Corporate and Banking Fraud, PMLA, and Auditor's responsibility

Introduction

Corporate and Banking fraud is a significant threat to the integrity of the business environment, undermining the confidence of investors, employees, and stakeholders. In India, the PMLA, 2002 is a robust legal framework to combat money laundering and related financial crimes. Inclusion of corporate fraud under Section 447 of The Companies Act, 2013 mainly through amendments introduced in The Finance Act 2018 in PMLA has further strengthened the Act\'s effectiveness in addressing fraudulent activities within corporations.

The PMLA empowers authorities to attach and confiscate assets derived from corporate fraud, thereby preventing the dissipation of illicit gains. This legal measure aims to ensure that individuals and entities involved in corporate fraud are held accountable. Offences under Section 447 of the Companies Act 2013 deal with punishment for fraud. This shows the government\'s commitment to maintaining high standards of corporate governance and safeguarding the financial system from fraudulent practices.

Objective

This article aims to explore the intricate relationship between corporate fraud and the Prevention of Money Laundering Act (PMLA), 2002, and examine the definitions of fraud in different Acts. It will examine the impact of recent legal amendments in the PMLA by enhancing its effectiveness. The article aims to provide an understanding of corporate fraud. It will examine the inclusion of offences under Section 447 of The Companies Act, 2013, under The PMLA to address Money Laundering issues and the responsibility of an auditor while conducting the audit.

Definition of Fraud as per Different Acts

Fraud is the intentional use of deceit, a trick, or some dishonest means to deprive another of his money, property, or a legal right. It involves falsification, whether through withholding vital information, lying, or faking documents.

It is clarified that civil and criminal proceedings have different standards of proof, making determining culpability complex. In civil cases, the plaintiff must prove injury on the \"balance of probabilities,\" while criminal cases require proof beyond a reasonable doubt. Frauds are offenses and are convicted under IPC, now known as BNS, and punishment has been prescribed under the relevant Acts.

i. Bharatiya Nyaya Sanhita, 2023

The new Act \"Bharatiya Nyaya Sanhita, 2023\" (BNS) has replaced the Indian Penal Code of 1860, which doesn\'t explicitly define fraud. However, fraud can be identified and understood through various acts falling under sections of the BNS. These sections deal with as per details below and some activities of IPC falls as scheduled offences under PMLA also.

• Section 318 (Section 415 of IPC) is related to Cheating and specifies punishment, which may extend to seven years with a fine or with both.
• Section 318(4) (Section 420 of IPC) pertains to cheating and the dishonest inducement of property delivery. It specifies punishment, which may extend to seven years, and shall also be liable for a fine.
• Section 320 (Section 421 of IPC) pertains to actions involving the removal or concealment of property in a way that may be considered dishonest or fraudulent, aiming to prevent fair distribution among creditors. It specifies that punishment shall not be under six months but may extend to two years, with a fine or both.
• Section 321(Section 422 of IPC) pertains to the act of dishonestly or fraudulently preventing debt from being accessible to creditors and specifies punishment that may extend to two years, a fine, or both.
• Section 322 (Section 423 of IPC) pertains to the deceptive or fraudulent execution of a deed transfer that includes a false statement regarding the consideration and specifies punishment that may extend to three years, with a fine, or with both.
• Section 323(Section 424 of IPC) pertains to dishonest or fraudulent removal or concealment of assets and specifies punishment that may extend to three years, a fine, or both.

ii. Sale of Goods Act, 1930

According to The Sale of Goods Act, 1930 \"fraud\" encompasses specific acts by a party to a contract (or with their involvement) to deceive another party or their representative. These acts include: Presenting something as a fact that is not true, even if the person making the claim does not believe it to be true. Essentially, fraud involves deceit and an intention to mislead.

The term \"fraud\" consists of two critical elements:

• Deceit: Intentionally misleading someone by providing false information.
• Harm to the Deceived Party: The Act of fraud resulting in harm to the party relying on the false information.

iii. Indian Contract Act, 1872

Under the Indian Contract Act, fraud refers to actions taken by a person or their agent with the intent to deceive another party or persuade them to enter into a contract. Such actions are considered fraudulent when there is an intention not to fulfill the contract. Fraud encompasses any of the following acts committed with the aim of deceiving another person or their agent or inducing them to enter into or create a contract.

• False suggestion
• Active concealment
• Promise without intention
• Any other act or omission intended to deceive the person to whom it is directed and the law specially declares to be fraudulent.

The term \"false\" can be defined under various laws, but one common context in the Indian Contract Act of 1872 is any statement or act that is not true and is made to deceive someone.

iv. Information Technology Act, 2002 (IT Act)

The definition of \"fraud\" within the context of the IT Act in India related to the following activities, and the penalties for fraud-related offenses under the IT Act have also been specified in relevant sections of the Act. Specified provisions fall under scheduled offenses under PMLA.

