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Lilliput: Ministry probes conflict of interest

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A week after the dispute between , the founder and chief executive of kidswear company , and the private equity investors in his company over alleged window dressing of accounts was dragged to court, the is looking into the role of Ernst and Young (E&Y) and its member firms.

The objective of the inquiry is to see whether there was a case of conflict of interest.

Elaborating on any ministerial inquiry to examine E&Y’s role, Naved Masood, secretary, ministry of corporate affairs, told Business Standard, “The matter is being looked into. It is too early to predict the outcome.”

Until late last month, S R Batliboi & Co, an E&Y member firm, was Lilliput’s external auditor. It resigned end-September after Lilliput’s board rejected the financial statements for FY’11, after allegations of financial mismanagement surfaced. Prior to that in 2010, when Lilliput was planning to raise capital from PE investors, it had mandated E&Y Pvt Ltd as the strategic advisor for the stake sale.

E&Y Pvt Ltd, at the behest of the company, also did the due diligence of the accounts and finances of Lilliput. Such ‘vendor diligence’ reports facilitate potential investments.

A conflict of interest, said people following the development, could arise from the same firm doing both advisory work and due diligence simultaneously for the same deal. Advisory firms or investment banks with sell-side mandates get advisory fee only upon the successful completion of an M&A transaction.

Moreover, said these sources, in Lilliput, an E&Y member firm was also the external auditor of the company, responsible for vetting the same company’s books.

In an emailed statement, S R Batliboi & Co said, “We confirm that S R Batliboi & Co has resigned as the auditor of Lilliput Kidswear. We are unable to make any further comment on this matter at this stage on account of our professional obligations. We would also like to state that S R Batliboi & Co follows the requirements of conflicts and independence as stipulated by the (ICAI).”

E&Y did not comment on the subject.

Sources add S R Batliboi & Co is a separate firm that has no common ownership with E&Y. They only share infrastructure like office space and a Chinese wall exists between the different audit, advisory and other departments.

In Lilliput, these sources say, even though E&Y Pvt Ltd did both the advisory and vendor diligence, it was only a “hold harmless diligence report”. In simple words, a preliminary report that only compiled the different financial data of the company in one place and it was not an exhaustive “forensic diligence report.”

Moreover, they add, the private equity investors had brought in their own independent diligence teams and had roped in several others, including KPMG, to help carry out a detailed diligence on their own.

KPMG did not want to comment on the issue.

But, this has triggered a debate among the different stakeholders concerned, giving enough fodder for full-fledged corporate shadow-boxing.

Other sources aware of the ongoing developments in Lilliput say it is a fact that KPMG was brought in by the PE investors before they actually concluded the deal, but KPMG’s report was only incremental to the diligence report already prepared by E&Y. The Lilliput stake sale, they add, was an auction process, so the PE investors had limited time to do an exhaustive diligence on their own and therefore had to depend on the vendor report.

Bain and TPG refused to comment as the matter is sub-judice. Narula was unavailable for comment. The company’s spokesperson told Business Standard he was travelling and would be unavailable for at least the next three days.

Some of the representatives of leading consultancy and audit firms that Business Standard spoke to said there was a prima facie issue of "conflict of interest", but felt that E&Y may be on the right side of the law. "It's a fine line that needs to be probed further. ICAI would have objected to this if E&Y was flouting any norms. Maybe the ministry (of corporate affairs) should take a call,” said a leading consultant who did not wish to be named.

ICAI president G Ramaswamy did not wish to comment before evaluating all the details of the matter as he was travelling.

But ICAI — the accounting standard setting body in India — in a recent report on Operation of Multinational Network Accounting Firms in India has looked into all the “surrogate” practices of global consultancy firms. Though the report does not mention any entity by name, all the Big 4 consultancy-audit firms have network linkages in Indian chartered accountancy firms. Pointing out several instances where India-registered audit firms were found to be sharing resources including offices and addresses with their multinational network partners, ICAI wanted the RBI, the ministry of corporate affairs and other relevant ministries to have a strict watch on such practices.

The immediate past president of ICAI, Amarjit Chopra, told Business Standard, “Personally, I feel that there is a very clear understanding all over India that Ernst & Young and S R Batliboi and Associates are one and the same. They share the same office, have the same address. ICAI has a clear position (on ethical grounds) that the other income of an audit entity (income from consultancy) should not exceed its audit income. In this case (Lilliput), E&Y has been the advisor, it did the financial due diligence, and its arm did the audit. This is what we call a surrogate practice to breach the veil of ethical standards. It is high time we lifted this veil.”

Meanwhile, ever since the allegations surfaced over a fortnight back, the two PE investors of Lilliput have withdrawn their support for the proposed Rs 850 crore IPO plans of the company. Six directors — including four independent ones — have resigned from Lilliput’s board.

Narula, in turn, has dragged these investors to court, claiming the PE players are pressurising to usurp control and ownership. Currently, as Lilliput’s promoter, Narula owns a 55 per cent stake in the company with the PE investors holding the rest.

Together, Bain and TPG had invested $86 million into Lilliput in April 2010 and have been since then predominantly depending on the financial statements provided by the company to inform their own shareholders that the value of their stake has gone up substantially. The company’s management has reportedly countered these allegations, stating the PE investors were always updated with the financials of the company.

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