Fraud Symptom 3 – Board’s failure to exercise judgment

The board performance and effectiveness differentiates between success and failure of the organization. Before, I mention the details; I am giving a brief background of the Indian corporate sector and relevant laws. Ministry of Corporate Affairs Annual Report 2009 states that there were 821,212 companies limited by shares registered in India. Of these 83,010 were public limited companies and 738,202 were private limited companies. There were 2903 foreign companies operating in India as of 31 December 2009.

Now the question is how this data is relevant. SEBI’s Listing Agreement Clause 49 defines the corporate governance requirements for publicly listed companies in India. That means it is applicable to less than one-tenth of Indian companies.

The clause mentions requirements for independent directors, formation and working of audit committee, corporate governance norms and disclosures, code of conduct etc. The Indian Company Law’s various sections define the requirement for true and fair financial statements, audit committee and corporate governance requirements. However, most of the sections provisions are applicable to public companies and deemed to be public companies. The SEBI guidelines and Company Law requirements on corporate governance are not applicable to private limited companies. Hence, from a fraud symptom perspective, the issues are different and I am dealing with them below separately.

 The most renowned case of boards’ failure to exercise judgment in India is of Satyam. So let me cover that briefly. Satyam’s board consisted of well-known business personalities, namely Mr. Krishna G. Palepu a professor in Harvard Business School and Mr. Vinod Dham known as Father of Pentium. The Central Bureau of Investigation report stated (as given in Top News) –

 “The members of the Board of Directors had acted as “rubber stamps”, unwilling to oppose the fraud. Not a single vote of dissent has been recorded in the minutes of the Board meetings.”

This clearly raises questions on the effectiveness and role of independent directors. Four independent directors of Satyam resigned within a short span after the fraud disclosure. This issue which was brought into focus was “should independent directors be held responsible for the fraud?” The impact was felt across corporate India. The research paper “Independent Directors and Firm Value: Evidence from an Emerging Market” mentions that in January 2009 at the time of disclosure of Satyam fraud there was a substantial peak in number of resignations of director. 197 directors voluntarily resigned though their term had not ended. The number consisted of 109 independent directors, 40 insider directors and 32 gray directors. There are certain challenges, which independent directors face in India that may not be applicable to developed countries. I will provide details after covering the SKS Microfinance case that also highlights boards’ failure in business ethics though not in fraud.

SKS Microfinance case came into light when the CEO Suresh Gurmani was unceremoniously fired by the board of directors. There were no performance or fraud issues. Eight of the ten directors voted in favor of his termination, the other two were absent. It is being said that this was done because the founder chairperson Vikram Aluka had some disagreement with the CEO.  Two of its reputed directors are Pramod Bhasin, President and CEO of Genpact and Chandra Shekran, Former Executive Director, SIDBI. This event brought focus to the internal operations of SKS Microfinance. The organization was formed as part of social entrepreneurship to give rural poor and farmers small value loans. It is said that the organization was charging an astronomical 28% interest and was coercing village women and farmers for recovery. A number of farmer suicide incidents were reported to police holding SKS responsible. Andra Pradesh government passed a revised law about microfinance lending which in the last three months has severely affected the microfinance industry. The question here is what was the board doing? Did the directors not question the excessive profits of the company whose objective was social entrepreneurship? Did they ask for information regarding operations? Shouldn’t the board of directors question business ethics of the organization?

The main reasons for failure of independent directors in India are that most of the public listed companies’ shareholding is structured differently. The family or founders bring in their relatives and friends as board of directors and control the organization. The independent directors do not receive insider information of the organization, as senior management is loyal to the founder / family. Hence, all effort is made to protect the family/ founders authority and control, rather than interest of the public shareholders. Therefore, though the qualifications of the directors are good and relevant they have little impact. The directors are appointed more to add prestige to the board and company, a men’s club is formed and nobody bothers to ask the right questions. For the directors it is a status symbol to be on the board, along with the director’s fee, free travel and various indirect privileges. In such a scenario, the board’s independence is lost and there is hardly any focus on curtailing fraudulent activities.  

Next issue to discuss is about private companies. As such, since the number of shareholders is less than 50, in most cases of fraud the financial impact is felt by a small group. The problem arises when the private limited company is a subsidiary of a public limited company or a multinational. According to SEBI Listing agreement  a subsidiary company having a turnover or net worth of 20% of the holding company or has a significant transaction which is more than 10% of its turnover, assets or liability with the holding company has to comply with certain requirements of independent director, audit committee and review by holding company board of directors. However, through multi-layered structuring of private companies, these rules can be circumvented.

