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This article is written by Raslin Saluja, from KIIT School of Law, Bhubaneswar. This is an exhaustive article on the role of auditors and independent directors in causing and preventing market manipulation.

Introduction

A lot happens under the guise of corporate governance which only becomes a reality and comes to the forefront when the failure becomes too big to hide. Governance failures are often a combined result of various entities involved and mostly happen with the consent or act of negligence of the Board. For this purpose, there are various intermediaries in companies who are also called gatekeepers such as auditors, rating agencies, independent directors, etc. They are present to have checks and balances on the corporate power to prevent any favors to company managements and not completely rely on company disclosures only.

However, the corporate governance assessment is not easy. Despite the country having regular compliance in the letter with the law, the recent cases of failure have made us question the effectiveness of the models applied and the functioning of the gatekeepers in terms of the role of the boards, audit committee, the independent directors, etc. These concerns also focus on the failure of these gatekeepers to fulfill their responsibilities, since they solely rely on the disclosures made by the company, they fail to identify any conflict of interest between the stakeholders and the management of the company in pursuance of the transactions taking place. It also highlights the fact that having a board composed of qualified and experienced directors/ audit committees may not always be a sufficient deterrence to bad governance when they are a part of such manipulation.

Need for strong corporate governance

Investments both, domestic or foreign has an immense role to play in the growth of the economy. However, continuous financial frauds give a bad image to the company as well as the country. In the light of such events, corporate governance has gained prominence. Infamous frauds such as Enron, WorldCom, Satyam, IL&FS, etc. highlight the importance of strong corporate governance. All the business begins on trust and the information disclosed, however often organizations resort to window dressing or manipulation of the data of the company which does not indicate the true position of the company. Hence, a body like an independent audit committee is often relied upon to keep in check such unscrupulous activities. The presence of independent auditors goes a long way in ensuring investor trust.

However, these frauds suggest that building a corporate governance index in India has not proved to be reliable because of its dependence on qualitative disclosures by the company itself or by relying on factors that are not worth reliable. 

In India, according to the PwC India Family Business Survey 2019, over 73% of businesses are family-owned and nearly all are run by families and in 2020, NIFTY 50 has 31 family-owned companies. Hence, the ownership concentration and agency problem, the low gap between management and owners in India is one of the constructs around which measures of governance need to be woven. A high concentration of ownership and its consequent reflection in management creates discretion in the hands of owners which determines the quality, manner, and quantification of financial and operating results. On the other hand, such powers do create opportunities for diversion of financial resources of the company for personal use or keeping severe liabilities off the books.

Role of the audit team in corporate governance

The audit team has a very prominent position in the working of a governance mechanism to ensure that a company produces relevant information and disclosures along with credible authentic data that can be used to assess the company’s performance. They help in presenting the true financial picture of the company and are also a part of the board of directors who are responsible for formulating strategies towards effective performance yielding of the company. They help in maintaining transparency about the company and contribute to improving the financial health of the company. 

They are viewed as a significant element because they are entrusted with powers to carry out monitoring processes and keep in check the faulty conduct. Companies Act, 2013 has made rules regarding the presence of an independent audit committee more stringent to curb financial fraud. It is believed that having an independent team may ensure the reliability of the financial reporting process keeping a check on manipulative, self-centered activities of other members of the company. The team with their regular meetings would reduce information asymmetry and prevent agency problems by providing timely and fair information to the investors. They can keep a check on financial frauds, misappropriation of funds, and losses to the company.

Role of independent directors in corporate governance

As for the independent directors, they improve corporate credibility and governance standards. They function as a watchdog and play a major role in risk management. The fact that they are independent of the company’s management and act as trustees for the shareholders implies their obligation to be fully aware of the company’s conduct at all times. The guidelines, roles and functions and duties and, etc. are broadly set out in Schedule IV of the Companies Act, 2013. They play various roles towards the shareholders and stakeholders providing transparency, taking beneficial decisions in their interest, upholding their rights and ensuring their welfare, reviewing related party transactions, and ensuring the efficiency of whistleblowers.

