Presented by:

CA. Anil GoelFOUNDER & CHAIRMAN

Head Office: E10A, Kailash Colony, New Delhi – 110048, Email id: anilgoel@aaainsolvency.com, Mobile: 9811055148,

NEW DELHI I MUMBAI | KOLKATA | HYDERABAD | CHENNAI I BENGALURU I AHMEDABAD | LUDHIANA | RAIPUR | KOCHI | BHUBANESHWAR I JAIPUR I KANPUR I NAGPUR I RANCHI I

AAA INSOLVENCY PROFESSIONALS LLPIndia’s largest Insolvency Professional Entity (IPE)

under IBC

AAA CAPITAL SERVICES PVT. LTD.India’s largest resolution and enforcement agents

under SARFAESI act

Forensic Audit under RBI Guidelines&

Transactional Audit under IBC

RBI Master Circular on Banking Frauds

Early Warning Signals

Red Flagged AccountsWilful Defaults

FORENSIC AUDIT UNDER RBI GUIDELINES

Master Directions on Frauds – Classification and Reporting by commercial banks and select FIs

• Master Circular No. RBI/DBS/2016-17/28 DBS.CO.CFMC.BC.No.1/23.04.001/2016-17 dated 1st July 2016

• Applicability: The provisions of these Directions shall apply to scheduled commercial banks (excluding RRBs) and select FIs operating in India

OBJECTIVES• Prevention and early detection of frauds and prompt reporting to the

RBI• taking timely consequent actions• examining staff accountability and do effective fraud risk management• stipulated time lines with the action incumbent on a bank• faster dissemination of information by the Reserve Bank of India (RBI)

to banks on the details of frauds, unscrupulous borrowers and related parties

Classification of Frauds under RBI Circular

In order to have uniformity in reporting, frauds have been classified as under, based mainly on the provisions of the Indian Penal Code:

a. Misappropriation and criminal breach of trust. b. Fraudulent encashment through forged instruments, manipulation of books

of account or through fictitious accounts and conversion of property. c. Unauthorised credit facilities extended for reward or for illegal gratification. d. Cash shortages. e. Cheating and forgery. f. Fraudulent transactions involving foreign exchange g. Any other type of fraud not coming under the specific heads as above

STRUCTURE FOR REPORTING OF FRAUDS TO RBI

• Central Fraud Registry (CFR) – a web-based and searchable database

• Furnishing Fraud Monitoring Returns (FMR) by banks online

• Flash Report (FR) for frauds involving amounts of ₹5 Cr and above within a week of such frauds coming to the notice of the bank’s head office

• Audit Committee of the Board (ACB) shall monitor all the cases of frauds in general

• banks are required to constitute a Special Committee of the Board for monitoring and follow up of cases of frauds (SCBF) involving amounts of ₹1 Cr and above

Guidelines for Reporting Frauds to State Police/CBI

Different Guidelines for private sector and public sector banks• State Police – Rs. 10000 to 1 Cr if committed by staff of Private sector or foreign banks• Serious Fraud Investigation Office (SFIO) , Ministry of Corporate Affairs, Government of India.

– 1 Cr and above by Private sector or foreign banks – no reporting to SFIO by public sector banks – no power with Private banks to report to CBI

• Criminal Investigation Department(CID) /Economic Offences Wing (EOW) under State Police –1 Lakh to 3 Cr.

• Anti Corruption Branch (ACB) of CBI (where staff involvement is prima facie evident) – 3 Cr to 25 Cr

• Economic Offences Wing (EOW) of CBI (where staff involvement is prima facie not evident) –3 Cr to 25 Cr.

• Banking Security and Fraud Cell (BSFC) of CBI (irrespective of the involvement of a public servant) – 25 Cr to 50 Cr

• Joint Director (Policy) CBI, HQ, New Delhi – more than 50 Cr

LOAN FRAUDS - NEW FRAMEWORK – APPLICABLE TO ACCOUNTS HAVING BANKING EXPOSURE OF 50 CR AND ABOVE

• Early Warning Signals (EWS)

• Red Flagged Accounts (RFA)

• Fraud Monitoring Group (FMG) or any other Group constituted by the

Bank

• Special Committee of the Board for monitoring and follow-up of Frauds

(SCBF) as constituted by the Bank

• Central Repository of Information on Large Credits (CRILC) under RBI

• Central Fraud Monitoring Cell, RBI, Bengaluru (CFMC)

