The recent constitution of a five-member expert committee by the Supreme Court to investigate any regulatory failure in the Hindenburg-Adani situation is yet another eye-opener, highlighting that the issue of corporate governance affects not only shareholders but also the general public. Though Hindenburg Research claims the Adani Group of pulling off “the largest con in corporate history”, rattling stock markets, it is not an isolated one. Similar instances, like that of WireCard AG in Germany and 1MDB in Malaysia, point to the lack of strict corporate governance, particularly involving international corporations.Hindenburg, a short-seller based out of the US, published a report on January 23 accusing India’s largest business conglomerate of various corporate wrongdoings including accounting irregularities, inflation of share value by inflating revenue and profit, using shell companies in tax havens and round tripping funds from related parties.‘Round-tripping’, also known as circular trading, is a method used by companies to bypass taxes and regulations. This allegation against the Adani Group is not new; the Directorate of Revenue Intelligence (DRI) filed a case for inflating export invoices and round tripping way back in 2014. The allegations suggested that the company had used its offshore entities to transfer funds to India as foreign investment and had used the funds to purchase assets in India, which were then sold to its own subsidiaries.Also read: Numbers Suggest Bangladesh Didn’t Need the Adani Power Deal. So Why Was it Signed?The allegations on Adani (though yet to be proven) are similar to those made in the infamous Wirecard AG and 1MDB cases. The Wirecard scandal involved fraudulent accounting practices (mainly using the round tripping method) of the German payment company, Wirecard AG, which resulted in a loss of €1.9 billion for investors. The 1MDB scandal was a major corruption case in Malaysia where funds meant for development were siphoned off by government officials and business elites, again through the same ‘round tripping’ method by moving funds to offshore entities in tax heavens and then back into country, thus creating an impression of higher revenue and profits at the one hand and at the same time evading taxes using tax heavens and tax incentive schemes within the local jurisdiction.Tax havens and tax incentive schemes to round trip fundsTax havens are offshore locations with low or no taxes, strict bank secrecy laws and a well-developed financial sector that enables individuals and businesses to manage their finances in a confidential and ‘tax-friendly’ manner. However, the same features that make tax havens so attractive to individuals and corporations also make them an ideal destination for round-tripping of funds, as funds will not attract both direct (income) and indirect (goods and services), taxes thus enabling them to re-route the funds back into the local entity in the form of investments or consideration for exports of goods or services.Locally, tax incentive schemes (for example SEZs, EOUs, DFCE, trading houses) play the role of tax havens, wherein funds from shell companies located in offshore tax heavens are routed to entities located in ‘tax incentive schemes’ in the form of consideration for export of goods or services, and thus the funds make a full round without suffering any tax both within the local jurisdiction and also abroad, at the same time increasing the valuation of the entity in the local jurisdiction as the round tripped funds are booked as receipts/consideration. That was the precise modus operandi in Wirecard AG and the much more serious one in 1MdB scandal, as it involved political/public institutional funds.Watch: Has Forbes Hammered Another Nail Into the Adani Coffin?It is to be noted that tax incentive schemes where tax cuts are given are a result of Reaganomics associated with ‘trickle down economics’, where maximum tax cuts were given to higher income earners and corporations, with an expectation that any benefit provided at the top will ‘trickle down’ to the poor in the form of job creation, higher output or infrastructure development. However, on the contrary, these schemes are often also used as tax havens to round trip funds and create superfluous valuation, which is not only an accounting malpractice but also a case of money laundering. More importantly, if political funds are round tripped back into the system (as it was done in 1MDB), making it legitimate, the concerns will be much serious. Adani has continued to deny such charges, but this concern has been raised frequently, in the case at hand, due to Adani’s close links with ruling establishment.Responsibility of gatekeepersWhile allegations of such corporate fraud call for strict international corporate governance structures to safeguard shareholders and public funds, the web of international actors and cross-border transactions involved (opaque shell companies in multiple tax havens) make it tough for any government or regulator to track and identify those involved as they are quite secretive about the ownership. Further, differing legal positions lead to lack of enforceability by a regulator. However, the same could be tracked by vigilant auditors, investment bankers (who are known as gatekeepers) whose duty is to provide an independent, objective and a professional