Corporate Frauds World Over

Introduction

“It was like riding a tiger, not knowing how to get off without being eaten.”

Corporate frauds world over, are extremely dangerous gambles the corporate executives or employees for a variety of profit maximizing motives encouraged by poor corporate governance mechanisms.

With the turn of the 20th century, instances of corporate fraud have emerged with a domino effect world over, with Enron’s failure perhaps being the characteristic example. Corporate fraud in India too is on the rise, a fact corroborated by 75 per cent of the top executives surveyed by consultancy firm KPMG. Understandably, since most of the corporate firms deal with public money and are listed, the clamor for prosecution of corporate fraud to bring ‘someone’ to the book has generated increasing interests in the last several years. In the US especially, quite a few high-profile cases have captured headlines, thrown the companies into death spirals, destroyed the careers of numerous managers, and put executives behind bars. Satyam is India’s Enron and public trials would propel the fiercest steps be taken against Satyam Computers, winner of Golden Peacock Global Award for excellence in corporate governance for 2008.

Recent research has established that financial development is largely dependent on investor protection in a country – de jure and de facto. So it is not surprising then that the Satyam fraud threatens to undermine investor confidence in India at a time when the country’s economy is already reeling from the world financial crisis and recession. In fact, in October and November, exports fell by more than 10 percent on a year-to-year basis. This fall represents a disaster in the making for the Indian elite since its plans to achieve 8 percent annual economic growth are predicated on boosting exports by more than 20 percent per year.

With the legacy of the English legal system, India has one of the best corporate governance laws but poor implementation together with socialistic policies of the pre-reform era has affected corporate governance. This paper intends to study and suggest amends to the same and examines the steps the government proposes to take.

Fraud is defined as ‘a knowing misrepresentation of truth or concealment of a material fact to induce another to act to his or her detriment.’ Fraud committed by or on large organizations is commonly known as corporate fraud. The agencies of fraud range from the top executives committing fraud on the markets to help boost the company’s market value, and indirectly their own profits to fraud perpetrated by employees, both junior and senior for either personal or professional gain. The KPMG Fraud Survey Report 2010 concluded that an increasing number of employees are indulging in fraudulent activities, mostly driven by financial stress and dissatisfaction with their company management. The survey indentified both junior and senior employees as perpetrators of frauds and concluded that consequently the real quantum of fraud in monetary value terms is on an upward spiral. Fraud losses of more than Rs. 10 lakh hit “87 per cent of survey respondents, against only 47 per cent in the last survey, according to KPMG. The survey noted that supply chain fraud (procurement, distribution and revenue leakage) is the area most prone to cases of fraud. An obvious conclusion of the survey was that the present control and regulation mechanisms are overtly ineffective.

The Reasons For Committing Fraud

In order to effectively tackle the issue of corporate frauds it is essential to understand and engage with the incentives for committing fraud and neutralizing these, apart from strengthening the fraud detection mechanisms or criminally prosecuting persons responsible. This is so because the latter two are merely ex post, while a pro active ex ante approach is often preferred and neutralizes the chances of commission of fraud better than a curative approach.

A Corporate Compensation

According to Becker’s economic theory of crime framework persons or organizations choose to commit crime ‘because the expected utility of the payoff outweighs the expected disutility of getting caught and prosecuted.’ One possible sufficiently enticing reason might be corporate compensations which are often tied to how the company shares perform in the markets. Most CEOs, like Steve Jobs, the Google co-founders, take a nominal token remuneration as salary for their contribution to their companies. Their revenues are instead linked with the financial performance of their companies. Firms design equity-based compensation contracts to provide executives with incentives to increase stock prices through legitimate means, but these contracts can also create greater incentives to produce fraudulent financial statements or take other actions to mislead analysts and investors about the value of their firms’ stocks.

In the Indian context, the issue of executive compensation has been seen with greater interest since the start of economic liberalization in the early 1990s. The post liberalization period has also seen a steady increase in the salaries of managers at all levels. Increasing profitability of companies, competition in the market for managerial talent and the practice of benchmarking company policies with global standards have all contributed towards the rise in executive compensation. At the same time, there have also been wide ranging changes in the regulatory aspects of corporate governance with the tightening of norms imposed by market regulators. All these changes have resulted in new ways in which top management compensation is decided and enforced in Indian companies. Another feature unique to the Indian context (vis-à-vis Western countries) is the dominance of ‘family owned’ companies in India.

In firms that do not follow strict corporate governance standards, the managers will be in a position to control the contracting process to their benefit, though at the expense of the shareholders. CEOs also earn greater compensation when corporate governance structures are less effective. In one such recent survey, Swami (2005) reported that CEOs of many Indian companies saw salary increases of the order of 300% in the year 2004. The study also reported that variable pay is increasingly becoming the highest contributor to the salary package.

The link between executive compensation and corporate performance has been explored extensively in Western countries but remains relatively unexplored in India.