STRICT AND DEFINED TIMELINE FOR REPORTING OF FRAUD UNDER RBI

• The initial decision to classify any standard or NPA account as RFA or Fraud will be at the individual bank level and it would be the responsibility of this bank to report the RFA or Fraud status of the account on the CRILC platform so that other banks are alerted

• The bank shall then report the fraud to RBI within 21 days of detection and also report the case to CBI/Police, as is being done hitherto

• Further within 15 days of RFA/Fraud classification, the bank which has red flagged the account or detected the fraud would ask the consortium leader or the largest lender under MBA to convene a meeting of the JLF to discuss the issue

• The meeting of the JLF so requisitioned must be convened within 15 days of such a request being received

• In case there is a broad agreement, the account should be classified as a fraud; else based on the majority rule of agreement amongst banks with at least 60% share in the total lending, the account should be red flagged by all the banks and subjected to a forensic audit commissioned or initiated by the consortium leader or the largest lender under Multiple Banking Arrangement (MBA)

• The forensic audit must be completed within a maximum period of three months from the date of the JLF meeting authorizing the audit

• Within 15 days of the completion of the forensic audit, the JLF shall reconvene and decide on the status of the account, either by consensus or the majority rule as specified above

• In case the decision is to classify the account as a fraud, the RFA status shall be changed to Fraud in all banks and reported to RBI and on the CRILC platform within a week of the said decision

• Besides, within 30 days of the RBI reporting, the bank commissioning/ initiating the forensic audit should lodge a complaint with the CBI on behalf of all banks in the consortium/MBA

• For this purpose, if the bank initiating the forensic audit is a private sector bank, the complaint shall be lodged with the CBI by the PSU bank with the largest exposure to the account in the consortium/MBA. If there is no PSU bank in the consortium / MBA or it is a solo bank lending by a private sector bank/foreign bank, the private bank/foreign bank shall report to the Police as per extant instructions

Early Warning Signals (EWS)

Early Warning Signals (EWS) 1. Default in undisputed payment to the statutory bodies as declared in the Annual report. 2. Bouncing of high value cheques 3. Frequent change in the scope of the project to be undertaken by the borrower 4. Foreign bills remaining outstanding with the bank for a long time and tendency for bills to

remain overdue. 5. Delay observed in payment of outstanding dues. 6. Frequent invocation of BGs and devolvement of LCs. 7. Under insured or over insured inventory. 8. Invoices devoid of TAN and other details. 9. Dispute on title of collateral securities. 10. Funds coming from other banks to liquidate the outstanding loan amount unless in normal

course. 11. In merchanting trade, import leg not revealed to the bank. 12. Request received from the borrower to postpone the inspection of the godown for flimsy

reasons.

Early Warning Signals (EWS)…Contd.

13. Funding of the interest by sanctioning additional facilities. 14. Exclusive collateral charged to a number of lenders without NOC of existing charge holders. 15. Concealment of certain vital documents like master agreement, insurance coverage. 16. Floating front / associate companies by investing borrowed money 17. Critical issues highlighted in the stock audit report. 18. Liabilities appearing in ROC search report, not reported by the borrower in its annual report 19. Frequent request for general purpose loans. 20. Frequent ad hoc sanctions. 21. Not routing of sales proceeds through consortium I member bank/ lenders to the company.22. LCs issued for local trade I related party transactions without underlying trade transaction 23. High value RTGS payment to unrelated parties. 24. Heavy cash withdrawal in loan accounts. 25. Non production of original bills for verification upon request. 26. Significant movements in inventory, disproportionately differing vis-a-vis change in the

turnover.

Early Warning Signals (EWS)… Contd.27. Significant movements in receivables, disproportionately differing vis-à-vis change in the

turnover and/or increase in ageing of the receivables

28. Disproportionate change in other current assets

29. Significant increase in working capital borrowing as percentage of turnover

30. Increase in Fixed Assets, without corresponding increase in long term sources (when project is implemented).

31. Increase in borrowings, despite huge cash and cash equivalents in the borrower's balance sheet

32. Frequent change in accounting period and/or accounting policies

33. Costing of the project which is in wide variance with standard cost of installation of the project

34. Claims not acknowledged as debt high

35. Substantial increase in unbilled revenue year after year.

Early Warning Signals (EWS)….. Contd.

