Saturday, October 5, 2013

NSEL: Let us not cry for investors, rather worry about the auditing profession and regulators

Economic Times reports that the Economic Offence Wing (EOW) of the Mumbai Police reported that thirty of the sixty warehouses it raided  were found to be empty. The EOW official also revealed that four warhouses that are on documents siezed by it did not exist.

It might be a revelation to some but not to the Forward Market Commission (FMC). Business Standard reports that it was known to FMC for more than a year.

The show cause notice issued by the Ministry of Consumer Affairs in April 2012 mentions "NSEL has not made it mandatory for the seller to actually deposit goods in the warehouse before taking a short-position through a member of the exchange. The exchange system has no stock check facility that validates the member's position. The exchange allows trading on the exchange platform without verifying whether the seller member has the stocks with him or not. In this way the exchange has violated conditions stipulated that no short-sale for the members of the exchange will be allowed."

NSEL replied within fifteen days from the receipt of the notice. FMC took fifteen months to issue instructions for stopping the launch of new contracts and for settling all contracts with open position.
We know that files in government departments move slowly. But speed of response of FMC iraises suspicion that officials of FMC and Ministry of Consumer Affairs connived with the management of NSEL and borrowers to defraud investors (!).

It is quite possible that investors knew the fact that the warehouses were empty. They were happy with the rate return on investment which was higher than the return that investors earn on unsecured long -term deposits with companies. The return on investment was attractive. It is difficult to believe that lenders (investors) are naive and do not understand that there is a correlation between risk and return. They are high net worth individuals and each must be holding a portfolio of investments.  Therefore, it might be incorrect to say the investors have been defrauded by lenders and NSEL management.

Quite likely that the auditor of NSEL also knew that some warehouses were empty. In 2012 Mukesh P Shah & Company was appointed as the auditor in place of S V Ghatalia & Associates, which expressed unwillingness to continue as the statutory auditor. As per the Code of Ethics issued by the Institute of Chartered Accountants of India, an incoming auditor must communicate with the outgoing auditor.   S V Ghatalia & Associate might have communicated the reasons for their unwillingness to continue as statutory auditor. This should have alterted the incoming auditor. Even if the outgoing auditor had not communicated transparently the reasons for its unwillingness to continue, the incoming auditor was responsible for applying additional procedure to assess the audit risk. Change of auditor itself is a red flag. An auditor is espected to approach an audit assignement with skeptical approach. It should be more cautious when taking over an assignment that was handled by another auditor. It is unlikely that the auditor (Mukesh P Shah & Company) did not verify warehouse stocks. Although a conjecture, we may reasonably assume that the auditor knew what was going on.

Everyone was happy so long as the crisis did not erupt. Let us not cry for the investors. However, the Institute of Chartered Accountants of India should investigate the auditor to protect the credibility of the auditing profession. Similarly, government officials need to explain the delay in issuing instructions to NSEL.

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