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K P Shashidharan: Towards eliminating corporate fraud An appropriate legal and regulatory framework ensuring a high degree of corporate governance,

as is being proposed, will create a strong foundation K P Shashidharan / New Delhi Jan 09, 2011, 00:18 IST No meaningful attempt to improve corporate governance in India can begin without learning lessons from the biggest corporate fraud in the country by Satyam, which drew attention to systemic flaws in Indias corporate governance framework and practices. The company won great accolades for being exceptionally well-governed, was listed on different global exchanges and was audited continuously by one of the best known international audit firms. However, the majority shareholder perpetuated fraudulent transactions and manipulated the entire activities of the company in his own selfish interests, bypassing all components of the then prevalent corporate governance framework. The Standing Committee on Finance wants to plug all loopholes in the legislation and proposed an elaborate control mechanism in The Companies Bill, 2009 in its 21st report submitted recently to Parliament. The changes proposed in the Bill include provisions for speedy incorporation with detailed disclosures at the time of incorporation, restrictions on companies in mobilising funds from the public, specifying legal sanction of accounting and auditing standards, and a modified legal framework for regulating insolvency, liquidation and winding up. Important changes have also been suggested in the corporate governance framework, such as incorporation of guidelines issued on the subject and the Listing Agreement prescribed by Sebi for listed companies, though the guidelines may be voluntary for unlisted companies. There are suggestions for separation of the offices of the chairman and chief executive officer, and the roles, responsibilities, qualifications and procedure for appointment of independent directors and their rights and liabilities are specified. The proposed change may explicitly provide for a mode of appointment of independent directors in which the management has no role, to enable independent directors to function objectively. The ministry of corporate affairs may possibly maintain a panel, from which companies can choose independent directors. The need for a procedure for the appointment of competent independent directors and for ensuring that they function objectively in the interest of stakeholders cannot be ignored. The amendments suggested in the Bill seek to enhance the mandate and role of the existing National Advisory Committee on Accounting Standards (NACAS), giving it additional regulatory powers to oversee, monitor and enforce

compliance with applicable auditing and accounting standards and quality of audits undertaken across the corporate sector. Objective and transparent procedures for empanelment of eligible auditors, allocation of audit assignments, and some oversight mechanism similar to public sector undertaking (PSU) audits by the Comptroller and Auditor General of India (CAG) may improve the quality of audits. Some of the other best practices followed by the CAG in PSU audits rotation of auditors, joint audits for major audits, and prohibition on taking jobs that come in the way of independence of audits are significant measures towards effecting good corporate governance. Explicit provisions are intended for ensuring protection of minority shareholders and small investors. They may enable shareholders associations and groups to take legal action in case of fraud by companies. The director of a company, if found defaulting on payment of interest to depositors, may be disqualified for future appointment. It is recommended that the source of the promoters contribution must be disclosed in the prospectus, there should be stricter rules governing acceptance of deposits from the public by bigger and solvent companies, and changes in the stake of the promoters or top 10 shareholders beyond certain limits must be disclosed to the Registrar of Companies. Separate disclosures are required to be made by companies in their annual report indicating company policy as well as specific steps taken. In order to safeguard investors from corporate delinquency, one-person companies, private companies, Limited Liability Partnerships and subsidiary companies may be prohibited from having further subsidiaries. The source of the promoters contribution is required to be disclosed, and the main objects of a public offer mentioned on the first page of the prospectus. The committee has emphasised that procedural defaults should be viewed in a different perspective from fraudulent practices. To promote shareholder democracy, it wants the system of proxy voting to be discontinued, and the quorum for company meetings fixed higher than the proposed five members. An appropriate legal and regulatory framework ensuring a high degree of corporate governance, as is being proposed, is expected to create a strong foundation for effective corporate governance. The experience so far has been that dominant shareholders manage to govern companies in their own interests. Adequate internal control mechanisms, strengthening of internal audits, enforcement of applicable regulations through creation of an effective overseeing authority, prescribing specific measurable performance indices for evaluating the quality of governance and effective monitoring and evaluation are, no doubt, vital steps towards improving corporate governance. Besides being an indispensable ingredient for good governance, corporate social responsibility and sustainable development concerns can also be

mentioned in the new legislation to safeguard the rights of shareholders and interests of other stakeholders, including the community at large. Shareholders respond positively to corporate philanthropic acts that go beyond the legal framework for community development

