Due diligence challenges and possible remediation steps in India

July 13, 2014 Julien Maillot

Conducting due diligence in India differs significantly from conducting due diligence in other countries. In particular, foreign corporations need to understand the Indian business environment, political landscape and local culture, as well as the complex ownership structure of Indian companies. In India, 85 percent of the country’s largest global companies are privately- or publicly-listed companies. In comparison to other countries, there is limited availability of public- and private-sector searchable databases; however government records and corporate documents in India are more accessible and are in English. Although record keeping is more advanced in India, some of the key issues Indian companies continue to face today are less-developed corporate governance processes, regulatory compliance and financial reporting practices, as well as high levels of corruption and bribery.

A weak corporate governance system

From a business perspective, many well-managed companies in India lack sophisticated corporate governance processes and systems. Many Indian companies are run by a ‘promoter’: an individual in charge of finding, organising and selling the company. In the case where a promoter owns a large share of a company and its board of directors is not independent, robust corporate governance may be lacking. Power is also more concentrated to a few individuals in those companies that are mainly owned by the promoter. Detailed research is thus mandatory to identify the directors, shareholders and related companies, and to determine the legal corporate structure of a company.

Due diligence assignments in India should be focused on the company and its owner and promoter. If government contracts are also involved, it is recommended to include a Foreign Corrupt Practices Act (FCPA) component to prohibit United States companies and individuals from obtaining business by making corrupt payments to foreign governments and officials. It is also recommended to perform an integrity check on owners, promoters and related companies. The due diligence should cover and examine areas such as the individual’s market reputation, their creditworthiness, their shareholdings in other entities, evidence of fraudulent business dealings, political affiliations, and involvement in civil and criminal proceedings related to third party transactions.

Be aware of changing regulations

Foreign companies and investors also need to be made aware of India’s rapid and evolving regulatory compliance environment. Several regulations need to be reviewed, including matters related to foreign direct investment (FDI) policies, foreign exchange regulations, securities and corporate law, various direct and indirect tax laws, and local labour and environmental regulations.

As the Indian government works towards further liberalising its FDI policies, uncertainty is expected to continue with regards to the changing regulatory landscape. Despite India opening up its retail industry to FDI in single-brand retail companies in 2006, allowing for 51 percent foreign ownership, according to The Wall Street Journal large mass-market retailers such as Wal-Mart and Carrefour are waiting for India to liberalise FDI rules and regulations on multi-brand retailers. Yet the new government in power – the Bharatiya Janata Party–led National Democratic Alliance – stated in its manifesto that it will oppose FDI in multi-brand retailers, so it is unlikely that India will relax its regulations any time soon.

Financials will require added scrutiny

Foreign companies and investors need to pay extra attention to the financial statements of Indian companies and reporting control environment. It is quite common in India for companies to lack regular reconciliation processes, have improper transaction cut-offs, have transactions without adequate supporting documentation, and have long-outstanding receivables and payables. It is important to understand that large Indian companies tend to have two or more sets of accounts; thus potential foreign entrants need to know that they have performed their due diligence on the correct account.

Rampant corruption and bribery to be expected

Corruption and bribery is a serious issue for foreign companies and investors looking to do business and implement due diligence on Indian companies. According to Control Risks’ 2013 International Business Attitudes to Corruption survey, more than 76 per cent of Indian businesses regard demands for operational bribes as one of their greatest concerns. Some common examples of operational bribes include demands from tax inspectors and handling agents, and officials processing licence applications. The same survey also made clear that companies may have to accept delays rather than making bribes.

To reduce risks, foreign companies looking to move into Indian markets should perform due diligence on Indian companies, paying special attention to:

  • Adopting policies and procedures that clearly lay out the company’s standards of conduct for all employees and third party contractors
  • Ensuring company policies are well defined with regards to gift and hospitality standards – foreign businesses should be aware that it is common and widely accepted in India for companies to practice gift-giving and business hospitality (especially during festive occasions such as Diwali) and should ensure that there are processes in place to record all gifts, entertainment and travel by both employees and clients
  • Developing a policy for staff that defines and restricts facilitation payments, including operational bribes
  • Reinforcing policies and procedures through frequent communication and training
  • Conducting a complete due diligence to assess the financial and tax implications they could face in India – including weak corporate governance standards, the developing Indian regulatory environment and financial reporting requirements – as well as conducting due diligence on all potential third parties
  • Establishing a whistleblowing system where employees can confidentially report concerns related to corruption and bribery and ensure that standard clauses related to the payment of bribes are included in contracts, especially to third party contractors
  • Performing a fraud risk assessment to identify vulnerable areas and indicate key red flags
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