The appointment is mandatory in the nomination, remuneration, investor relations committee, and audit committee for ensuring corporate governance compliance. They have fiduciary duties, duty to act diligently and in good faith, and address all the concerns relevant to the company. Independent directors play two major roles one is monitors of controlling shareholders that work on behalf of minority shareholders; second as the brain trust, consultant, or strategic advisor to the controlling shareholder. Under the monitoring role, independent directors are supposed to help and address corporate governance concerns of controlled entities.

Frauds and market manipulation

Earlier there have been a few cases in India such as that of Satyam, Sahara, Saradha, etc. as well as abroad such as Enron Corporation, Global Crossing, WorldCom, Adelphia, Tyco, etc where frauds were committed and investors cheated. At the time, they were such that they were not identified from financial statements. Emphasizing the need for an independent audit committee, asserted that one of the factors contributing to the Satyam fraud was weak independent directors and the audit committee. Had the audit committee comprised a greater number of independent directors, the financial accounts might not have been manipulated for so long.

Auditing in India is especially required as there are many family-run businesses as mentioned earlier, which need to reflect public interest and trust. To go through a few examples, 

The Satyam scandal

Satyam Computer Services (2018) caused a great deal of market uproar after its chairman confessed to manipulating the company’s accounts. It was stated that the board of directors and the auditors allegedly knew nothing about the scam, however, it seemed more as if the audit firm had intentionally chosen to not abide by the accounting standards and failed to fulfill its duties as per the acceptable standards. Later in 2018, the Central Bureau Investigation (CBI) upon investigation found the audit firm guilty of conspiracy as they were paid more than any firm at that time and portrayed discrepancies in the treatment of Satyam as they did not conduct any independent investigation and just relied on the document provided by the accused. Among various other corporate governance issues, there was simple manipulation of revenues and earnings, and operating profits were artificially boosted from the actual Rs. 61 crore to Rs. 649 crore. Its financial statements for years were false and cooked up.

Tri-sure India Ltd. v. A.F. Ferguson (1985)

In this case, the court determined the duties of the auditor towards the company and its shareholders. Herein the company which was initially financially healthy showed a steep increase in its profits which led to oversubscription of shares in public issues. Later when the company was exposed, it blamed the auditors for not fulfilling their duties and having missed the discrepancies in the profit margins. Dealing with the issues, the court clarified the duties and responsibilities of the auditors and the extent of their involvement in preventing such fraud, however, it in no way takes away the responsibility from the part of management to ensure the proper mechanism is being followed in the preparation of the statements.

Punjab National Bank Housing Finance

One of the very recent cases, where the Securities and Exchange Board of India (SEBI), sent a letter to PNB Housing Finance Company on its proposed deal with an American investor. SEBI has questioned the housing finance company why all its shareholders were not given equal opportunities and why the common shareholders have been ignored. Further, it raised issues relating to corporate governance based on the records and stated that the company has not complied with the process of making principal governing disclosures and obligations of a listed entity. The board of directors has further been called upon to explain this transgression of the law. 

Yes Bank

Once soaring high with the flavor for foreign institutional investors, YES Bank was on a lending spree with the highest proportion of loans to stressed companies. There were huge divergences in the non-performing asset levels which led to the Asset Quality Review (AQR) program. In the year 2016-17, the bank reported gross Non Performing Assets (NPA) as Rs. 2019 crores, whereas according to RBI’s assessment it was Rs. 8373 crores. The bank made every attempt to downplay the situation and even falsely highlighted that most of their accounts have been paid back, some paid to asset reconstruction companies, etc. Thus the auditors failed to fulfill their responsibilities by helping the management and agreeing to their proposals.