• Tampering with Computer Source Documents
• Hacking with Computer System
• Receiving a Stolen Computer or Communication Device
• Using the Password of Another Person
• Cheating Using Computer Resources
• Fraudulent Use of Electronic Signature or Password
• Cheating by Personation
• Publishing Private Images Without Consent
• Acts of Cyberterrorism

v. The Companies Act, 2013

Section 447 of The Companies Act 2013 addresses the punishment for fraud. It defines fraudulent acts as those performed with the intent to harm the interests of the company, its shareholders, creditors, or any other individual, regardless of whether these acts result in wrongful gain or wrongful loss. It specifies the punishment; if any person is found guilty of fraud involving a sum of at least Rs.10 lakh or 1% of the turnover of the company, whichever is lower, the person shall be sentenced to imprisonment for a term of not less than six months but which may extend to ten years. They shall also be liable to a fine which shall not be less than the sum involved in the fraud which may extend to three times the sum involved. If the fraud involves public interest, the term of imprisonment shall not be less than three years.

It has also been provided that where the fraud involves a sum less than Rs.10 lakh or 1% of the company\'s turnover, whichever is lower, and not involving public interest. Any person guilty of such fraud shall be punishable for a term that may extend to 5 years or with a fine that may extend to fifty lakh rupees or with both.

It has further been explained that fraud includes any activity with the intention to deceive, to ingenuine gain, or to injure the interests of the company, its stakeholders, or any other person.

Method of Frauds

Different types of methods are generally used by people to defraud stakeholders in different sectors. Some examples are as follows:

• Misrepresentation: Providing false or misleading information to investors or other stakeholders for personal gain or to manipulate perceptions.
• Embezzlement: Illegally misappropriating or stealing funds or assets from a company for personal use.
• Financial Statement Fraud: Deliberately manipulating financial reports or statements to deceive stakeholders about a company\'s financial performance or position.
• Insider Trading: Illegally trading stocks or securities based on non-public information can result in unfair advantages or losses for other investors.
• Kickbacks: Illicit payments made to individuals or entities as a reward for facilitating business transactions or contracts.
• Securities Fraud: Misleading investors about securities (stocks, bonds, etc.) to manipulate prices.
• Mortgage Fraud: Includes identity theft, falsification of income/assets, and property flipping.
• Bankruptcy Fraud: Concealing assets during bankruptcy proceedings.
• Over Invoicing: Taking invoices from vendors over the actual value.
• Fictitious Bills: Booking the fictitious bills without taking delivery.
• Straw Buyers: Using intermediaries to hide the true buyer\'s identity.
• Tax Fraud: Involves intentionally misrepresenting tax information to reduce tax liability.
• Insurance Fraud: Ranges from false claims to more elaborate schemes like staged accidents.

Classification of Frauds as per RBI Circular

RBI has issued Master Circular UBD.BPD. MC. No. 17 /12.05.001/2013-14 dated July 1, 2013, containing detailed information under which circumstances fraud will be treated and how the reporting shall be made. To ensure uniformity in reporting, frauds have been classified based mainly on the provisions of the Indian Penal Code, now known as BNS. However, cases of cash shortages and irregularities in foreign exchange transactions are to be reported as fraud if the intention to cheat/defraud is suspected/ proved. The following are also examples of bank fraud:

• Misappropriation and criminal breach of trust.
• Fraudulent encashment involves forged instruments, manipulation of books of account, and conversion of property.
• Unauthorised credit facilities extended for reward or for illegal gratification.
• Cheating and forgery.
• Any other type of fraud not coming under the specific heads as above.

Other Terms Used

i. Falsification

Falsification is intentionally providing false information or altering the truth to defraud. It can occur in various contexts, including scientific research, legal documents, financial statements, and other situations.

ii. Connivance

Connivance is also used to refer to the act of deliberately allowing or being involved in wrongful or illegal behaviour without directly participating in it. It means turning a blind eye or giving silent consent to unethical actions. Corporate Scandals are examples of convenience. Executives know about unsafe practices in their company but do not address them, enabling the continuation of those practices. Connivance often results in the individual being held accountable for the wrongful acts they allowed to happen, even if they did not directly engage in those actions.

iii. Siphoning

It involves misappropriating assets entrusted to someone for personal gain. In banking, \"siphoning of funds\" refers to the unauthorized movement of money from a bank account or financial system to another account or destination. This can happen through various means, such as creating ghost employees on the payroll or other deceptive techniques. The funds are often used for personal gain or illegal activities. RBI has also prescribed different limits for reporting fraud by banks to different authorities as per the jurisdiction.