B Poor Deterrents

While one end of the spectrum is potential benefits of committing fraud, the other is clearly the possible harm, in the Becker theory. The consequences for those who commit fraud are usually nonexistent, as most frauds are uncovered accidentally and the word is still grappling with devising effective detection mechanism. It is an exercise that learns from each fraud that is uncovered. However, once uncovered the penalties for criminal corporate fraud are usually exponential in most jurisdictions. Some claim the exponential penalties and continuously evolving corporate governance mechanisms are sufficient to deter perpetrators, yet practical instances suggest otherwise.

In India the problem of deterrence becomes even more unfortunate for political nexus helps it thrive. For e.g. the former Telugu Desam Party (TDP) chief minister of AP, Chandrababu Naidu, routinely lauded the Satyam CEO, the current Congress state government awarded Maytas Infra—another owned business associated with B. Ramalinga Raju—a Rs. 120 billion contract to build a 71-km metro (rapid transit) system in Hyderabad, although Maytas Infra has no experience in metro construction. Further, the Congress state government of Y.S. Rajasekhara Reddy had allowed Satyam to purchase 50 acres of land in a Special Economic Zone in Visakhapatnam, a port city in AP, at a cost of Rs. 1 million per acre, although the market price is Rs. 50 million per acre.

When the governmental agencies charged with regulation collude with the perpetrators of crime, the civil society if most often called upon to contribute. However, unfortunately the civil society agents in the corporate world too are enveloped in collusion.

All companies are required by law to appoint ‘independent’ directors on their boards. These directors are supposed to provide an independent voice to the functioning of the board and provide their expertise to the executive directors. Clause 49 of the Listing Agreement of SEBI lays down the definition of an independent director. The objective is to place a third party check on the dealings of the company.

The role of independent directors has been outlined differently by various committees on corporate governance such as the Birla Committee, Narayan Moorthy Committee etc. The presence of independent directors is supposed to serve as an internal monitoring mechanism for the actions of the managers of the firm. As per Clause 49 of the Listing Agreement of SEBI, the number of independent directors on the board should not be less than half the total strength of the board when the Chairman is an executive director and should not be less than one third the total strength of the board when the Chairman is a non executive director. The implicit assumption behind this clause is that a greater number of independent directors will ensure better monitoring of the firm and limit managerial power to act against the interests of the shareholders. Also as pointed out above in theory, the independent directors play a critical role in designing the compensation of the CEO apart from their monitoring roles. However, unfortunately the independence of ‘independent directors’ in India is doubtful for good reasons. In controlling shareholder situations, the independent directors are often appointed by the controlling shareholders, and may hence owe a sense of responsibility to those shareholders.

The problems highlighted in the previous chapter deal predominantly with the inefficacy of the corporate governance mechanisms. Corporate governance is commonly understood as the set of processes and conventions that affect the way a corporation is directed, administered or controlled. The principal players are the shareholders, management and the board of directors. The principles of corporate governance lay out a set of practices that the board of directors needs to adopt to ensure economic efficiency and the alignment of interests between all the stakeholders of the organization.

Remedying The Incentives Of Corporate Compensation

In the context of executive compensation, efficient corporate governance necessitates mechanisms which monitor and regulate the process of fixing compensation and computing reward-worthy top management performance. Establishment of compensation or remuneration committees, consisting of independent directors and other notable members of auditing background, is essential. Corporate governance standards must ideally call for transparency in the form of disclosure of information about compensation contracts with top management personnel to all stakeholders.

In India according to corporate governance standards, with respect to executive compensation, Clause 49 of the Listing Agreement of the Securities and Exchange Board of India (SEBI) mandates all companies to constitute a remuneration committee. The remuneration committee was first suggested by the Birla Committee Report, 2000. The committee consists of directors, all of whom are non executive, with the Chairman of the committee being an independent director. It is the remuneration committee that recommends the compensation that is paid out to the CEO and other executive directors on the board.

Independent Directors

Independent directors, who are truly independent, can be an effective bulwark against corporate frauds and scams. If corporate India is serious about raising the bar on governance standards, it should appoint competent independent directors after a thorough search.

The move by the Andhra Pradesh Government to arrest former independent directors of Nagarjuna Finance for alleged default in repayment of public deposits has raised the question of whether independent directors should be arrested for misgivings of the company. ‘In a country like India where foisting of criminal cases is quite common in certain segments of society, such a trend would be suicidal if allowed to affect independent directors.’ It is suggested that statutory protection be granted to directors against prosecution. Suggestions have also been made to set up ‘The Institute of Independent Directors’ to nurture promote and regulate the profession of independent directors, established in private public partnership as a self-regulating body for the orderly growth and regulation of the profession of independent directors.

