A blueprint for improving Corporate Governance & preventing scams

Improving Corporate Governance: A blueprint for preventing future scams like Satyam Computers

By Atim Kabra

Why are we so surprised at Satyam Computer blowing up?

Probably not because there were accounting shenanigans, not because Raju placed himself before shareholders, not the fact that auditors were probably hand in gloves with the management and conveniently turning a blind eye to the fraud being perpetrated at the company, certainly not the fact that the so called independents were dwarfed by Raju, his charm, his wealth, his connections or were just plain incompetent and beholden to Raju for inducting them as independent directors in the first place. We are surprised by the sheer scale of the fraudulent activities which went on unchecked by reputed auditors and the numerous corporate governance awards which multiple organizations vied to bestow on Satyam. Well, it speaks volumes for these organizations but that is a matter for another debate. I wonder whether we are more shocked at the events that unfolded at Satyam or shocked by the fact that Raju had to own up to the going ons at Satyam. That such a well connected man with assets of gigantic size had to own up to mischiefs and scams , gives rise to innumerable conspiracy theories ranging from blackmail to jail in India being preferred over jails in the USA by Raju.

I have had the opportunity to discuss this issue in details with many fund managers based in India as well as overseas and I am attempting to detail a few steps which might help in preventing such scams in the future. I acknowledge that greed and hubris is an integral part of human nature. History of mankind and the scams perpetrated by humans on unsuspecting fellow humans make for an interesting reading. I believe that no amount of regulation can eliminate completely the possibility of recurrence of such scams. However, we certainly can make efforts towards minimizing the probability of scams and their size, by utilizing the twin tools of enhanced scrutiny and deterrent punishment.  It is critical to work towards increasing the probability of discovering nascent scams early enough if we were to minimize damage to trust and transparency which combined together form the underpinnings of any financial system.  The interesting part if that most of these suggestions are already being applied in parts in India with quite positive results. So we are not reinventing the wheel but just suggesting extending the existing format for wider coverage. While I do believe in self regulation, I also believe in strong industry regulators who can ‘police the police’. Without further ado, here is a prescription sheet which if implemented can probably control the spread of the disease.

Make the watchdogs accountable for the theft: punishment should be substantial

We hope that the truth about the role played by Satyam’s auditors will come out after an extensive investigation. When questioned about the investment decision, the common refrain is that the investors relied on certifications by Price Waterhouse, the reputed auditors of Satyam. If these so called savvy and professional watchdogs could not detect the fraud at Satyam, then how can we expect the due diligence done by investors to throw up the mischief?  I am not in a position to conclude conclusively whether the auditors were misled and were negligent in the conduct of their duties or they willfully colluded with the management at Satyam in perpetrating the fraudulent events. In any event, the impact of their role cannot be underestimated.

In both the scenarios, they failed their duties miserably. I would not be alone in calling for an exemplary punishment to be meted out to these auditors, a punishment which would raise the stake for others who may have been knowingly or unknowingly aiding or turning a blind eye to similar events at other firms.

SEBI had passed strictures against some prominent foreign banks some time back due to their role in activities considered undesirable. I am told that this action by SEBI had indeed led to a greater due diligence by their risk management and compliance departments and certainly has led to a salutatory effect on these and other foreign banks in respecting the laws of the land. Do not get me wrong. Deterrent punishment is not the panacea for all ills. However, it does serve its purpose in raising the stakes for players abusing the system. I must mention here that while SEC in the USA prosecuted more than 600 companies for wrongdoing in 2008, it still was unable to prevent Madoff from ripping off more than $50bn from investors.

Rotate the Watchdogs : fixed, finite and rotating tenure

Auditors and Independent directors are the first line of defense against abuse for ordinary investors. The best strategy would be to have one watchdog watch the other. I suggest a fixed tenure for auditors for a finite period of three years. At the end of his tenure the auditor will have to hand over his assignment to a new auditor. The new auditor will take a signoff from the previous auditor and it would be reasonably difficult for any auditor to assist in perpetuating wrongdoings if there is a more than reasonable chance of being discovered by the new incoming auditors. This could be a simple and effective deterrent against wrongdoing.

