CORPORATE GOVERNANCE AND FRAUDS

AVTAR SINGH Associate Professor Head PG Deptt of Commerce G.T.B.National College Dakha.

Objectives
To trace the major developments taking in the Indian corporate scene How does Globalisation impact the student How can we as students integrate with Globalisation How are corporates managed and directed What are corporate frauds and how do they impact us

What do you understand by the word

CORPORATE ?

According to the Chambers Dictionary

legally united into a body so as to act as an individual: belonging or pertaining to a corporation

A legal entity, created under the authority of a statute, which permits a group of people, as shareholders, to apply to the government for an independent organization to be created, which then pursues set objectives, and is empowered with legal rights usually only reserved for individuals, such as to sue and be sued, own property, hire employees or loan and borrow money.

Implications of separate legal personality (Solomon Vs Solomon & Co Case)

Power to sue and be sued, To contract and be contracted with by its corporate name To have a common seal To alter or change it at pleasure, To have perpetual succession, To acquire and hold personal property for the purposes for which the corporation is established and to alienate that property at pleasure

Four core characteristics of the business corporation

Legal Personality
Limited Liability Transferable shares

Centralized management under a board structure

Corporate Governance
Sir Adrian Cadbury
Corporate Governance is holding the balance between economic and social goals and between individual and community goals. The aim is to align as nearly as possible the interests of individuals, corporations and society.

The OECD Principles of Corporate Governance states: "Corporate governance involves a set of relationships between a companys management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined."

Corporate governance consists of two elements:

THE LONG TERM RELATIONSHIP WHICH HAS TO DEAL WITH CHECKS AND BALANCES, INCENTIVES FOR MANAGER AND COMMUNICATIONS BETWEEN MANAGEMENT AND INVESTORS THE TRANSACTIONAL RELATIONSHIP WHICH INVOLVES DEALING WITH DISCLOSURE AND AUTHORITY.

The Agency Problem and Corporate Governance (considered the basis of CG).

This implies an adversarial relationship between management and investors, and an attitude of mutual suspicion. This was the basis for much of the rationale of the Cadbury Report, and is one of the reasons why it prescribed in some detail the way in which the board should conduct itself: consistency and transparency towards shareholders are its watchwords.

AGENCY PROBLEM DEFINITION

A situation in which agents of an organization (e.g. The management) use their authority for their own benefit rather than that of the principals (e.g. The shareholders). The agency problem also refers to simple disagreement between agents and principals.

Milestones in CG

1992 Sir Adrian Cadbury Committee on Financial Aspects of CG 1994 Mervyn .E. Kings Committee on Corporate Governance 1995 Greenbury Committee on Directors Remuneration 1996 CalPERS Global CG Principles 1997 Business Round Table statement on CG 1998 Hampel Committee on CG 1999 OECD Principles of CG 2002 Sarbanes Oxley Act in USA

Five Elements of Corporate Governance.

LONG TERM STRATEGIC GOALS

EMPLOYEES: PAST, PRESENT AND FUTURE ENVIRONMENT/COMMUNITY CUSTOMERS/SUPPLIERS COMPLIANCE (LEGAL/REGULATORY)

Government
taxation, vat ,legislation low unemployment, truthful reporting

Employees
rates of pay, job security, compensation, respect, truthful communication

Creditors
new contracts liquidity

Trade Unions
quality, staff protection, jobs

Stakeholders

Customers
value, quality, customer care, ethical products

Community

jobs, involvement, environmental protection, shares, truthful communication

Suppliers

providers of products and services used in the end product for the customer, equitable business opportunities

Corporate Governance includes care for stakeholders

Government : taxation, vat ,legislation low unemployment, truthful reporting Employees : rates of pay, job security, compensation, respect, truthful communication Customers : value, quality, customer care, ethical products Suppliers : providers of products and services used in the end product for the customer, equitable business opportunities Creditors : credit score, new contracts, liquidity Community : jobs, involvement, environmental protection, shares, truthful communication Trade unions: quality, staff protection, jobs

The OECD Principles of Corporate Governance

I. Ensuring the Basis for an Effective Corporate Governance Framework II.The Rights of Shareholders and Key Ownership Functions III.The Equitable Treatment of Shareholders IV.The Role of Stakeholders in Corporate Governance V. Disclosure and Transparency VI. The Responsibilities of the Board

I. Ensuring the Basis for an Effective Corporate Governance Framework

The corporate governance framework should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.