36. Large number of transactions with inter-connected companies and large outstanding from such companies

37. Substantial related party transactions

38. Material discrepancies in the annual report

39. Significant inconsistencies within the annual report (between various sections)

40. Poor disclosure of materially adverse information and no qualification by the statutory auditors

41. Raid by Income tax /sales tax/ central excise duty officials

42. Significant reduction in the stake of promoter /director or increase in the encumbered shares of promoter/director.

43. Resignation of the key personnel and frequent changes in the management

PRINCIPLES OF PUTTING *RED FLAGS*

OR ISSUING

GUARDED WARNINGS

TO THE BANKERS & THE STAKE HOLDERS

RED FLAGS SOME ILLUSTRATIONS• Evergreening: means the debt never comes down, repaid in one account, fresh loan in

another account.• Business cycle continuously going up, inventory is going up and credit extended to

customer is also going up.• Third party confirmations of receivables are not obtained• Physical verification of inventory or fixed assets is not allowed or not liked• Market credit is also increasing constantly.• Regular Capex in the same existing unit with little increase in the capacity or sales• Always take suggestions about how to raise further loans• Offers higher interest rates to friends and relatives• Living beyond one’s means, luxurious life to display that his business is doing well• Unusually close association with vendor or customer, regular parties with creditors• No delegation of authority in the accounts department• The director will directly interact with you and will not allow the accountant to speak to

you

ROLE OF CAs UNDER IBC AND AS AUDITOR OF COMPANIES UNDER FINANCIAL STRESS

ROLE OF CAs PARTICULARLY STATUTORY AUDITORS

• IRP is having the authority to access the books of accounts, records and other relevant documentsof CD available with statutory auditors, accountants, government authorities -Sec 17(2)(d)

• Punishment for falsification of books of CD – Sec 71 of IBC – any person alters or falsifies anybooks, papers or securities or makes any false or fraudulent entry in any books with the intent ofdefrauding the creditors – 3-5 years imprisonment or fine 1 Lakh to 100 Lakh or both

• Sec 147 of the Companies Act, 2013 – Punishment for contravention – fine 25K to 500K or 4 timesof fee – for wilful and with the intent to deceive the creditors, shareholders – fine 50K to 2500K or8 times of fee – Imprisonment for 1 year

• Sec 147 further provides that the auditor will refund the remuneration taken from the Companyand pay compensation and damages to members, creditors and Govt authorities

• National Financial Reporting Authority (NFRA) has been set up with vast powers and there is apossibility of complaints against erring CAs to NFRA and the powers are very large. NFRA is havingpowers u/s 132 of the Companies Act, 2013 to fine 1 Lakh to 5 Lakh – 5 time to 10 times of fee –debarring from practice for 6 months to 10 years

• All depends upon the regulator – like IBBI if complainant will get response – everyone will file acomplaint; if NFRA would be responsive – more complaints would be filed by creditors,government authorities, IPs (based on forensic audit report)

PRACTICAL TIPS ON WHAT PROFESSIONALS’ OVERLOOK FROM REPORTING POINT OF VIEW WHEN AN ACCOUNT SHOWS:

A. Signs of diversion of Bank Loan – deceiving other parties for personal gains – is classified as fraud

• DBR.No.CID.BC.22/20.16.003/2015-16 dated 1st July 2015 titled as Master Circular on Wilful Defaulters has provided that in case Statutory Auditor has not reported such diversion, then the banks are required to report to:

I. ICAIII. RBI (Department of Banking Supervision, Central office) for records and sharing the information with banks

and CAG & MCAIII. IBA for records and circulating the information with banks for caution and removal from panels, if any

• Standard on Auditing- 240 “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements” puts the onus on the auditors to report the fraud w.e.f. 1st April 2014

• Section 143 of the Companies Act, 2013 puts an onus on the auditor to report any fraud and also report any non-compliance of Standards on Auditing

• CARO clauses (a) & (b) also require auditor to qualify or modify the audit report if any losses or litigation is foreseeable

• Clause 41 of the Listing Agreement fraud reporting to Central Government is required by auditors

• ICAI has given notices to the auditors of IL & FS

B. Business cycle starts increasing• Business cycle starts increasing with higher inventory of RM, WIP & FG and higher credit period extended

to customers.

