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Harry Cassin
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Avoiding the fraud trap when buying distressed assets

A $40 billion bad loan problem eventually led to India’s 2018 enactment of legislation completely overhauling the bankruptcy mechanism. The new Insolvency and Bankruptcy Code has had a significant impact on the debt resolution process. It has also produced an unlikely result — the discovery of widespread corporate fraud.

Forensic audits were commissioned by lenders (as per directions from the central bank) or by resolution professionals who needed to know if the bankruptcy was truly a result of bad business decisions or as a result of siphoning of cash or fraudulent activities perpetrated by the management.

Fraudulent transactions have now been reported in over a hundred companies under resolution are worth over $5.7 billion. These fraudulent transactions take various shapes — transactions with related parties and fictitious persons, exaggerated asset purchases, siphoning of funds, promoter and vendor conflicts, falsifying accounting entries, transactions through shell firms, and more.

At the same time, the distressed assets can be extremely valuable to investors (specialized funds included) and require a specific focus when evaluating these assets. Here are some of the points that should be borne in mind. These are, by no means, comprehensive and may vary by the nature of industry or asset.

Review forensic audit reports. It is important for the investors to review forensic audit reports and scrutinize them carefully. The forensic auditor may not have full access to the books or personnel of the target. So a careful review of the limitations is important. One needs to check if the forensic audit covers at least the most typical “schemes,” such as procurement fraud, financial misstatements, vendor conflicts, kickbacks and bribery issues, and so on.

Putting boots the ground. The documents provided in data room or forensic audit reports generally give a sense of only certain aspects of the complete story. So it is important for any potential investor to seek a more in-depth “boots on ground” approach to validate or verify the audit. This process is relevant to the discovery of potential fraud and also to the acquirer’s own compliance in its home jurisdiction. For example, it is extremely important to know if the target has made any payments to government officials during festivals, or has extended any in-kind goods or services to government officials. Similarly, it is important to know if the vendors of the target could be connected with the target’s management in any manner.

Industry specific testing. It is important for investors to ensure that industry specific checks are carried out to verify the adequacy of internal controls and propriety of transactions. For example, what procedures are followed for disposal of scrap material, what are the existing internal controls for verifying contract labor, and the like. Testing these sorts of issues often depend on the industry in question.

Review of operational ratios and comparison with industry standards. It is key to comprehensively analyze the operational ratios and profit margins and run a comparison with the industry standards. Such a review allows investors to understand any gaps or variances that may impede the target entity’s business and assist in identifying compliance and internal control deficiencies.

Managing initial operational hurdles. Investors must factor in the initial operational costs and hurdles that may be faced, including issues around lack of support from existing staff, vacancies in critical positions, availability of records etc.

Contractual safeguards. The Code specifically provides for individual liability of persons who were knowingly parties to the carrying on of the business in a fraudulent manner. Investors must adequately ring fence their interests by: (i) adequately remediating past misconduct, to the extent possible, and (ii) incorporating appropriate contractual terms including indemnity clauses, conditions precedent, conditions subsequent, and the like. 


Kunal Gupta, pictured above, is partner and head of the white collar investigations practice at Cyril Amarchand Mangaldas in India. He is regularly involved in assisting clients with multi-jurisdiction investigations in Asia. He can be contacted here.

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