Forensic Audits: When Full Disclosure Is Not Better Transparency

With no guardrails around the mandatory disclosure on forensic audits, the regulation will defeat its own purpose of improving transparency for market participants: it will increase stock price volatility, create opportunities for price manipulation, and add noise to the market. SEBI needs to define the contours of its disclosure requirements, else boards will become reticent in instituting forensic audits, which is detrimental to the long-term interests of capital markets.

The Security and Exchange Board of India’s decision to amend regulation and compel disclosure on forensic audits surprised both companies and investors. The regulation requires companies to disclose, on the stock exchanges, forensic audits at the time of initiation, and file the forensic audit report along with management comments. This regulation raises more questions than it answers.

Forensic audit has not been defined by SEBI – nor is it defined in any other Indian legislation: it is a common parlance term and is generally understood. The requirement for disclosure related to forensic audit or “by whatever name called” allows a wide scope for the definition. This width in definition may have been inserted to stop companies from circumventing the disclosure by renaming the investigation. Even so, in leaving such wide room in the nomenclature, SEBI has burdened itself with deciding whether an audit is forensic or not, opening a flank for litigation.

The regulation, in its current form, has damaging implications for capital markets – both in the long-term and the short-term.

The Creation Of A False Market And Potential ‘Weaponisation’ By Short Sellers

Investors are likely to make Type I and Type II errors.

I: Announcing the initiation of a forensic audit report may cause undue panic for investors, which may result in an almost fear-based lowering of the stock price. The forensic audit process will take its own course, and if there is no material outcome of the report, the bounce back of stock price will be delayed. Compelled by the new regulations, as companies disclose all sort of special audits (material or otherwise), over time investors may begin to smell smoke without there being any fire.

II: On the other hand, material information may get lost in the subsequent information overload and investors may indeed miss a real fire. To this extent, unfiltered information regarding forensic audits can only increase stock volatility.

Short-sellers can weaponise the disclosure requirements – they can either use the whistle blower mechanism to compel a forensic audit which will likely need to be disclosed, or use the existing disclosures to create a mountain out of a molehill.

Public opinion can be swayed, causing reputational damage that may result in lowering of the stock price and distraction for the company’s board and its management.

Boards And Managements May Refrain From Instituting Forensic Audits

Forensic audits are routinely undertaken by managements themselves to test for the integrity of their systems – this may be a function of internal information or a regular system check. If the company is expected to disclose the initiation of the audit and the entire audit report (once the audit is completed), the board is likely to pre-empt the outcome and debate intensely before instituting the audit. This is sub-optimal: companies becoming circumspect in implementing self-checks cannot be in the long-term interest of markets.

The board’s reticence in instituting these audits may also impact whistle-blower complaints. After the episodes at Infosys, Sun Pharma, and ICICI Bank, boards tend to play safe by instituting inquiries (internal or even independent investigations) when they receive a complaint. Undertaking such investigations gives boards an independent view on the nature and degree of the suggested problem, and possibly provide them some cover in case of any subsequent class action lawsuits.

Almost a month has passed since the regulation has come into effect and there are no disclosures on initiation of forensic audits, save one audit ordered by RBI at Srei Infrastructure Finance Ltd. If well-governed companies with strong boards are to continue to do what they do, they are likely spending a considerable amount of time with lawyers drafting engagement letters for forensic auditors to undertake ‘not-forensic audits’ or formulating the narrowest definition of forensic audit, to avoid disclosure upon initiation. This is a waste of time and energy, more so when boards, in wanting to institute forensic audits, are doing the right thing.

The Forensic Audit Process Will Be Compromised

Forensic audits are usually conducted in stealth mode, or under the guise of another investigation. Announcing the audit at the time of its initiation is forewarning the entire system – and in cases of frauds, the perpetrators. With Gautam Thapar as the chairperson of the board, how successful would CG Power and Industrial Solutions Ltd.’s Operations Committee have been in unearthing the financial irregularities, if it had announced the investigation upfront?

Forensic audit reports contain confidential and sensitive information – companies will be exposing employees and the company’s secrets by divulging this information. Supporters of the forensic audit may lose the romance of becoming the next Deep Throat (or Karamchand). People named in the report will be considered guilty of wrongdoing without due process, their personal information will become public, as will sensitive company information. For example, if there was an investigation on a leak of sensitive information, then the nature of the information would be carried in the forensic audit report – putting this on the stock exchange would become a data breach by itself.

Also Read: Disclosure Of Forensic Audit: A Blunt Instrument

The Disclosure Requirements Increase Litigation Risk For Companies

Once the entire forensic audit report is filed with the stock exchanges, the document loses confidentiality and privilege. As a result, the company and its board can be sued by stakeholders for the findings of the forensic audit report, even though the audit was instituted by the board to find and fix the problem. Therefore, the provision opens the company to both class-action suits and nuisance suits.

The Way Forward

1. SEBI needs to revisit the disclosure requirement on initiation of the forensic audit, since it will compromise the entire forensic audit process.

2. SEBI needs to define the term ‘forensic audit (by whatever name called)’. The disclosures should apply only to those audits that are material to investors’ decision making, which by itself will bring in materiality thresholds.

3. Companies should be allowed to redact confidential and sensitive information from the forensic audit report before filing these with the stock exchanges. Alternatively, SEBI needs to allow boards to file only the summary of findings.

The intent of the regulation is right – there needs to be disclosures around forensic audits. But the current regulations open the market to higher stock price volatility and increase the risks for boards and companies. In the longer run, boards will likely hesitate before instituting a forensic audit. Both these issues are not in the interest of developing India’s capital markets. SEBI needs to publish contours of the disclosure requirements, to reduce chaos and enable better transparency.

Hetal Dalal is President and Chief Operating Officer at Institutional Investor Advisory Services.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.