A similar system is already in place for the Indian banking sector where auditors are appointed in rotation for a fixed tenure of three years.

Make Independent directors truly independent with a finite tenure

A lot of hopes have been pinned on the role of Independent Directors on the Board of Directors in recent times. However, their impact has been hollowed by giving the managements the prerogative of choosing the Independent directors. This in itself is a contradiction with directors being called independent. More often than not, the Independent directors chosen by the management are chosen because of their proximity to the controlling management and are beholden to the management for choosing them to the Board of their companies. This raises serious conflicts of interest in impartial discharge of their duties. Many of the independent directors are not technically and professionally qualified to head the committees they chair in the companies.

I recommend that the Independent Directors be chosen from a pool of qualified professionals who are known for their expertise and integrity. Further, like the auditors they should be chosen for a fixed tenure of three years after which they should be replaced by other set of independent directors from the identified pool of independent directors.

A small note on identifying this pool of watchdogs (auditors and independent directors) would be appropriate at this juncture. SEBI is quite suitable for implementing this scheme.

·         There should be clear guidelines for eligibility for admission to the proposed pool of auditors and independent directors.

·         A thorough and open vetting process at the selection stage itself is critical for this initiative to succeed. Internet as a medium can be used effectively for this. The list of eligible candidates and their resumes and qualifications should be posted on the internet and public feedback invited. The feedback so received should be considered on due merit. My guess is that the rotten apples amongst the eligible candidates would be exposed by empowering the masses in this manner.

·         The watchdogs should be divided into various categories depending on their size and experience in the case of auditors and experience and qualifications in the case of independent directors. An appropriate match between experience, size and qualifications of these watchdogs and the size of the companies where they are to be appointed should be made.

·         The companies should be given a slate of eligible Independent Directors from the pool from which they can choose the directors.

·         A 360 degree feedback system could be used to monitor the performance of the watchdogs and keep the pool fresh with movement between the various categories depending on skill sets and feedback

·         A market driven compensation guideline for the watchdogs should be disclosed. The compensation should be reviewed every three years to keep it in line with market requirements.

 Subsidiaries over a certain size to have different auditors than the parent company

The business conducted in subsidiary companies is normally not scrutinized in the same details as the parent company and is open to abuse. Subsidiary companies which cross a certain size relative to the size of the parent company should not be audited by the same set of auditors auditing the parent company. This combined with a rotating tenure for auditors would ensure transparency and further minimize the possibility of conflicts of interest.

Institutional nominees on the Board

Pension Funds, Mutual Funds and FIIs today own a bigger chunk of equity than the promoters in many of our large companies. They owe it to their own shareholders and stake holders to work towards protecting their business interests and underlying investments. The same pool of independent directors which I spoke about earlier could be utilized to have them nominate their directors on the Boards of various companies.

To finish off, there is another significant player in the curious cast of characters who has been the first one to cry foul but this play of events could not have been as intriguing and melodramatic as it has been now without them. We would be erring if to the cast of Raju brothers, their ‘independent directors’, the infamous auditors, the bestowers of corporate governance awards, we forget to add the collective conscience of the ‘fund managers and brokers’ who, in my opinion, had a fair inking of not all being well at Satyam. Any broker or fund manager worth his salt would have heard not only of the huge real estate parcels said to be owned by the Rajus but also of their extremely close political connections. They would have known of the phoenix like rise of Maytas and the lucrative contracts housed in these ‘Satyam Group Companies’. They would have had an understanding of the nature of real estate transactions in India and the significant cash component which accompanies these transactions. Yet, they chose to turn a blind eye to the shenanigan, invested and traded in Satyam Computers, contributed to the enhancement of its market capitalization and ironically now profess shock at the lack of corporate governance at Satyam. While the financial community needs to introspect at its own doing and the propensity to turn a blind eye to the going ons in Corporate India, I believe that collectively, the financial community can be one of the most significant agents of change.  However, I worry that by the time change is implemented and percolates down the system, the same Satyam story might have been repeated in many companies in India and Satyam most certainly would not the last one to hit the can due to accounting fraud.