As most of the multinationals operating in India have a business process outsourcing or information technology outfit, I am taking an ITES company example to explain how multi-layered structure increases management’s propensity for fraudulent activities. Suppose company “A” is a public listed company in US. A separate private limited company “B” is formed in US with a common founders or board members. Now a separate private limited company “C” is formed in India. Now company A enters into an agreement with company B for providing software development and call center services. Company B enters into an agreement with company C in India for providing the same services. Now let us say majority of the back-office operations are performed by company C in India. Some senior managers maybe reporting to company A and B senior managers. However, now because of the autonomy available to company C and then company B senior managers, the full information does not flow to company A’s board of directors. Hence, the board of directors of company A, whose funds have been used to setup company B and C, would have very little visibility of actual operations. With such minimal control and high autonomy, company B and C senior managers separately or in collision can undertake fraudulent activities without detection.      

Considering the above-mentioned factors, one needs to assess the intent of board of directors. If the intent is wrong, there will definitely be laxity and ineffectiveness.

Recommendations

The board’s independence and critical thinking is necessary for effective corporate governance and preventing large-scale fraud within organizations. The following recommendations are useful from Indian perspective:

1)    Ministry of Corporate Affairs should focus on providing a structure for corporate governance. Applying similar provisions as developed countries is useful, however if similar support structure is unavailable, the provisions become ineffective.

2)    SEBI should delve deeper into appointments of independent directors to ensure that public shareholdings interests are protected.

3)    Reputed professionals who are appointed as directors should fulfill their obligations in true spirit and sincerity. Directorships shouldn’t be just treated as status symbols.

4)    Organizations while forming a multi-layered structure of companies should build processes to ensure transparency and accountability. Procedures for corporate governance should be implemented across the group uniformly.

References:

1. Ministry of Corporate Affairs Annual Report (http://www.mca.gov.in/Ministry/annual_report_2009.html)
2. SEBI Listing Agreement (http://www.sebi.gov.in/Index.jsp?contentDisp=Database)
3. Satyam CBI Report (http://www.topnews.com.sg/content/22973-satyam-scam-board-directors-also-party-fraud)
4. Satyam Board of Directors Resignation (http://newkerala.com/topstory-fullnews-66077.html )
5. SKS Microfinance (http://www.sksindia.com/ )
6. Independent Directors and Firm Value: Evidence from an Emerging Market (authored by: Rajesh Chakrabarti, Krishnamurthy Subramanin and Frederic Tung) http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1631710

To read the full list of Fraud Symptoms, click here.

Fraud Symptom 2- A Weak CFO

Continuing with the series, as per COSO report “Fraudulent Financial Reporting 1998-2007- An Analysis of U.S. Public Companies” in 65% of the total 347 alleged cases of fraudulent financial reporting in 1998-2007, the CFO of the organization was involved. When we add CEO and/or CFO involvement, they are responsible for 89% cases of fraudulent financial reporting. Hence, the question comes up why CFOs participate in a fraud when their role is of being gatekeepers and protectors of the organization.

According to research done in the paper “Why Do CFOs Become Involved in Material Accounting Manipulations?” the CFOs participate in fraudulent financial reporting either because they are complying with the instructions of CEO or they are themselves perpetrating the fraud. The CEOs generally take the decisions about CFO employment terms and whether CFO can report to the board. Hence, if the CEO is powerful, the CEO can force the CFO to participate in accounting manipulations. The CEO can build a corporate culture to meet quarterly accounting targets that would put undue pressure on the CFO to meet them or directly threaten CFO with job loss. As in the Satyam case, Ramalinga Raju was in a powerful position and the ex-CFO Vadlamani Srinivas did not refuse to pass fraudulent accounting entries and do illegal fund transfers.

The second situation is when CFO instigates fraudulent activities. In these situations the CFO is lured by the financial benefits and misuses his position for personal gain. This occurs when CFOs are powerful, have minimum oversight control and the organization has weak internal controls. Internal and external auditors might be under the influence of CFO. This case can be exemplified by the recent Citibank fraud. The Hero Honda Assistant Vice President Mr. Sanjay Gupta allegedly took Rs 20 crore (USD 4.46 million) from Mr. Shivraj Puri of Citibank to divert Hero Honda group funds amounting to Rs 200 crore (USD 44.67 million).

The third situation is when the CFO role is given to an unqualified or an inexperienced person. The Enron ex-CFO Mr. Fastow was not a qualified certified public accountant. As mentioned in Greed and Corporate Failure authored by  Stewart Hamilton and Alicia Micklethwait  – “It is doubtful if he had the skill set required of the CFO of a major corporation, let alone one as complex as Enron.” In India, a company’s financial statements are required to be signed by its CFO who must be a certified chartered accountant. However, organizations can hire inexperienced chartered accountants and force them to sign of the financial statements.

