The increase of capital infusion into companies through various methods, including obtaining credit facilities, has witnessed a parallel increase in corporate fraud, financial irregularities, mismanagement and the potential of embezzlement of funds. Corporate fraud and/or businesses run with an intent to defraud the creditors threaten the rights of financial institutions and investors. They also affect the economic stability of the company. This eventually results in losses incurred by financial institutions, thereby increasing the level of bad debts.

Corporate fraud can take many forms, such as asset misappropriation, bribery and financial fraud. In Union of India v Deloitte Haskins and Sells LLP, auditors of the company were held accountable for false accounting practices under sections 140(5) and 447 of the Companies Act, 2013 (act). The Supreme Court held that the broad scope of corporate fraud and the need for strong enforcement mechanisms to protect the interests of stakeholders required robust corporate governance. This is in addition to the remedies available in other fields, such as criminal law.

To combat instances of financial fraud a vital remedy available under the act is an investigatory mechanism. This takes the form of actions to be taken by the Serious Fraud Investigation Office, and strict penalties under section 447 along with the provisions, which would enable investigations into the affairs of the companies, i.e., sections 210, 212 and 213 of the act.

The government, under sections 210 and 212, and the National Company Law Tribunal (NCLT) under section 213, are given powers to investigate corporate affairs in cases of fraud and mismanagement, and where there are public interest concerns. The jurisprudence that has built up around these investigations and consequential actions under the act is based on the view of corporate governance since the beginning of company law. However, the powers, checks and balances of the act have transformed how fraud and the mismanagement of companies are dealt with.

Section 213 empowers the NCLT to direct an initiation of investigation after application by eligible members, creditors or aggrieved persons if there is evidence of fraud, misfeasance or the withholding of material information. However, section 213(b) goes further to allow any other person to apply for an investigation. This provision is sufficiently widely worded to include banking as well as other financial institutions.

The National Company Law Appellate Tribunal, or NCLAT, went still further in RS India Wind Energy Private Limited v PTC India Financial Services Limited and Ors. It held that the NCLT itself can otherwise also look into any matter of its own volition. In interpreting the provision broadly, the NCLAT determined that even non-shareholders with legitimate grievances can apply for an investigation.

These provisions of the act clearly aim to bring ethical management, accountability and transparency into the corporate finance world in order to protect the financial interests of companies, as well as their creditors, stakeholders and the financial institutions. In Barium Chemicals Limited and Anr v Company Law Board and Ors, the Supreme Court held that section 237(b) of the Companies Act, 1956, the predecessor of the 2013 act, was enacted to protect stakeholders from management’s misconduct. The decision made it clear that while the authority’s decision to investigate is subjective, it must be based on relevant material suggesting fraud or mismanagement.

The Companies Act, 2013 has significantly strengthened corporate governance by providing an effective investigatory mechanism. It imposes strict penalties for fraud and embezzlement that, if left unchecked, will adversely affect the financial institutions that also have exposure in such companies. The continual streamlining and strengthening of such remedies available to stakeholders and, as importantly, to financial institutions can be seen only as a positive step in curbing malfeasance and upholding the rights of affected parties.

However, it is equally important that safeguards are put in place once investigations have been ordered under the act. These must ensure that such investigations are not undertaken for arbitrary reasons. Indeed, they have to be based on strong and reliable evidence

This article authored by our Partner, Ashish Kumar and Lawyers, Lokesh Malik and Atika Chaturvedi has been published by IBLJ.