Bain Capital sues EY in US for ‘wrong advice’ on Lilliput investment

Gobal private equity firm Bain Capital has sued EY in a US court, claiming the auditing firm wrongly advised it to invest $60 million (Rs360 crore) in India's Lilliput Kidswear.

In its lawsuit, Bain alleged in May 2010, it had invested in a 30.99-per cent stake in Lilliput, based on false financial statements that EY had audited and certified.

Bain says EY, acting as statutory auditor for Lilliput, knew about the key aspects of a fraudulent scheme to systematically falsify and misrepresent the company's revenue, costs, inventory and indebtedness.

"The false financial information provided by EY improperly presented Lilliput as a thriving, reputable business, with an impressive track record of growth in revenue and earnings through the previous three years when, in fact, the business was performing poorly," said Bain Capital.

EY (formerly Ernst & Young) denied the charges. "These allegations of wrongdoing are baseless and EY will vigorously defend this matter," it said in a statement.

In the suit, pending at a Massachusetts court, Bain said the investment in Lilliput was now worthless.

Apart from Bain, TPG had also invested $26 million in Lilliput in April 2010.

Bain said EY provided clean audit opinion that certified Lilliput's financial statements and assured Bain these statements could be relied upon to make investment decisions.

According to court documents, EY knew about key aspects of this fraudulent scheme and was aware the financial information it was providing to Bain was inaccurate and unreliable.

This dual role of EY represented a clear conflict of interest, in light of the firm's responsibilities as statutory auditor for Lilliput. Further, EY's compensation for its work as the seller's agent was based on convincing potential investors to place a high valuation on Lilliput in any transaction, a clear incentive to misrepresent the company's financial position to justify the high "success fee" it was paid, Bain said.

The private equity firm came to know about the problems in Lilliput's account after a call from a whistleblower, following Lilliput's initial public offering (IPO) being approved. Bain stopped the IPO process and investigated the claims of the whistleblower, which turned out to be true.

Soon, this turned into a battle between Bain investors and Lilliput promoter Sanjeev Narula. The investors accused Narula of fudging the books of the company and not providing auditors access to its financials. Narula, on the other hand, alleged the investors were trying to stall the company's Rs 850-crore IPO and seize majority control.

Bain said EY violated many relevant audit and accounting standards, a clear failure of its professional responsibilities. Its internal audit papers acknowledged Lilliput was improperly recognising revenue before it was earned, and knew (but did not disclose) Lilliput had taken a substantial loan that wasn't reflected in its financials.

Later, while reviewing Lilliput's financials, an independent, court-appointed auditor uncovered evidence of widespread fraud and discrepancies permeating nearly every aspect of the company's accounts, including bank records, cash on hand, revenues and inventory position.

This is not the first time Indian audit firms are under fire. PriceWaterhouse is facing trial in a Hyderabad court for falsifying the books of Satyam Computers, which imploded in 2009. Also, in October 2012, PricewaterhouseCoopers paid a fine of $6 million to the Securities and Exchange Commission, the US market regulator, for "deficient" audit in the Satyam case.