The last problem which needs to be addressed in large corporate is the role of Chief Financial Officer and Financial Controllers (FC). If the organization has a number of business units or geographically distributed offices, the financial controllers are responsible for the business unit financial statements. In some situations they report to the business unit operational head and in some they have direct or dotted line reporting to the CFO. In this situation the CFO can be bypassed by the FC. The CEO or business unit head can directly influence the FC to manipulate financial records. This may be done with or without the knowledge of CFO.

India as such faces additional challenges and the pressure to comply is huge. It does not have a whistleblower protection act. In 2010, 11 whistleblowers were shot dead. The dilemma faced by whistleblowers is not just about risking a career; it is also about risking one’s own life and those of family members.  Considering that it is extremely difficult to fight a legal battle in India, due to high corruption in law enforcement agencies, it is nearly impossible for senior officers to report corporate misdemeanors of powerful people.

Do not lose hope, the CFOs in India are continuing despite the challenges. On the lighter side, here is an incident. A friend of mine, married with a kid, is a CFO in a multinational organization and reports to a CEO. She was once having a bad day and angrily said to me – “You know what Sonia, my boss is a fraud. But when I see him virtually holding a revolver over my head, I tell him he is more suave than Richard Gere, more intelligent than Einstein, has wisdom of Aristotle! ” Straight-faced I asked knowing her heart and soul are in the right place – “Isn’t that over the top”. She gave me a dirty look and responded – “He believes it.”

Recommendations

The need of the hour is to make a CFO more powerful in the organization to enable him/her to work independently. This would prevent CEO and other CXOs from exerting undue influence on CFO.

1.  The board of directors and/ or audit committee should be responsible for recruiting and terminating a CFO. The CEO shouldn’t be allowed the authority to terminate a CFO at will.

2.    Indian Company Law Board has recently requested Institute of Chartered Accountants of India (ICAI) to initiate disciplinary action at the earliest against chartered accountants who breach the code of ethics. If chartered accountants believe that they will suffer no or minimal consequences for transgressions, they will resort to them actively. Hence, actively initiating disciplinary action is a step in the right direction.

3.   ICAI should also provide a peer support and assistance to chartered accountants who wish to disclose wrongdoings. Though this is stated on paper, it is not being actively practiced. This will reduce pressure on chartered accountants to comply with incorrect instructions of CEOs.

4.   Audit committees should be vigilant about CFOs becoming perpetrators in frauds.

5.   Internal audit heads or other risk heads should not report to CFOs. If internal audit heads and risk heads report to CFOs, they lose their independence and cannot report on fraudulent activities of CFO.

6.   CFO pay should not be linked to quarterly returns or stock market performance.

References:

• Why Do CFOs Become Involved in Material Accounting Manipulations? (Authors Mei Feng & Weili Ge)
• COSO Fraudulent Financial Reporting 1998-2007- An Analysis of U.S. Public Companies (Authored by Mark S. Beasley, Joseph V. Carcello, Dana R. Harmanson & Terry L. Neal)
• Greed and Corporate Failure – The Lessons from Recent Disasters ( Authors Stewart Hamilton and Alicia Micklethwait)
• The Illegal Mining Whistleblower Case

To read the full list of Fraud Symptoms, click here.

Fraud Symptom 1- Insatiable hunger of CEO

The recent report of COSO “Fraudulent Financial Reporting 1998-2007- An Analysis of U.S. Public Companies” states that CEOs are involved in 72% of the 347 alleged cases of fraudulent financial reporting listed with SEC during 1998-2007 period. The report shows that the average period of fraud was 31.4 months. The data clearly indicates that in most major cases of fraudulent financial reporting the CEO’s of the organization are the main instigators and it is a planned initiative.

The research paper titled “Why Do CFOs Become Involved in Material Accounting Manipulations?” shows that 46.15% of CEOs involved in fraudulent activity benefitted financially from accounting manipulations. The COSO report states that motivations of fraud as specified by SEC are to meet the financial expectations, hide worsening business situation, increase executive compensation and/or improve chances of gaining debt and equity funding. Since CEO performance and benefits are measured by financial numbers submitted to the stock market, they rationalize the need to report fraudulent financial numbers to protect their positions.   

