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THEIR FAILINGS, OUR LEARNINGS

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WHEN THE BELLS OF GOVERNANCE TOLL?

Context:

As this garment company discovered, when Private Equity investors bring in funds, they sometimes also bring in problems. To seemingly play along with the management, and to then blow the whistle, can destroy even a good company. Investors, auditors and managements seemed to have stepped out of line. Did the Directors do too little, too late?

  • In 2010, 2 Private Equity (PE) firms had together co-invested in 45% stake in a garment company, with the remaining stake being with the promoter. It was a secondary transaction with another PE investor, and was brokered by one of the Big 4 audit firms. The Indian arm of that Big 4 firm was the Statutory Auditor of the Company since 2007-08.
  • In September, 2011, the PE investors and the Board approved a plan to go ahead with an IPO of the Company.
  • A day later, an unnamed whistleblower, believed to be a senior executive of the Company, alerted one of the PE firms regarding the lack of authenticity of the Company’s accounts. He had apparently mentioned this to the Auditors, who did not take cognisance of his complaint, and instead certified the Company’s accounts.
  • Thereafter, the investors received a number of anonymous calls, within a span of 3 days, raising doubts on the credibility of the Company’s financial statements.
  • One of the 2 Nominee Directors sent a mail to the promoter mentioning the anonymous phone call and the information received by him, and indicated that an independent agency (another Big 4 audit firm) should investigate the accounts of the Company, its subsidiaries and related parties. He also mentioned that the Company should not incur any more debt, and should not draw down existing facilities any further, till the next Board meeting.
  • The next day, the promoter received another letter from the PE firm, withdrawing consent for the IPO. The promoter expressed surprise that the investors were acting on the basis of an anonymous call, since their representatives were involved in day-to-day operations of the Company, and that financial decisions were taken with their active knowledge. He suggested that an internal investigation should be conducted, and he be allowed to report to the Board within 2-4 weeks, since involving an outside agency at that juncture would have created a panic and hampered work, having regard to the proposed IPO. This was not agreed to.
  • In the next Board meeting, 5 days after the IPO was approved by the Board, a resolution was passed to direct the Statutory Auditors to re-audit the accounts, and to appoint another audit firm, the one that had been suggested by the Nominee Director, as an independent agency to investigate the accounts.
  • Simultaneously, the annual accounts for FY 2010-11 were not approved by a majority vote.
  • The PE firms also wanted to inform the banks and financial institutions about the developments, but the proposal was struck down as it was certain to “destroy the Company’s reputation, hampering its operations and financial prospects.”
  • The Company wanted banks having exposure of over INR 500 crores, to suggest the name of an auditor for an investigative audit. After a meeting with the bankers in October, 2011, a Chartered Accountancy (CA) firm was nominated to look into the books of accounts. However, later, the High Court chose another CA firm.
  • Subsequently, the 2 Nominee Directors and 4 Independent Directors resigned, leaving only 2 Directors, including the promoter, on the Board.
  • The Statutory Auditors also resigned, and in the resignation letter stated that they were not being granted access to the books. When a team from the Auditor went to re-audit, it was only provided with limited information, and later was denied permission to enter the premises of the Company.
  • The promoter alleged that the PE firms were trying to take over the control of the Company by derailing the IPO, since they did not want to be diluted. He also alleged that the PE firms were getting too involved in the operations of the Company.
  • In early October, 2011, the Company filed a case against the PE investors in Delhi High Court, seeking an ad-interim relief to stop them from obstructing the operations of the Company or harming the image of the Company. In his petition, the promoter had asked the Court to restrain the two PE firms from selling, alienating, transferring or creating third party interest in the stake that they owned in the Company.
  • He alleged that they were trying to get the Company into a mode akin to distress sale. It was also alleged that the PE firms had forced the Company to take a property which belonged to their legal advisor on a monthly rent of INR 33 lakhs. This highlighted their material interest and involvement in the transaction. This had caused the Company to incur losses since the lease agreement carried a 3 year lock-in.
  • The PE firms, in their reply to the Delhi High Court, asked for a forensic examination of the Company’s accounts, and also sought to appoint a different auditor to investigate the financials of the Company. They also mentioned that the promoter was resisting the demand for an audit on the grounds that the 2 PE firms had full access to the Company’s monthly profit and loss accounts and expansion plans.
  • Following litigation in the High Court, both the PE firms and the promoter were restrained from giving any adverse publicity and were instructed to act according to the minutes of the earlier Board meeting. It also asked the two parties to come up with 3-4 names each for the appointment of an auditor and an arbitrator by the next hearing.
  • In November, 2011, the High Court decided that another audit firm should be appointed to carry out an independent audit. It also asked the Statutory Auditors, who had resigned, to reconsider its communication with the Company, and help with statutory audit of the accounts. It also restrained the 2 PE firms from selling their shares without first offering them to the promoter.
  • Subsequently, both the sides also agreed to resolve all their disputes and differences. But this did not happen since the Company did not provide the relevant documents to the Auditors. At one stage, the Court also ordered the Company to provide all the necessary information to the Auditors.
  • Finally, the Company approached the 2 PE firms for an out of court settlement, and in October, 2012, the PE firms wrote off their investments, and the promoter again owned 100% of the Company.
  • Creditors from within and outside India approached the High Court with winding up petitions against the Company, since it had defaulted on payments due to them.
  • The Company again tried to file for IPO, but did not succeed.
  • Later, one of the 2 PE firms, attempting to recover its written off investment, sued the Statutory Audit firm, as well as its India chief, for fraud and negligent misrepresentation. The PE firm also alleged that the auditing group, acting as the auditor and as the agency for bringing in investment, was clearly a conflict of interest. This conflict pre-dated the investment by the 2 PE firms, but was ignored at that time.
  • It was alleged that the Statutory Audit firm did an out of court settlement with the PE firm.