• That means losses are being parked in current assets to deceive the creditors and present a rosy picture

• ‘Zombie Company’ scenario means carrying the corpse duly decorated with the objective of defrauding the creditors

• Diversion of funds out by padding up the purchase for the purpose of personal use of funds

• Increasing the closing stock to declare profit

• Not recording rejections, debit notes issued by customers, not recording purchase bills and amount paid is being shown as advances.

• Swelling of fixed assets without corresponding increase in capacity and business. That means loading losses to Capital Assets by higher capitalisation or by raising fake bills for fixed assets.

• Quantitative records of inventory is not satisfactory or complete or there is no records of inflow, outflow, consumption, yield, shortage, burning loss, wastage on each process and closing stock for each process or stage of inventory.

• Asset verification is primary duty of the auditor and in case not verifiable, it has to be reported.

• Auditors responsibility in reporting is the same as discussed earlier

Outstanding balances are not squared/ reconciled up bill to bill

B. Bill to bill reconciliation is very important

C. Third party confirmation is also necessary

D. Asset verification is primary duty of the auditor and in case not verifiable, it has to be reported.

E. Auditors responsibility in reporting is the same as discussed earlier

When Corporate Debtor requires more funds to meet out old known liabilities or demands enhancement of

Fund or Non-Fund limits to fulfil its obligations.

• Evergreening: means the debt never comes down, repaid in one account, fresh loan in another account.

• Business cycle continuously going up, inventory is going up and credit extended to customer is also going up.

• Third party confirmations of receivables are not obtained

DUTIES OF AUDITORS UNDER THE CURRENT SCENARIO

• First is educating himself as auditor and start detailed duediligence and comply with all auditing standards

• Report all facts and observations in audit report or CARO afterseeking clarification from the auditee

• Comply with RBI Master circular dated 1st July 2015

• Comply with SA 240 all duties u/s 143 of the Companies Act,2013

• Must verify the financial statements submitted to banks andother creditors and also uploaded on MCA website

DUTIES OF AUDITORS UNDER THE CURRENT SCENARIO

• Avail the professional opportunity under IBC and if not IP thenshould practice as consultant for the benefit of clients

• Should also adopt the profession of registered valuer as theopportunities are increasing under IBC, Companies Act, SEBI,Income tax, business transactions, Ind AS.

• Multiple sources of income will reduce your dependence onauditees and you can afford to achieve auditor’s independence

• Early detection of stress and default regime

• Insolvency attacks on companies by operational creditors,workers and government authorities

DUTIES OF AUDITORS UNDER THE CURRENT SCENARIO

• Forensic audit in each case under CIRP and forensic auditors are alsoreporting connivance of statutory auditors in most reports

• NFRA

• Section 147 & 132 of the Companies Acct, 2013

• Section 17(2)(d) and 71 of IBC

• RBI Master dated 1st July 2015 circular on wilful default and directions tobanks would be adhered to more seriously.

• Proper audit, due diligence and proper reporting

• Proper guidance to clients and discuss the changed environment withclients

MASTER CIRCULAR ON WILFUL DEFAULTERS

MASTER CIRCULAR ON WILFUL DEFAULTERS

• Master Circular No. RBI/2015-16/100 DBR.No.CID.BC.22/20.16.003/2015-16 dated 1st July 2015

• Application: To all Scheduled Commercial banks (excluding RRBs) and All India Notified Financial Institutions on wilful defaults of 25 lakhs and above

• Debt is due on account of banking transaction including off balance sheet transactions such as derivatives, guarantees and letters of credit

• There are about 30 circulars issued by RBI with regard to identification of wilful defaulters, measures to be taken and reporting by Banks/Fis

• There is no mention of Forensic Audit in any of the Circular of RBI regarding Wilful Defaulters

Defaults considered as Wilful Default

• Default in repayment obligations even when it has the capacity to honour the said obligations

• Default in repayment obligations and has not utilised the finance for the specific purposes for which finance was availed of but has diverted the funds for other purposes or the funds are not available with the unit in the form of other assets i.e diverted outside the unit

• Defaulted in repayment obligations and has also disposed off or removed the movable fixed assets or immovable property given for the purpose of securing a term loan without the knowledge of the bank / lender

Defaults considered as Wilful Default Contd.