Halsburys Law Monthly Shardul Thacker Properly constituted audit committees and board risk committees play an important role in the sustained growth of a corporation and eliminate the risk of corporate crimes, explains Shardul Thacker Introduction Corporate crimes and frauds have been prevalent for as long as commercial enterprises have been in existence. These involve criminal activity on behalf of a business organisation, entailing deceptive techniques, to obtain an unfair advantage to which the perpetrator is not entitled. Corporate crimes and frauds are commonly committed by those outside an organisationthird parties, employees, or through the collusion of employees and third parties. Recent surveys have revealed that a majority of frauds are being perpetrated by the managements of large commercial houses. The estimate of losses borne from such frauds vary widely, and in most economies, the extent of such corporate frauds assume significant proportions. The generic and interrelated sources of corporate crime find their roots in increased profits and decreased costs, increased demand and decrease in competition, control of markets, workers and supplies. The predominant factors attributable to the current levels of major corporate crimes and frauds comprise of: the growing complexity of corporate organisations, escalating speed of modern commerce and computerisation, understaffing of internal audit functions, outdated and ineffective internal control mechanisms, increasingly transient employees and corporate global expansion combined with a lack of familiarity with local business practices.

In the Indian and international scenario, the entire legal framework to make corporations and multi-national companies accountable, is being systematically dismantled. The corporate sector now enjoys far more rights with laws being amended to empower corporations with the right to control and regulate their own governance. Prevalent corporate crimes Corporates represent a distinct and powerful force at the regional, national and global levels and they wield enormous economic powers. Corporate crimes result from a corporate business houses motive to profit at any cost. The major corporate crimes prevalent in the global economic scenario include within its ambit: financial crimes, insider trading, tax evasion, anti-trust, bribery, siphoning company funds, embezzlement, falsification of financial documents and data, public corruption etc. Corporate governance Lack of corporate governance is one of the primary factors contributing to corporate crimes. Corporate governance denotes the set of processes, customs, policies and laws governing the manner in which a corporation is directed, administered and controlled. One of the principle objects of corporate governance is to ensure accountability of individuals in an organisation. The legal, regulatory, and political environment within which a corporation operates, determines in large measure the quality of corporate governance. Corporate governance mechanisms are economic and legal and are often the outcome of political decisions. The huge corporate frauds in India, in recent times, have resulted from a flagrant disregard of and non-compliance with the Indian corporate governance regime. Properly constituted audit committees and board risk committees play an important role in the sustained growth of a corporation and eliminate the risk of corporate crimes. With the increase in the number of business transactions, combined with the lack of effective monitoring and adequate risk management strategies, corporate frauds are a real-time threat for most corporations globally. The various cumbersome procedural formalities governing corporates should be liberalised and simplified so as to ensure that corporate governance becomes an effective governing force.

White collar crimes

White collar crimes constitute serious legal and regulatory contraventions of the process of law. These crimes are committed by means of deliberate and planned conspiracies and were originally synonymous with crimes committed by the middle and upper strata of corporate personnel, in the normal course of their employment. The first major scandal of the 21st century was that of the Enron Corporation, which inflicted tremendous damage upon the company and created a crisis of investors confidence and has since become a popular symbol of willful corporate fraud and corruption. In the American context, annual losses from white collar crimes have been estimated to be as high as $ 200 billion. In India, white collar crimes are also on the increase. Such crimes have swindled investors in the booming India IPO (initial public offer) market, evidencing the lack of preparedness of the stock-market administration and the law enforcement agencies to regulate and control white collar crimes. In India, approximately 300 companies which made IPOs through the stock exchanges have vanished, resulting in millions of investors being left in possession of useless and unmarketable securities. The hundreds of spurious promoters who have misused the stock exchanges to fleece the public, have till date, not been held accountable by the Indian regulatory authorities. Forensic accounting Forensic accounting has assumed tremendous importance in recent times in the wake of rising corporate frauds and white collar crimes. Forensic Accounting is a hitherto untrodden field in India, and is the result of amalgamation of accounting, auditing and investigative expertise. The scope of Forensic Accounting envisages quantifying the impact of lost earnings owing to: stolen trade secrets, insurance disputes, malpractice claims, employee thefts, financial solvency reports, loss of goodwill, criminal investigation, professional negligence etc.

