It’s the same after every corporate fraud. There are cries of outrage, shrill demands for “bringing the culprits to book”, agonizing over “how could this happen”, numerous suggestions on “how to improve corporate governance”, perhaps the setting up of another committee and—this happens in the most extreme cases—some tightening of regulation. After every corporate scandal, the unholy nexus between auditors and companies is once again laid bare, as is the impotence of the so-called independent directors, the ineptness of the audit committee and the chicken-heartedness of the rating agencies. Every serious observer has time and again pointed to the basic flaw in the system: that company managements appoint the auditors, appoint the independent directors and the rating agencies or that merchant bankers who are supposed to vet prospectuses get their fees from the company.
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Numerous studies have been done about these conflicts of interest. For instance, a National Bureau of Economic Research paper by Edward J. Kane, Dangers of Disinformation in Corporate Accounting Reports, has this to say: “In practice, accountants can and do earn substantial profits from credentialling loophole-ridden measurement principles that conceal adverse developments from outside stakeholders.” In fact, in a study of frauds in the US, (Who Blows the Whistle on Corporate Fraud? by Alexander Dyck, Adair Morse and Luigi Zingales) the authors point out auditors detected only 14.1% of the frauds. Here’s their list of who detected what proportion of frauds: employees 19.2%, non-financial market regulators 16%, media 16%, analysts 14.7%, auditors 14.1%, strategic players 7.1%, the Securities and Exchange Commission 5.8%, equityholders 3.2%, professional service firms 2.6% and short-sellers 1.3%. Clearly, there’s a lot to be said for making whistle-blowing by employees more remunerative, particularly as the researchers found that “in 82% of cases with named employees, the individual alleges that they were fired, quit under duress, or had significantly altered responsibilities as a result of bringing the fraud to light”.
If there is to be real reform and not a cosmetic cover-up, the ties between the company management and auditors and independent directors need to be cut. The way forward has indeed been suggested by the Securities and Exchange Board of India (Sebi), which has called for peer reviews of audits among the companies that are part of the Nifty and Sensex indices. Presumably, Sebi will allocate the audits to firms that are part of a panel of reputed auditors. The simple solution would be for the regulator to make this course of action mandatory—auditors could be allotted audits by the regulator. If that smacks of overregulation, companies could have the option of submitting a list of their preferred auditors, from which the regulator will have to choose. Audits could also be rotated annually, another tool to keep auditors on their toes. And the same rules for appointing auditors could also be made applicable to rating agencies, internal auditors, independent directors, et al. It’s not as if such suggestions have not been made before. Sure, they could be fine-tuned and made more practical, but any solution needs to prevent the glaring conflict of interest that’s so clearly a part of these relationships at present.
The interesting question is: Why haven’t these rather obvious suggestions for reform been acted on before? The answer is, it depends on who’s got more lobbying power. In the US, you have the large pension funds that have been instrumental in getting more transparency from company managements. India, on the other hand, has no tradition of shareholder activism, despite organizations such as the Life Insurance Corp. of India having substantial stakes in companies. The dependence of political parties on business interests to fund elections also doesn’t help. The failure of governments and regulators to pass what seems like very basic safeguards preventing conflicts of interest, not only in India, but across the world, clearly establishes the clout that corporate interests have. Corporate governance is thus a charade, a cosmetic exercise rather than an attempt to get to the root of the problem.
Of course, too rigid a focus on the stock market also has its own set of problems. As Satyam Computer Services Ltd’s founder B. Ramalinga Raju said in his confession, the apparent reason why he inflated earnings was because he feared that bad results would lead to a fall in the stock and a takeover attempt. We needn’t take Raju’s word for it, but the fact remains that too much of a focus on quarterly earnings and the linking of executive compensation with the stock market via stock options could act as powerful incentives for inflating earnings.
And finally, of course, regulation and transparency can only serve to lower the incidence of fraud, rather than eliminate them. As John Kenneth Galbraith pointed out long ago, frauds, too, have a business cycle. This is what he said in his book The Great Crash of 1929: “In good times, people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances, the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression, all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”
The “bezzle” is Galbraith’s term for what he calls “the inventory of undiscovered embezzlement”. If Galbraith is right, Sebi’s peer reviews of the audit of Nifty companies promise to be very interesting.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at email@example.com