of actions,” said Sarkar.

While some cases have come to the fore as irate investors, vigilant whistleblowers or taxmen have probed and found shortcomings, analysts fear that most start-ups that have similar ‘adverse events’ in their financial management just gloss over them and get away as the story of their success outshines shortcomings.

“We start suspecting when large fundings are not matched by consistent end results and the story gets blurred by a fog of publicity,” said Sarkar with a wry smile.

Gupta feels the government has undertaken extensive digitisation efforts, exemplified by the API Setu portal, making a wealth of data, including GST, MCA, and Parivahan portal data, accessible to the public. “By harnessing technology and effectively accessing publicly available data, organisations can significantly diminish the risk of fraud,” he said.

“Recent instances of fraud in certain startups could have been identified and prevented with the application of technology. Issues such as collusion between employees and vendors, related party transactions, and document manipulation can be detected in real-time through the use of technology,” said Gupta, who is the MD of Protiviti and leads the Internal Audit and Financial Advisory (IAFA) practice.

The Road Ahead

The role of Independent Directors, who come from all walks of life, will have to evolve as a professional with necessary standards and practices even as they scale up with training in areas of risk management and fiduciary controls.

Independent Directors will need to ensure that they maintain their independence, not hesitate to demand necessary information and have the conviction to ask tough questions where needed. The alternative is of course facing tough legal, and at times criminal, action as stipulated by the law.

“Under the circumstances, these directors will have to outgrow the habit of drinking coffee and treating the boardroom as just another club meeting,” highlighted Sarkar.

The CII-Protiviti report also says that auditors, especially Internal Auditors, will also need to understand the agenda and requirements of the Board and Independent Directors to enhance their work to assist them in meeting their objectives.

“In several cases, they may also need to collaborate with Independent Directors to help them understand their roles and responsibilities related to Internal Controls and seek their support in enhancing the stature of Internal Audit within the organisation,” the report said.

However, as India Inc. and the start-up ecosystem in the country evolve, the nature of corporate frauds will also change and will often be more tech-supported.

Consequently, the conversation over risk management and internal financial controls will have to continue as boards wake up to the new possibilities of both crime and criminal control.