However, not all CEO’s feel pressured to resort to fraud to maintain positions. Most CEO’s do not rationalize fraud and do submit accurate financial statements. Hence, the psyche of these CEOs is generally different as they have little regard for ethical standards and legal requirements. For example, Jeff Skilling had a poster boy status prior to the debacle of Enron. He was known as a charismatic leader and was highly influential. Some state that he had a narcissistic personality. However, at that time he was held in high regard as he gave financial profits which no other energy company was showing. As Stewart Hamilton and Alicia Micklethwait authors of the book Greed and Corporate Failure describe –

“Skilling’s desire to accelerate revenue, and thus, earnings, by using mark-to-market accounting, inevitably led to a ‘treadmill’ effect. If you took all the profit from a deal in one quarter, you were going to have to find another and larger deal in the next. This inevitably put pressure on employees to do deals – often with little regard as to how they were to be managed – and to ‘make the quarter’ by whatever means necessary. There was also self-interest in this as an individual’s remuneration was based on deals done and profits recorded in the previous quarter. The focus on earnings rather than cash led to some crazy deals being done”

In India, in Satyam fraud the founder CEO Ramalinga Raju confessed to fraudulent financial reporting to Rs 7000 crore (USD 1542 million). Now investigators are stating the fraudulent activities were commenced in 2002-2003 and the amount is nearly Rs 14000 crore (USD 3085 million) . He stated in this confession letter:

“The gap between in the Balance Sheet has arisen purely on account of inflated profits over last several years (limited to Satyam standalone the book of subsidiaries reflect true performance). What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew significantly (annualized revenue run rate of Rs 11,276 crore (USD 2484 million) in the September quarter of 2008 and official reserves of Rs 8,392 crore (USD 1849)). As the promoters held a small percentage of equity, the concern was that poor performance would result in a takeover, thereby exposing the gap. The aborted Maytas acquisition deal was the last attempt to fill the fictitious assets with real ones. It was like riding a tiger, not knowing how to get off without being eaten”.

The capability to deceive can be assessed by the awards Ramalinga Raju received on behalf of Satyam. He was awarded Ernst & Young Entrepreneur of the Year Services Award 1999 & 2007 (which was withdrawn later), Dataquest IT Man of the Year Award 2000, CNBC’s Asian Business Leader – Corporate Citizen of the Year award in 2002 and Golden Peacock Award for Corporate Governance 2008 (withdrawn later).

It is not that people are completely taken in by the charisma. However, the political power of the man was such, that no one raised questions. As reported in the media, the board of directors, SEBI, ICAI and Income Tax department all had information of some irregularities being done by Satyam. A senior officer in Income Tax department was the only person to conduct an investigation about illegal transfers in 2002. Subsequently, the senior officer was transferred and investigation report suppressed. No other regulator initiated any other investigation. The message was clear no one in Hyderabad (corporate office of Satyam is located in Hyderabad) could raise questions on Satyam.

Recommendations

In my view the reason CEO’s are able to continue fraudulent and illegal activities is that there is no one checking and questioning their decisions and behavior. Hence, the recommendations to curtail CEO’s perpetuated frauds are:

• Regulators should maintain independence and initiate investigations on early warning signs.
• Board of directors should question the spirit of the contract, and not just the technical aspects. For example, why was Satyam a software company considering a deal with a construction company Maytas?
• Audit committees should play a stronger role in protecting Chief Audit Executive and Chief Financial Officers. This will enable audit committee members to understand the real situation within the organization.
• CEO pay should not be linked to quarterly results alone. Longer-term performance measures may lower pressure to give quarterly financial numbers.
• Lastly, board members and audit committee members should be vigilant on news about misdemeanors of CEOs and the company. They should conduct specific investigations of the transgressions and start action to reduce risks.

The CEO is the leader of the organization. If he/she chooses an unethical or illegal path, eventually the organization will suffer severe damages. The responsibility rests with the board and regulators to safeguard the organization. Playing a blame game after the damage is done, doesn’t help the economy or the country. Do not let a CEO’s insatiable hunger get out of control.

References:

1.  Why Do CFOs Become Involved in Material Accounting Manipulations? (Authors Mei Feng & Weili Ge)
2. COSO Fraudulent Financial Reporting 1998-2007- An Analysis of U.S. Public Companies (Authored by Mark S. Beasley, Joseph V. Carcello, Dana R. Harmanson & Terry L. Neal)
3. Satyam Fraud Case- Confession letter of Ramalinga Raju
4. Satyam Scam Tip of Corporate Fraud Iceberg ( Article in IPS News written by Praful Bidwai)
5. Greed and Corporate Failure – The Lessons from Recent Disasters ( Authors Stewart Hamilton and Alicia Micklethwait)

To read the complete list of fraud symptoms, click here.