II. The Rights of Shareholders and Key Ownership Functions

A. Basic shareholder rights : Registration, transfer, vote B. Shareholders should have the right to participate in, and to be sufficiently informed on, decisions concerning fundamental corporate changes C. Shareholders should have the opportunity to participate effectively and vote in general shareholder meetings and should be informed of the rules D. Capital structures and arrangements that enable certain shareholders to obtain a degree of control disproportionate to their equity ownership should be disclosed. E. Markets for corporate control should be allowed to function in an efficient and transparent manner. F. The exercise of ownership rights by all shareholders, including institutional investors, should be facilitated. G. Shareholders, including institutional shareholders, should be allowed to consult with each other on issues concerning their basic shareholder rights as defined in the Principles, subject to exceptions to prevent abuse.

III. The Equitable Treatment of Shareholders

The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. A. All shareholders of the same series of a class should be treated equally. B. Insider trading and abusive self-dealing should be prohibited. C. Members of the board and key executives should be required to disclose to the board whether they, directly, indirectly or on behalf of third parties, have a material interest in any transaction or matter directly affecting the corporation.

IV. The Role of Stakeholders in Corporate Governance

The corporate governance framework should recognize the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.
A. The rights of stakeholders that are established by law or through mutual agreements are to be respected. B. Where stakeholder interests are protected by law, stakeholders should have the opportunity to obtain effective redress for violation of their rights. C. Performance-enhancing mechanisms for employee participation should be permitted to develop. D. Where stakeholders participate in the corporate governance process, they should have access to relevant, sufficient and reliable information on a timely and regular basis. E. Stakeholders, including individual employees and their representative bodies, should be able to freely communicate their concerns about illegal or unethical practices to the board and their rights should not be compromised for doing this. F. The corporate governance framework should be complemented by an effective, efficient insolvency framework and by effective enforcement of creditor rights.

V. Disclosure and Transparency

The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company. A. Disclosure should include: 1. 2. 3. 4. 5. 6. 7. 8. The financial and operating results of the company. Company objectives. Majority rights Remuneration policy for managerial personnel. Related party transactions. Foreseeable risk factors. Issues regarding employees and other stakeholders. Governance structures and policies, in particular, the content of any corporate governance code or policy and the process by which it is implemented.

Disclosure and transparency contd

B. Information should be prepared and disclosed in accordance with high quality standards of accounting and financial and non-financial disclosure. C. An annual audit should be conducted by an independent, competent and qualified, auditor in order to provide an external and objective assurance to the board and shareholders that the financial statements fairly represent the financial position and performance of the company in all material respects. D. External auditors should be accountable to the shareholders and owe a duty to the company to exercise due professional care in the conduct of the audit. E. Channels for disseminating information should provide for equal, timely and cost-efficient access to relevant information by users. F. The corporate governance framework should be complemented by an effective approach that addresses and promotes the provision of analysis or advice by analysts, brokers, rating agencies and others, that is relevant to decisions by investors, free from material conflicts of interest that might compromise the integrity of their analysis or advice

Strengths of Corporate Governance

Transparency Accountability Fairness Responsibility Disclosure Openness

India and the CG response

Industry Initiative
The Confederation of Indian Industry (CII) produced in 1998 a document titled Corporate

. Stressed on the need for transparency in reporting and the imperatives of having independent nonexecutive directors who could protect the interests of shareholders were clearly articulated. The code is self-regulatory in nature and contained 17 recommendations.
Governance - A Desirable Code through a task Force headed by Shri Rahul Bajaj

Department of Company Affairs

Companies (Amendment) Act, 1999

Nomination facility for shareholders and deposit-holders Buy-back of securities Relaxation in norms relating to inter-corporate loans and investments Setting up of Investor Education and Protection Fund Allowing sweat equity Compliance of accounting standards in preparation of annual accounts

Companies (Amendment) Act, 2000 Postal Ballot Audit Committee

Directors Responsibility Statement, Debenture Trustees Secretarial Compliance Certificate Reduction of Time for Payment Dividend (including interim dividend) Ten fold increase of fines and Option for Election of a Director by small Shareholders etc.

National Company Law Tribunal and an Appellate Tribunal 2003 Serious Frauds Investigation Office set up.

Initiatives of the Reserve Bank of India (RBI)

Reserve Bank of India has appointed a Committee to report on governance requirements specific to banks and financial institutions

Initiatives of the Securities and Exchange Board of India (SEBI)

KUMARAMANGALAM BIRLA REPORT 2000 implemented. SEBI constituted a committee under the chairmanship of Shri Kumar Mangalam Birla. Its report recommending guidelines on corporate governance published in February 2000 is a well balanced compendium of good practices that will stand corporates in good stead in their governance-improvement endeavours. The Securities Law was amended, bringing in some important changes: all stock exchanges are to be corporatised and demutualised. SEBI announced the establishment of a Central Listing Authority, whose permission is mandatory for companies seeking listing on any recognized stock exchange in India. Narayana Murthy Committee on Corporate Governance submitted its report to SEBI. The recommendations were accepted in Toto and as a result of this the clause 49 of listing agreement was amended in August 2003.

