How to get away with fraud - Episode 2
Related Party Transactions
Promoters are always finding new ways to pull money out of the firm. So today we try to identify ways and means that firms do this - so that we can spot it in firms we are analyzing.
Related Party Transactions
Promoters are always finding new ways to pull money out of the firm. So today we try to identify ways and means that firms do this - so that we can spot it in firms we are analyzing.
If you haven't yet, read Ep 1: Receivables & Revenue:
https://twitter.com/bharatbetpf/status/1487306015045726210
Before we dive deeper into this section - it is important to differentiate between an individual and the firm.
Firms are broadly created to enable good risk taking - i.e enable risky enterprise without driving financial ruin for the ones who take those risks when the firm goes side-ways.
These firms are funded by debt (bank loans) and equity (shareholder capital). Under this structure - all the shareholders (including the promoter) own the business together.
The funds of the firm therefore should be managed for the best interest of the firm. Problems begin to arise when promoters start using it as their personal piggy bank. Let's see how they do this using our Ramu from the previous example.
Ramu from our previous example - wants to expand from just distributing milk to producing and processing it in his factory. He establishes a firm to enable him to do this better.
Let's see how he can pull money out of the firm in some shady ways
1. Key asset ownership:
Ramu starts a brand called Ramu's milk. However instead of having the firm own the brand, he owns the brand himself. The firm therefore has to pay him a royalty. There is also the additional risk of a key asset of the firm (brand) not owned directly by it
Ramu starts a brand called Ramu's milk. However instead of having the firm own the brand, he owns the brand himself. The firm therefore has to pay him a royalty. There is also the additional risk of a key asset of the firm (brand) not owned directly by it
Always look for who owns the key assets & intangibles (brand and IP) and the outflows that the firm pays - and the risks associated with having those intangible with an external party
A leading mattress manufacturer has the brand owned externally.
A leading mattress manufacturer has the brand owned externally.
2. Loans from Promoter
Ramu's milk firm has a lot of spare cash and investment. Ramu however chooses to provide loans to his firm and earn a healthy 12% interest on these loans. Generosity nobody asked for!
Ramu's milk firm has a lot of spare cash and investment. Ramu however chooses to provide loans to his firm and earn a healthy 12% interest on these loans. Generosity nobody asked for!
Always be wary of firms sitting on a tonne of cash borrowing from promoters and paying them abnormal interest. Either the cash isn't really there - or the promoter has identified a very generous bank!
A leading net manufacturer consistently takes high cost loans from its promoters.
3. Management pay & perks: Ramu can take not only excessive pay, but also get additional perks - rent, driver and house-help salaries - you get the drift!
Ramu further decides that he wants a Mercedes for his personal use. But instead of buying it using his own money, he buys it using the firms and shows it as an asset.
A leading tyre company has its management take excessive compensation. A tier 2 jeweller has jets on its balance sheet.
4. Loans to Promoters + Contingent liabilities
Ramu has a son who has a gambling addiction and no job. Obviously no bank will lend to him - so Ramu says his firm will act as guarantor for the loan if his son defaults. This is now a contingent liability for the firm.
Ramu has a son who has a gambling addiction and no job. Obviously no bank will lend to him - so Ramu says his firm will act as guarantor for the loan if his son defaults. This is now a contingent liability for the firm.
Ramu can also borrow from the firm at extremely low rates to fund his lifestyle.
This is one of the most common RPT and you'll find a host of companies doing this.
This is one of the most common RPT and you'll find a host of companies doing this.
5. Private businesses in competing segments
This is not an RPT per say - but still a red flag to be aware off. Many companies begin private business in similar lines of business.
This is not an RPT per say - but still a red flag to be aware off. Many companies begin private business in similar lines of business.
This not only reduces promoter bandwidth to the original firm, but also leads to a conflict of interest - the public firm might not participate in the opportunity that they have started the private venture in.
A leading tiles company did something similar some time back.
A leading tiles company did something similar some time back.
The list of how management siphons off money and opportunity from the firm is unending - but this should be a good list to keep top of mind.
What other modus operandi have you observed? Let us know of interesting ones in the comments!
What other modus operandi have you observed? Let us know of interesting ones in the comments!
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