assessment of a company’s financial information. Further, it is their responsibility to detect and report any material misstatements or irregularities in a company’s financial statements, all of which helps to restore the confidence of stakeholders, including shareholders.However, in most such cases, auditors and investment bankers have been found to be in collusion with the board in declaring the round tripped funds as fresh revenue, thereby inflating the accounts. This malfeasance is often exposed by investigative journalists or short sellers. However, by the time they raise the red flag, shareholders and the public end up having lost their funds.Also read: Who Is Buying Jet Airways? What the Spate of Unknown Actors Buying Indian Firms MeansIt is after six years, that too after Dan McCrum, journalist at Singapore Financial Times, highlighted the issue, that KPMG was able to identify that 2 billion euros was artificially booked in the accounts of WireCard (through round tripping) to increase the share price and using this artificially inflated value, Wirecard was able to obtain a $1 billion investment from Softbank fraudulently, just months before its collapse. In the case of 1 MDB, corporate fraud was discovered after many years by investigative journalist Clare Recastle Brown, resulting in a 12-year jail term for Malaysia’s premier Najib (the judgement is currently under appeal) and also an indictment of its Wall Street investment banker Goldman Sachs for direct involvement in the scandal. This was later settled by Goldman Sachs by paying $3.9 billion to Malaysia, which was a rare occurrence in corporate history.In Adani’s case, Hindenburg has brought to light the inexperience and non-suitability of Adani’s auditors (a boutique firm with a partner aged 28, fresh out of an audit course), alleging that the auditors are incapable and might be hand-in glove with the delinquency, if established. It re-instates the position that tight regulation/responsibility should be cast on the gatekeepers (auditors, investment bankers) that will promote transparency in financial affairs.International mechanism for regulating cross border flight of capitalEver since major corporate scandals of Worldcom and Enron (which led to the 2002 Sarbanes-Oxley Act in the US establishing stricter accounting rules for public companies), the international community is concerned about accounting fraud as it leads to white washing of blood money (arising out of illicit trading of diamonds, gold, coal, timber and other natural resources mainly from Africa), corrupt funds from fragile and developing economies (Mobutu from Zaire, Abacha from Nigeria and Marcos from Philippines are examples) or terror funding/war proceeds – all of which affect the economic and political stability of emerging economies.The World Bank, IMF and G20 countries have consistently advocated for financial transparency in cross-border transactions. Further, a majority of such transactions happen between a parent entity located in the domestic jurisdiction and subsidiary in foreign jurisdiction and vice-versa, through the adjustment of ‘transfer pricing’ to avoid taxes. Therefore, G20 has recommended that the Financial Action Task Force (an inter-governmental body that sets standards for anti-money laundering laws and its compliance) to revise and reinvigorate the review process for compliance by nation states on anti-money laundering standards. Further, experts have advocated for measures like automatic country-wise reporting (where sales, profit and all financials are reported countrywide in their balance sheet), setting uniform and tangible standards for ‘transfer pricing’ and declaration of beneficial ownership of ‘companies and trusts’ in all jurisdictions including in the tax heavens.In short, an international public register system where details of a business and its proceeds from multiple jurisdictions are recorded should be made accessible to the public from any country, to remove the financial opacity in international corporate transactions.Also read: Why the Modi Government Policy of ‘National Champions’ Is UnravellingThe Adani issue is particularly concerning for India Inc, as the lack of transparency and accountability in India’s corporate sector has led to a lack of trust in the country’s businesses, which will deter foreign investment. The last few years have witnessed a substantial number of corporates from India (including unicorns, FinTech, SAAS, e-commerce platforms) going in for listing at multiple stock exchanges (some even under SPAC model in NASDAQ), claiming to have higher revenue/EBIDTA margins and thus higher valuation.If tighter regulations and effective monitoring mechanisms are not put in place by the regulators, gatekeepers and international actors to keep this corporate delinquency under control and promote transparency, any company (including unicorns) from emerging economies like India will be looked at with suspicion in international markets. This will spell trouble not only for the corporates but also to the economy as a whole.Puhazh Gandhi P. is a Chennai-based lawyer who has specialised in international trade and investment. An alumnus of NYU Law School, he has led numerous cross border transactions in Singapore, Malaysia, Europe, the Middle East, US, Canada and Africa. He can be contacted at puhazh@spabandco.com.