Frauds and Corporate Governance

Fraud, an intentional deception made for personal gains or to damage another individual, is a significant factor worldwide in todays competitive world, and in entities irrespective of their size. Fraud is a major source of risk which can have disastrous effects on the finances of a company. It can cause irreversible and often irreparable damage to the image and reputation of a company

Impact of corporate Frauds

Lack of Investor confidence. Failure of Corporate Governance mechanism Decline in stock prices and shareholders wealth Loss of talented manpower Loss of clients Criminal penalties to managerial personnel Question mark on financial reporting Question mark on independent directors

Top 10 corporate frauds

. Worldcom (America): The United States second largest long distance phone company admitted that its profits had been inflated by $3.8bn (2.5bn) between January 2001 and March 2002, to keep them in line with Wall Street expectations. Later, it was investigated that chief financial officer Scott Sullivan improperly booked expenses as investment in order to make the company look much healthier than it actually was.

Enron (America):

One of the largest securities fraud in history of 21st century, and the investigation into the extent of the fraud committed by Enron is still ongoing. As a result, Enron was forced to file for bankruptcy in December 2001. The problem for Enron was that those who had invested had been promised and expected to get more money from selling gas and electricity and this was not happening. Like the majority of other companies in this position it sought to hide the truth from the public and borrow more money to fill the hole. Enrons stock price, which hit a high of US$90 per share in mid-2000, caused shareholders to lose nearly $11 billion when it plummeted to less than $1 by the end of November 2001.

. Bank of Credit and Commerce International (United Kingdom):

It was reported that BCCI had a 5.6bn deficit at the time of closure. It was the largest financial fraud in the world to that date. The Abu Dhabi government tried to rescue the bank with a 1.8bn cash injection proposal. It later emerged that BCCI had stolen 1bn from the personal account of Sheikh Zayed of Abu Dhabi.

Subprime Mortgage (America): This organized corporate fraud has gone through stages. First, during late 2007, over 100 mortgage lending companies went bankrupt as subprime mortgage-backed securities could no longer be sold to investors to acquire funds. Second, starting in Q4 2007 and in each quarter since then, financial institutions have recognized massive losses as they adjust the value of their mortgage backed securities to a fraction of their purchased prices. These losses as the housing market continued to deteriorate meant that the banks have a weaker capital base from which to lend. Third, during Q1 2008, investment bank Bear Stearns was hastily merged with bank JP Morgan with $30 billion in government guarantees, after it was unable to continue borrowing to finance its operations.

American International Group (America): the largest aircraft leasing company AIG acknowledged that it had improperly accounted for the reinsurance transaction to bolster reserves, and detailed numerous other examples of problematic accounting. It also announced the delay of its annual 10-K filing, and said the moves may have inflated its net worth by up to $1.7 billion.

Bernie Madoff (America): The former chairman of Nasdaq Stock Market and well known as the founder of Bernard L. Madoff Investment Securities, Bernie Madoff was alleged for $50 billion fraud. Within hours, investors who had trusted the 70-yearold Madoff for years including the owner of the New York Mets were reeling at charges that one of the most trusted names on Wall Street was a full-time fraud. The last decade has seen an amazing number of corporate frauds, which have had a spiraling effect on the incomes and savings of common people. Most of these led to losses totaling billions of dollars, and have led to a clamor for more stringent rules against corporate and accounting practices.

Barlow Clowes (United Kingdom): The Barlow Clowes affair in the late 1980s cost the government 150m in compensation to thousands of mainly elderly investors, many of whom lost their life savings when Barlow Clowes was closed down by the Department of Trade and Industry in 1988. Peter Clowes and others were jailed in 1992 for their part in the affair, which remains one of the worst scandals to hit Britains savings industry.

