labels: IT news, Management - general, Shivshankar Verma
Can we prevent another Satyam? news
19 January 2009

The preventive measures now considered by the government and SEBI are not enough to prevent another Satyam. The ICAI should regularly review and rate all auditors. Listed companies should have full-time independent directors, who should not be given other professional assignments or granted stock options and commissions and be accountable to the regulators. By Shivshanker Verma

It is nearly a month since Satyam delivered its first shock, the aborted deal to acquire the two Maytas companies. But, there are no clear initiatives from the government or the market regulator to improve corporate governance standards and prevent frauds.

Of course, the magnitude of the fraud revealed subsequently is unprecedented and investigations are still going on. Even so, when the shortcomings of the current system are quite evident, do they need to wait longer to plug the loopholes?

Most of the measures suggested so far and said to be under the consideration of the government and SEBI, involve tightening the regulatory and supervisory structure from the top. But, as repeatedly proven, stricter regulatory frameworks do not prevent frauds. Instead, they add to the bureaucratic controls and stifle genuine business activity.

What are required are sincere and effective measures to improve governance, auditing and financial reporting standards at the ground level.

Peer review and rating of auditors

This is not a new idea, but unfortunately it has not gained acceptance. Auditors are professionals, regulated by an independent professional body like the Institute of Chartered Accountants of India (ICAI).

Anyone who has cleared the qualifying exam and obtained a 'certificate of practice' can audit and certify the financial statements of any business, from small proprietorships to large multinational companies.

Once they gain entry into the club, the membership is valid for life, irrespective of the professional capabilities and the quality of service provided. True, the ICAI has some continuing education programmes for its members to keep them updated about the latest trends and developments in the profession.

However, there is no mechanism in place to monitor the quality of services provided by ICAI members on a continuing basis. Unless a member is accused of grave professional misconduct or negligence, the ICAI never evaluates a member's professional capabilities or service delivery.

It may be worthwhile for the ICAI to institute a continuous review process for all its members. This is not as difficult as it sounds, despite the large membership base. The ICAI has an established institutional structure of regional councils and local chapters, spread across the country, which can conduct such reviews at their level.

Audit firms can be rated by the ICAI according to their size, professional capabilities and past record. Like credit ratings given to companies, such ratings should become an easily understood reference for clients while appointing auditors. To begin with, the rating assigned to an audit firm can be valid for longer periods. But, ideally, the ratings should be reviewed on an annual basis.

Currently, a listed company can appoint even the smallest firm as its auditors. This is the case everywhere, including the developed economies. Bernard Madoff, who admitted to running a Ponzi scheme that is said to have cost his clients a staggering $50 billion in losses, was employing the services of an audit firm with just three employees!

It should be made mandatory for all listed companies to appoint auditors who satisfy some minimum requirements. This can be possible only if the ICAI can institute a rating system for its members. Further, companies which have their stocks as constituents of major indices like the Sensex and the Nifty should be asked to appoint only top-rated auditors. 

The ICAI should also strengthen its supervisory systems and speed up disciplinary proceedings. It is completely unacceptable that, even after four years, the institute is yet to conclude its proceedings against PricewaterhouseCoopers for the audit firm's role in the downfall ofthe Hyderabad-based Global Trust Bank. No wonder the same audit firm is again under the cloud for the Satyam fiasco.

Make additional monetary benefits to independent directors illegal

Independent, non-executive directors are supposed to function as the eyes and ears of minority shareholders. Their primary role is to ensure that the executive management is performing its fiduciary duties in the best interests of the company and its shareholders. When that is the case, independent shareholders should have no professional or businesses relationship or dealings with the company or its promoters. In this country, as in most other countries, that is almost never the case.

Take the case of Satyam. Krishna Palepu, the Harvard Business School professor who was an independent director on Satyam's board, had a very lucrative consultancy contract with the company. Over the last few years, the company paid him more than Rs3 crore for consultancy services.

When the executive management has complete discretion in finalising contracts for such professional services, it is very difficult for an independent director who is also a consultant to perform his duties as a director. The conflict of interest is too evident for such a director to be perceived as independent, even if that is indeed the case.

Another common practice which can cause conflict of interest is the grant of stock options to independent directors. Most Indian companies, including the likes of Infosys, award lucrative stock options to independent directors and pay commissions directly linked to profits. This monetary benefit is over and above the fixed annual remuneration and sitting fee paid to the directors.

When independent directors are in no way responsible for the financial performance of the company, why compensate them on the basis of business results? Such grants can easily be misused by promoters and managements to curry favour with independent directors or buy their silence. This practice should be stopped at the earliest.
Appoint full-time independent directors

Independent directors hardly spend more than 10 or 15 days a year to fulfil their responsibilities to the companies they serve. They get very little information about crucial matters beforehand, so that they can study, reflect or consult others before the board meeting. Very often, independent directors are presented with a fait accompli and are merely expected to pencil in their approval. The audit committees of companies, which are often constituted with majority independent directors, meet only for a few days every year. When they meet, much of the committee's time is taken up by routine matters like appointment of auditors.

The shortcomings of this system were very evident in the case of Satyam. When the company held its board meeting to decide on the Maytas takeover, there is no indication that the independent directors were informed in advance. The Raju brothers presented the deal to the board meeting, which two of the independent directors attended through video conference.

The independent directors are said to have deliberated on the deal for a couple of hours, in the absence of executive directors who were interested parties because of their financial stakes in Maytas. Then, without deliberating further or consulting anyone, the board stamped its approval on the $1.3 billion deal at the middle of the night.

What followed was even more absurd. After the Satyam stock tanked the next day, the promoters decided to call-off the deal. Some of the independent directors were 'told' about the decision over phone. The promoters didn't even bother to discuss the new decision to Professor M Rammohan Rao, the former ISB dean who chaired the previous day's board meeting that had approved the Maytas deal, even though he resides in Hyderabad where Satyam is based.

Instead, he was sent an email informing him about the new decision.

Independent directors of Satyam do deserve a fair share of the blame. But, unless the whole concept of independent directorships is changed, things will not improve.

The best possible option may be to have full-time independent directors. They will have no role in the day to day affairs of the company, but will act as watchdogs to protect the shareholders' interests. They should not report to the board of directors, which are often controlled by promoters, but directly to shareholders at general meetings.

They should be paid a fixed annual compensation for their services, but no variable pay or stock options should be granted. They should conduct their own evaluations and analyses and present a formal report on the company's affairs to the shareholders. Independent directors should have their own staff to support them and should be held responsible for their report to shareholders. They should be also required to report directly to the market regulator or the ministry of company affairs about any irregularities or misconduct.

Independent directors should have had considerable management, administrative or academic experience before they become eligible for appointment. The government or the market regulator should take the initiative to establish a professional body for independent directors, on the lines of the ICAI or the Institute of Company Secretaries. Eventually, a qualifying examination and certification process should be in place for all independent directors.

Can these steps prevent another Satyam? No. There is no way to completely eliminate corporate frauds and scandals. Someone, somewhere will find a way to trip even the most sophisticated systems set up to prevent frauds. But, such measures will make it difficult for the fraudsters and go a long way in improving the corporate governance standards and reliability of financial statements.

Not having such systems in place will only encourage more Rajus.

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Can we prevent another Satyam?