• The identification of the wilful default should be made keeping in view the track record of the borrowers and should not be decided on the basis of isolated transactions / incidents.

• The default to be categorised as wilful must be intentional, deliberate and calculated.

• Guarantors and corporate guarantors managed by the same promoters, if not honoured should also be declared as wilful defaulters

• Non-group corporate guarantors and individual guarantors can also be declared as wilful defaulter with effect from September 9, 2014

Diversion of Funds – 25 Lakhs and above

• Utilisation of short-term working capital funds for long-term purposes not in conformity with the terms of sanction

• Deploying borrowed funds for purposes / activities or creation of assets other than those for which the loan was sanctioned

• Transferring borrowed funds to the subsidiaries / group companies or other corporates by whatever modalities;

• Routing of funds through any bank other than the lender bank or members of consortium without prior permission of the lender

• Investment in other companies by way of acquiring equities / debt instruments without approval of lenders

• Shortfall in deployment of funds vis-à-vis the amounts disbursed / drawn and the difference not being accounted for

Siphoning of Funds – 25 Lakhs and above: In case any funds borrowed from banks / FIs are utilised for purposes unrelated to the operations of the borrower, to the detriment of the financial health of the borrower

• End Use of Funds to be monitored by lenders

• Meaningful scrutiny of quarterly progress reports / operating statements / balance sheets of the borrowers

• Regular inspection of borrowers’ assets charged to the lenders as security;• Periodical scrutiny of borrowers’ books of accounts and the ‘no-lien’ accounts maintained

with other banks; • Periodical visits to the assisted units; • System of periodical stock audit, in case of working capital finance; • Periodical comprehensive management audit of the ‘credit’ function of the lenders, so as

to identify the systemic-weaknesses in their credit administration.

Penal Measures for Wilful Defaulters • No additional facilities - debarred from institutional finance for a period of 5 years from

the date of removal of their name from the list of wilful defaulters as published /disseminated by RBI/Credit Information Companies (CICs).

• The legal process against the borrowers / guarantors and foreclosure for recovery of dues should be initiated expeditiously.

• The lenders may initiate criminal proceedings against wilful defaulters, wherever necessary.

• Wherever possible, the banks and FIs should adopt a proactive approach for a change of management of the wilfully defaulting borrower unit.

• A covenant in the loan agreements, with the companies to which the banks / FIs have given funded / non-funded credit facility, should be incorporated by the banks / FIs to the effect that the borrowing company should not induct on its board a person whose name appears in the list of Wilful Defaulters and that in case, such a person is found to be on its board, it would take expeditious and effective steps for removal of the person from its board

Role of auditors where the account of the Auditee is declared as Wilful Defaulter

• Falsification of accounts on the part of the borrowers

• It is observed that the auditors were negligent or deficient in conducting the audit

• Banks to file a formal complaint against the auditors of the borrowers:

• With ICAI to examine and fix accountability of the auditors

• Pending disciplinary action by ICAI, the complaints may also be forwarded to the RBI (department of banking supervision, central office) and

• IBA for records and circulate the names of the ca firms amongst all banks who should consider this aspect before assigning any work to them.

• RBI would also share such information with other financial sector regulators / ministry of corporate affairs (MCA) / comptroller and auditor general (CAG)

• Some of the financial sector regulators other than RBI are SEBI, IRDAI (Insurance Regulatory And Development Authority Of India), FMC (forward market commission of India), Pension Fund Regulatory And Development Authority (PFRDA)

Reporting to Credit Information Companies

Reserve Bank of India has, in exercise of the powers conferred by Section 5 of the Credit Information Companies (Regulations) Act, 2005 and the Rules and Regulations framed thereunder, granted Certificate of Registration to

i. Experian Credit Information Company of India Private Limited, ii. Equifax Credit Information Services Private Limited, iii. CRIF High Mark Credit Information Services Private Limited and iv. Credit Information Bureau (India) Limited (CIBIL)To commence/carry on the business of credit information

Mechanism for identification of Wilful Defaulters

Identification Committee: The evidence of wilful default should be examined by a Committee headed by an Executive Director or equivalent and consisting of two other senior officers of the rank of GM / DGM

The Committee shall issue a Show Cause Notice to the concerned borrower, call for their submissions and after considering their submissions issue an order recording the fact of wilful default and the reasons for the same. An opportunity should be given to the borrower and the promoter / whole-time director for a personal hearing if the Committee feels such an opportunity is necessary.