The opportunities for forensic accountants are rapidly developing, with forensic accountants being employed by banks, insurance companies, government agencies, public sector undertakings etc. The collapse of Enron Corporation, as also the World Trade Centers twin towers, has created enormous prospects for American forensic accountants. In India, establishment of the Serious Fraud Investigation Office is a landmark development for forensic accountants. Increasing cyber crimes, failure of

regulators to track security scams have necessitated forensic accounting. Serious Fraud Investigation Office (SFIO) The SFIO was set up in the backdrop of the recent stock market scams, failure of non-financial banking companies and the phenomena of vanishing companies. The SFIO is a multidisciplinary organisation comprising of experts from the financial sector, capital market, accountancy, forensic audit, taxation, law, information technology, corporate laws, customs and investigation. The prime responsibility of the SFIO is to investigate corporate frauds, referred to it by the governmental authorities and forward its investigation reports on violations of the provisions of Indian law to the concerned agencies, for prosecution and appropriate action. Regulating corporate crimes Common law jurisdictions have adopted the approach and recognised that corporations may be held criminally liable, where the corporation itself, through its policies and practices, has violated established legal principles. The law pertaining to corporate criminal liability is not confined to the general criminal law, but is scattered over a plethora of statutes. The incidence of various frauds and scandals of enormous proportions have disrupted both the international and domestic capital markets, which has resulted in market regulators being constrained to devise mechanisms and establish standards which act as a barrier to prevent the re-occurrence of corporate scams and frauds, in the form of corporate governance standards. Corporate criminality represents the instrumentalities through which the trust of investors is betrayed by persons in position of responsibility, authority and power in the business sector. In a measure to combat corporate crimes and frauds, organisations have codified guidelines on dealing with ethical and fraud related behaviours, such as codes of conduct, governance codes, response plans and anti-fraud policies.

Cadbury Committee In the United Kingdom, the Cadbury Committee was set up in 1991 to make recommendations on Corporate Governance which, inter alia, recommended that all listed companies should mandatorily appoint audit committees

comprising of non-executive directors with clear duties and authority. The guidelines laid down by the Cadbury Committee underscore shareholder accountability and transparency by recommending a non-executive board of directors in professionally managed companies and a non-family board in family run companies. Blue Ribbon Committee Similarly, the Blue Ribbon Committee set up in USA made recommendations on the effectiveness of Corporate Audit Committees, which should disclose its self-determined role, structure, and practices. Such transparency is at the heart of good governance, serves to inform investors, and also acts as a disciplinary measure. Confederation of Indian Industries: Code of Corporate Governance In India, as a part of Corporate Governance practices to be followed, the Code on Corporate Governance released by the Confederation of Indian Industries (CII) in 1997, recommended the establishment of Audit Committees by listed and public companies having a prescribed paid-up capital and turnover. The Audit Committees have been mandated to consider and evaluate all financial parameters and policies, internal controls, review of auditing, project implementation, reconstruction, merger and amalgamation and any financial irregularities. Audit Committees are also required to periodically consider internal control systems, the scope of audit including the observations of the auditors, review half-yearly and annual financial statements and also ensure compliance of internal control systems. J.J. Irani Committee Report The J.J. Irani Committee Report on Indian Company Law, proposed that in order to ensure compliance with corporate governance, the appointment of independent directors well versed in financial management, audit or accounts should be made by Indian companies.

Economic Intelligence Wing The Central Bureau of Investigation (CBI) traces its origin to the Special Police Establishment set up by the Government of India in 1941. In order to deal with increasing incidents of white collar crimes globally, the CBI has formed an Economic Intelligence Wing, to investigate and tackle the growing menace of economic crimes. This Wing has been tasked to gather intelligence and also share and act on information furnished by regulatory authorities.

Further, Indian companies listed on the US stock exchanges are obligated to adhere to and comply with the provisions of the US Foreign Corrupt Practices Act that requires them to accurately record their transactions and imposes several sanctions, fines and penalties for potential violations.

CONCLUSION Indian listing norms and public issue rules are required to be made as stringent as GAAP in the United States. Greater transparency needs to be forced upon corporates in terms of their overall management. The combination of a prolonged and expensive judicial trial coupled with Indian courts rarely awarding significant exemplary damages against errant corporate houses, has deterred compliance with corporate governance practices. Although, companies tout that they follow the Cadbury Committee recommendations on corporate governance, there is a need for global corporates to change for the better. The plethora of corporate crimes committed globally across a range of activities in various sectors indicates the necessity for increased control, monitoring and accountability of corporate activity in a global economy. 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 stateowned, 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 harmfulit clearly is by undermining investor confidence in the financial marketsbut 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 whistleblowing 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.