Section 448 of the Companies Act, 2013: Punishment for False Statement

This section addresses the penalties for making false statements. It states that if a person provides a statement in any return, report, certificate, financial statement, prospectus, or other document required by the Act or its rules, and that statement is false in any significant way—while knowing it to be false, or if they deliberately omit any important fact while knowing it to be significant—they shall be liable under Section 447. In simpler terms, if someone knowingly provides false information or omits important information in any official document related to a company, they can face legal consequences. Based on the severity of the false statement, the penalties for this offense may include fines, imprisonment, or both.

Measures under PMLA and other Acts

The government has made several legal amendments to the PMLA, 2002 which have business implications. Corporate fraud under section 447 has been brought under PMLA. However, they impose additional compliance burdens on businesses. Major amendments are:

• The Central Government issued notification F.No. P-12011/12/2022-ES Cell-DOR dated March 07, 2023, and detailed virtual digital assets (VDAs) guidelines.
• Businesses, especially financial institutions and service providers of virtual digital assets, must adhere to stricter compliance requirements. This includes continuous due diligence regarding business relationships. Businesses dealing in cryptocurrencies and other VDAs must now maintain Know Your Customer (KYC) records and report suspicious transactions to financial intelligence units.
• The threshold for identifying beneficial owners has been reduced from 25% to 10%. This means businesses must identify and disclose individuals who own or control 10% or more of the company\'s shares, capital, or profit.
• The amendments have defined Politically Exposed Persons (PEPs) in accordance with the Financial Action Task Force suggestions. Businesses must now identify and monitor transactions involving PEPs, which include individuals entrusted with prominent public functions by a foreign country.
• Enhanced Disclosure Requirements: Non-governmental organizations (NGOs) and other entities must provide more detailed disclosures. Reporting entities like financial institutions and intermediaries are required to register details of non-profit organizations\' clients on the DARPAN portal of NITI Aayog and maintain these records for a specified period.
• In May 2023, the Ministry of Finance issued two notifications under PMLA to establish professionals as reporting entities.
• Besides, the Income Tax Act has also been amended, and tax has been imposed on gains from cryptocurrency.
• The Companies Act has been amended to report more disclosures regarding cryptocurrency, deviation of reporting of quarterly returns filed with banks, willful defaulters, utilizations of borrowed funds and premium and investment of funds received, including FDI for specific purposes, etc.
• The RBI issued notification RBI/DBR/2015-16/18 and DBR.AML.BC. No.81/14.01.001/2015-16 dated February 25, 2016, last updated on November 06, 2024, titled \'Master Direction Know Your Customer (KYC) Direction, 2016\', about avert money laundering.

Auditors\' Responsibility for Consideration of Fraud in an Audit of Financial Statements

Section 143(12) mandates that if an auditor, during their duties, has reason to believe that the company\'s officers or employees have committed a fraud involving a prescribed amount or amounts, they must report it to the Central Government. The amended Rule 13 provides specific guidelines on the manner and timeline for reporting fraud. The auditor should follow the auditing standards, including the definition of fraud as per SA 240 and Section 447 of The Companies Act, 2013. As per SA 240, although the auditor may suspect or identify the occurrence of fraud, the auditor does not legally determine whether fraud has actually occurred. The determination of \"offence\" is a legal determination, and accordingly, the auditor may not be able to legally determine that an \"offence or suspected offence involving fraud\" has been or is being perpetrated against the company by its officers or employees.

Paragraph A52 of SA 240 states that in evaluating and disposing of the misstatements identified, the auditor should consider the requirements of SA 450, \"Evaluation of Misstatements Identified during the Audit\". Misstatements arising from fraud will need to be communicated to the management and/or those charged with governance as required under paragraphs A21 to A23 of SA 450 and also reported to the Central Government as per the requirements specified in Companies (Audit and Auditors) Rules, 2014, as amended, in case the amount involved or expected to involve is individually Rupees One Crore or more. The auditor should comply with the relevant SAs with regard to illegal acts (e.g., SA 240 and SA 250, \"Consideration of Laws and Regulations in an Audit of Financial Statements\").

Penalty on Auditors

It is also pointed out that \"if an auditor has contravened such provisions knowingly or willfully intending to deceive the company or its shareholders or creditors or tax authorities, he shall be punishable with imprisonment for a term which may extend to one year and with fine which shall not be less than Rs.1 lakh but which may extend to Rs. 25 lakh.\" pursuant to the provisions to Section 147(2) in the context of punishment to auditors for contravention with the provisions of Section 143 of the Act.

Conclusion

After having reviewed the definitions of fraud, there should be loss or deceive to others to gain in general, increased compliances under the provisions of PMLA, compliances and disclosures requirements under schedule III of The Companies Act, 2013 for better corporate governance, the auditor is duty bound to take utmost care while auditing and finalizing the financial statements as per accounting standards and standards of auditing. In case of defaults, the auditor has to face the consequences of professional negligence and misconduct.