Review Committee: The Order of the Committee should be reviewed by another Committee headed by the Chairman / Chairman & Managing Director or the Managing Director & Chief Executive Officer / CEOs and consisting, in addition, to two independent directors / non-executive directors of the bank and the Order shall become final only after it is confirmed by the said Review Committee. Some Relief to non-promoter / non-whole time directorAction can be taken only against an officer who is in default to mean only the directors as defined under Section 2(60) of the Companies Act, 2013

Criminal Action against Wilful Defaulters

• It is essential that offences of breach of trust or cheating construed to have been committed in the case of loans should be clearly defined under the existing statutes governing the banks, providing for criminal action in all cases where the borrowers divert the funds with malafide intentions.

• It is essential that banks closely monitor the end-use of funds and obtain certificates from the borrowers certifying that the funds have been used for the purpose for which these were obtained.

• Wrong certification should attract criminal action against the borrower

Criminal Action by Banks / FIs against Wilful Defaulters

Provision to initiate criminal action against wilful defaulters depending upon the facts and circumstances under the provisions of Sections 403 and 415 of the Indian Penal Code (IPC), 1860.

Section – 403 of the Indian penal code reads that, whoever dishonestly misappropriates any movable property to his own usage, shall be punished with imprisonment up to 2 years or with fine or both

Section 415. Cheating.—Whoever, by deceiving any person, fraudulently or dishonestly induces the person so deceived to deliver any property to any person, or to consent that any person shall retain any property, or intentionally induces the person so deceived to do or omit to do anything which he would not do or omit if he were not so deceived, and which act or omission causes or is likely to cause damage or harm to that person in body, mind, reputation or property

It should also be ensured that the penal provisions are used effectively and but after careful consideration and due caution.

Criminal Action by Banks / FIs against Wilful Defaulters

Board Approved Transparent Mechanism: Banks / FIs are advised to put in place a transparent mechanism, with the approval of their Board, for initiating criminal proceedings based on the facts of individual case.

It needs to be noted that a default to honour commitments to repay borrowed funds amounts to a breach of contract. Any breach of contract to repay debt is not a crime.

The only right of the aggrieved party is to approach the civil court to attach and sell securities or other unencumbered properties and recover the defaulted loan.Mere breach of contract cannot give rise to criminal prosecution under Section 420 IPC, unless fraudulent or dishonest intention is shown right at the beginning of the transaction time, when the offence is said to have been committed.

The directors, whatever the wealth and assets owned by them, are not liable for any default, except when they have given a personal guarantee for loans or it is established that borrowed funds were used to acquire personal assets

Criminal Action by Banks / FIs against Wilful Defaulters

Section 447 of the The Companies Act, 2013 w.e.f. 12/09/2013, The Companies Act, 2013, has created a new offence of fraud in relation to the affairs of a company, which provides that any act or omission, concealment of any fact or abuse of position committed by any person with intent to deceive or to injure the interest of the company or its shareholders or creditors, whether or not there is a wrongful gain or loss, can be investigated by Serious Fraud Investigation Office (SFIO) established under the Act and any violation is punishable with imprisonment of up to 10 years

Cases of wilful defaults can, therefore, be entrusted to the SFIO to investigate whether such default amounts to serious fraud under Section 447 of the Companies Act

Criminal Action by Banks / FIs against Wilful Defaulters

Punishment for Fraud.

Without prejudice to any liability including repayment of any debt under this Act or any other law for the time being in force, any person who is found to be guilty of fraud 1

[involving an amount of at least ten lakh rupees or one per cent. of the turnover of the company, whichever is lower] shall be punishable with imprisonment for a term which shall not be less than six months but which may extend to ten years and shall also be liable to fine which shall not be less than the amount involved in the fraud, but which may extend to three times the amount involved in the fraud:

Provided that where the fraud in question involves public interest, the term of imprisonment shall not be less than three years