Caveats

A Looking Beyond

The corporate governance models in India borrow heavily from the US and the UK. For e.g. Clause 49 of the listing agreement and other corporate governance norms have been largely borrowed from the Cadbury Committee recommendations in the UK and the Sarbanes-Oxley Act in the US. While following examples of corporate governance these countries a few distinctions must be kept in mind. It must be kept in mind that targeting corporate compensation work for the west because in those jurisdictions, managers (such as the CEO, CFO and other senior executives) are compensated through stock options and equity and hence there is a strong incentive to inflate earnings. On the other hand, corporate compensation exists in India, yet here the there is concentrated shareholding. The critical actor is not the senior management but the controlling shareholder. In such a scenario, where fraud is involved, it usually does not result in an inflation of earnings, but in related party transactions whereby assets of a company are siphoned out to other companies owned by the controlling shareholder. In short since in UK and the US where the shareholding is diffused, if their governance patterns are mimicked in India they would be doomed to fail as in India the shareholding pattern is vastly different. With most listed companies being either family-owned or state-owned, if the governance mechanisms are subject to the control of the dominant shareholder, they will necessarily fail.

So for an effective corporate governance mechanism in India, more than corporate compensation must be looked at. It is because the Indian system refuses to acknowledge such fundamental differences that it fails to cater to our needs effectively.

B Learning From Mistakes

Moreover, lessons ought to be learnt from these jurisdictions while imbibing their solutions. In the US, corporate scandals have led to increased vigilance by policymakers and the Sarbanes-Oxley Act (SOX), enacted in 2002. The Act imposed strict accounting and reporting controls on public companies. Complying with SOX costs American companies between $5.5 and $35 billion per year depending upon the estimate one considers.

Under SOX, Chief Executive Officers and Chief Financial Officers must attest personally to the accuracy of their companies’ financial disclosures and are subject to criminal penalties for false disclosures. With many executives hauled off to jail in the years following the Enron debacle, time behind bars for violating these requirements is a threat taken seriously. Around the same time, the President’s Corporate Fraud Task Force was established to increase the focus on corporate fraud, both within the Department of Justice as well as with other government agencies. The number of convictions quintupled from 50 in 2002 to 250 in 2004.

Given that the effectiveness of ‘threat of criminal indictment has become a controversial weapon in this war against corporate wrongdoing’ it should be reconsidered as being the only or the popular solution. Even the Naresh Chandra Committee was clear that imprisonment of directors in undesirable as that would lead to a chilling effect on the pool of potential directors.

The issue is not whether corporate fraud is harmful—it clearly is by undermining investor confidence in the financial markets—but whether prosecution of complex business decisions, especially in front of a lay jury, is the most effective way to address and deter fraudulent behavior by corporate executives.

C Alternatives And New Developments

Various suggestions have been furthered post-Satyam, to tighten corporate governance in India. Some of those include:

1. The Company Law should provide statutory powers to a Serious Fraud Office with investigating teams consisting of corporate lawyers, forensic accountants and senior officers seconded from the police departments. To curb the recurrence of corporate frauds, the statutory auditors report should state that sufficient systems exist in the company for early detention of frauds. The government has followed this suggestion. It has set up a Market Research and Analysis Unit (MRAU) in the Serious Fraud Investigation Office (SFIO) with the objective of improvements in the regulatory system in corporate sector.
2. Incentivising ‘whistle blowing to facilitate early detection. “Ineffective whistle—blowing systems… (is one of the) the reasons for the increase in the number of frauds that one can see in the industry today.”
3. The GoI has introduced an Early Warning System (EWS). With the EWS the government would look for unusual developments by scrutinising quarterly results of companies, their public announcements, filings with exchanges, tax returns, media reports etc. and detect wrong doings.
4. The Companies Bill, 2009 (pending) also stipulates “disbursement of any profits made by officers or the company at the expense of shareholders. The draft law, also aims to allay fears of potential overseas investors, will make it mandatory for companies to operate transparently.” Such a move is welcomed the government may even borrow from the Regulations which give shareholders greater say in executive compensation referred to as ‘Say on Pay’ that companies like Microsoft have adopted. This provides greater transparency and removes the undesirable nexus between the Board of Directors who set the compensation and executives. The Companies Bill, 2009, which is before the Parliamentary Standing Committee, also allows Class Action Suits in the benefit of shareholders for the first time in the country.

Corporate fraud must be pursued vigorously however, in the frenzy it must be remembered that too strict a regulatory frame work may stifle corporate creativity and competition. ‘Harsh and comprehensive paper laws and powerful institutions have often been found to make life difficult for the 95 other law abiding companies when 5 companies are found guilty. Particularly, when the other 95 companies play fair and abide the law in its letter and spirit – in fact, they may do this for their own reputation, whether such laws existed or not. There are ways for the government to make these non-interfering regulations. It can consider tax benefits for firms that voluntarily set reasonable compensation limits.

Conclusion

Corporate frauds and scams greatly erode corporate wealth. Corporate India as a whole has a vested interest in preventing and minimising corporate frauds and scams. Independent directors on audit committees provide one of the best ways of reinforcing internal audit and annual statutory audit. Their independence must be strengthened. With respect to incentives, in end executive compensation is about ethics and can only be sparingly controlled. The solutions to corporate fraud must be comprehensive and all encompassing.

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