Infrastructure Leasing & Financial Services Limited (IL&FS)

Even during their deteriorating phase from 2011 to 2019, five rating agencies gave them a total of 429 ratings which was not known to the market as well as the regulators until 2018 Later when a forensic audit was done at the behest of the new board, it was found that the management had manipulated some of these agencies to give a good rating. These agencies also often accept the data as given by the company without taking any insights from people outside the management such as auditors, bankers, etc. Even the company’s auditors too failed in their responsibilities. The auditors for the company have been highly criticized. The National Financial Reporting Authority (NFRA) recently even declared the appointment of Deloitte as the statutory auditor of IL&FS Financial Services as an illegal act due to conflict of interest and besides Deloitte also was not eligible under various sections of the Companies Act, 2013. There was professional misconduct compromising the independence of mind and appearance of statutory audit. There was intentional recklessness, a lapse in discharging the duties, and collusive behavior to the fraudulent presentation of financial statements.

Independent directors who majorly rely on the data given by the company, often prefer to leave when things go downhill as their position is not protected. There have been instances when the independent directors chose to opt out when things did not work very smoothly in the companies. Like Vikram Mehta who suddenly resigned from Jet Airways wherein he was the independent director and a member of the audit committee, giving the reason of time constraint however continued to be on the boards of several other companies.

Similarly, Analjit Singh now the Chairperson of Max Healthcare and Max Bupa Insurance company had resigned as a non-executive independent director from the board of Tata Global Beverages when the dispute arose between Ratan Tata, an Indian industrialist, and a philanthropist who was the Chairperson of Tata Sons and other major Tata companies, and Cyrus Mistry who served as the chairman of the Tata group. Even in the loan scam of Punjab National Bank, Gitanjali Gems reported that their second independent director, Anil Umesh Haldipur resigned citing personal reasons after the alleged fraud came into the media.

The way forward

Even after these scams, there has not been an effective change in the governance, rather more and more regulations have been added. We need to implement some harsh measures in order  bring any change such as:

  • Punishing individuals instead of companies for noncompliances of frauds. To have a database of the companies for promoters, directors, and key managerial persons, people who are reasonable for maintaining governance, their relatives and interlink them to have enhanced surveillance software-driven systems.
  • Widely publishing information on frauds, holding liable individual persons, imposing huge penalties on personal capacities, or even imprisonment. To have a deterrent effect and retribution severe punishments need to be imposed.
  • Most scams are money-related and always professionals are involved. In that case, the responsibilities and duties of the Chief Financial Officer (CFO) need to be enhanced.
  • The focus should be increased on auditors as people should be able to place their trust in them. They cannot be accomplices. To ensure a fair game, auditors must be selected randomly from the database maintained by the ICAI and they should be provided greater independence which can be done by paying their audit fees out of the investor protection funds of MCA, SEBI, and other such bodies.
  • The audit firms of the companies should be registered with SEBI. NFRA should also get super involved in creating a strong body of auditors who are diligent and honest in their work. Auditors who leave before their terms are treated as a red alert situation which must also be subjected to extensive interview sessions along with the companies.
  • Having internal auditors must be mandated for at least big size companies with enhanced roles and responsibilities working in collaboration with statutory auditors
  • Having law firms involved compulsorily with the listed companies to carry out risk analysis, check all compliances, opine over legal cases. These analyses must be made public.
  • Improvement of the quality of information disclosures and their usability help the regulators and the investors determine for themselves the status of the company.

Conclusion

Due to increasing financial crises all over the world, the need for strong corporate governance has become a basic requirement for regulators as well as investors. It’s a bitter truth that the audit team and independent directors are hired for the sake of compliance with the legal regulation, but they have a major role in terms of contributing to the strategy and direction of the firm in its overall control and accountability. As for the audit committee, their independence should be supported despite their bitter recommendations.

For independent directors, it could be said that even though they are appointed in the interest of the company and the stakeholders, they end up doing good to the promoters. Even if few of them discharge their duties and responsibility prudently and effectively, at the end of the day the decision of the majority prevails, which dilutes their effectiveness. There are huge responsibilities cast on them however only having stringent norms would not improve the corporate governance practices, efforts need to be made for their implementation too.

References


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