Frauds on a rise: What you should do?

Wed, 5 Feb Pre-Open

   Previous Close   

   09:30 am   

   11:30 am   

   01:30 pm   

   Closing   

Corporate frauds would be a big letdown for any investor. And when such cases keep happening and that too at bigger scales year after another, it would only lead to investors viewing capital markets in a negative manner.

As reported by the Mint recently, corporate frauds in India have been on the rise ever since the Satyam scandal. In 2008, for instance, frauds worth Rs 107.4 bn were reported. In 2009, the figure shot up to about Rs 1.4 trillion. In 2010, 2011 and 2013 the figures came in at Rs 304 bn, Rs 669 bn followed by Rs 154.4 bn. As per the leading business daily, the average size of frauds stood at Rs 2.8 bn prior to 2009. However, the same increased sharply to a figure of Rs 5 bn in the years thereafter.

It may be noted that the figures may be seemingly higher due to better supervision by the concerned authorities.

What is, however, unusual is that only 44% of the companies surveyed in the study were listed on stock exchanges. And within those, about two-thirds had promoter shareholdings in excess of 50%; the latter usually being considered as one of the measures of safety when investing in a listed firm.

What are the causes for such frauds? Well it turns out that siphoning of funds is the largest method having a share of more than 36%. Defrauding lenders formed about 17%, while defrauding investors and the government contributed to about 13% each. Tax evasion cases formed about 12% of the total while defrauding customers formed about 5%.

As for the final outcome of these frauds - about 43% of companies had either or were in process of liquidation or had discontinued operations; nearly one-fourth of the companies continued to be operational with their share prices being battered; and one-fifth of the businesses continued with marginal impact. About 7% of the businesses saw their operations continuing albeit at reduced levels, while 5% of business continued with changed managements.

What can investors do?

Well... frauds have happened in the past and they may continue to happen in the future. This is why it is important to invest in companies having good managements. While businesses may be good having distinct advantages and good prospects, at the end of the day, it all depends on the people running the show. As a famous fund manager pointed out, if a management puts its hand in shareholders' pockets once, he's much more likely to do so again.

So in short, stay away from companies with dubious managements.

While judging and gauging management quality is not an easy task, there are certain factors that people can look at; related party transactions and salary levels (when compared to peers in industry) being examples.

Investors should also try and find answers to whether the management team is honest and transparent. Whether it is good at allocating capital. Whether it really cares about shareholder wealth creation and is not just behind revenues and wanting to grow at any cost.

Basic answers to such questions should go a long way in making good investment decisions from poor ones.