Fannie Mae and Freddie Mac (America): IN A MAJOR INVESTIGATION OF FBI, FANNIE MAE AND FREDDIE MAC WERE CHARGED FOR FRAUD IN CONNECTION WITH THE SEPTEMBER 2008 ECONOMIC CRISIS ON WALL STREET. MILLIONS OF INVESTORS HAVE SEEN THEIR PORTFOLIOS AND RETIREMENT ACCOUNTS DEVASTATED BY THE COLLAPSE OF FANNIE MAE AND FREDDIE MAC, WHICH SHOULD HAVE BEEN PREVENTED. IN 2006, FANNIE MAE WAS FINED $400 MILLION FOR USING ACCOUNTING PROCEDURES THAT GAVE A MORE OPTIMISTIC PICTURE OF THE FINANCIAL HEALTH OF THE MORTGAGE GIANT THAN WAS ACTUALLY THE CASE

Daewoo Group (South Korea): Daewoo, the second largest conglomerate in South Korea with interests in about 100 countries, went bankrupt, with debts of about 80 billion won ($84.3 million). In 2005, chairman of Daewoo Group, Kim Woo Choong was charged with masterminding accounting fraud worth 41 trillion won ($43.4 billion), illegally borrowing 9.8 trillion won ($10.3 billion) and smuggling $3.2 billion out of the country.

Satyam Computers (India): The fourth largest IT company of India with 53,000 employees was charged in manipulating the balance sheet by illegal means. Satyams operating margin wasnt the 24% as shown in its accounts audited by Price water house Coopers, but just 3%. And Satyam had nothing close to the reported Rs. 5,360 crore ($1.1 billion) cash pile on its balance sheet. The real amount was just a measly $78 million. On January 9, 2009, chairman Ramalinga Raju surrendered to the police and confessed for the Rs. 7,100 crore fraud case.

Important findings KPMGs Indias Fraud Survey 2010

There is a rise in the incidence of fraud in India ineffective control systems and diminishing ethical values are key contributors to this trend An overwhelming majority of the respondents indicated that the incidence of fraud, overall and specifically within their industry and company, is rising thereby indicating that India Inc needs to deal with fraud risks firmly. Supply chain fraud (procurement, distribution and revenue leakage) is the single most exposed area. Weak internal control systems, eroding ethical values and a reluctance on the part of the line managers to take decisive action against the perpetrators are cited as the most vital underlying reasons for frauds being on the rise.

Stakeholders view financial statement frauds as one of the major concerns in India

Stakeholders in India continue to perceive financial statement fraud as a major area of concern. A desire to achieve / exceed targets and earnings of senior executives linked to financial performance are the reasons for senior management involvement in such frauds. Ineffective whistle-blowing systems, lack of objective and independent internal audit functions with forensic skills, inadequate oversight of senior management activities by the audit committee and weak regulatory environment are the reasons for growing worries in respect of financial statement fraud.

Fraud risk management is not prevalent in India Inc.

Indian companies have a reactive approach to dealing with fraud. Even amongst those that do undertake a fraud risk assessment, the focus is more on financial frauds rather than a holistic assessment. The usage of data analysis tools to analyse critical patterns and trends in data and understanding scenarios of potential fraud which should be inter-woven into the fraud risk assessment process is still work in progress. Respondents suggest that a fraud risk management program should be a shared responsibility across the company board, senior management, internal audit and risk functions.

The enemy within continues to pose the biggest threat

Committing frauds is not confined to a select few, both junior and senior employees are perpetrators of frauds. The quantum of fraud in value terms is also increasing. The encouraging sign is that fraud detection mechanisms have improved with a majority of the frauds being detected through internal audits and whistleblower mechanisms rather than by accident (as indicated in our 2008 Fraud Survey). However, the incidence of legal action against fraudsters islow with a majority of the frauds being investigated and dealt with internally.

Bribery and corruption continue to remain a challenge in conducting business

Bribery and corruption is viewed as an inevitable aspect of doing business in India. Bribery and corruption are most rampant in seeking routine regulatory approvals and to win new business from prospective clients. Despite the presence of anti-corruption laws, weak regulatory enforcement has contributed to the current impasse. With Indian companies going global, we see an increasing trend of Indian companies pro-actively taking measures to adhere to international anti-bribery laws/ regulations (e.g.: Foreign Corrupt Practices Act) and strengthening their code of business ethics at the board and senior management levels to regulate dealings with external stakeholders.

Intellectual Property, computer-related fraud, bribery and corruption and supply chain fraud are going to be the risk areas in coming years

Whilst supply chain and bribery and corruption will continue to dominate the fraud horizon,Intellectual Property and e-crime are emerging as the new dimensions and organisations in India seem ill equipped to fight these threats. Strong enforcement of Intellectual Property and anti piracy laws, the right to audit within third party contractual arrangements, vendor compliance / performance reviews and technology preparedness through document management and retrieval systems are important focus areas if organisations have to successfully counter these new types of fraud threats.

Conclusion
Corporate Governance is more of an ethical issue rather than a regulatory one Corporate Governance is more about self regulation rather than legal regulation Even companies with a very good governance record can fall prey to corporate frauds eg Satyam Role of independent directors Role of audit committees