New Delhi: The author of Corporate Management, Governance, and Ethics Best Practices (John Wiley & Sons, 2008), S. Rao Vallabhaneni, discusses why independent directors are never really independent and why frauds always show up at the end of a financial boom. Edited excerpts:
Power corrupts: Vallabhaneni has authored a book on best practices in corporate management.
Are Indian corporate governance rules strong enough?
Yes. There is no shortage of government regulations, but there is a shortage of proper implementation of those regulations by corporate management and a shortage of strict enforcement by regulators.
Does the fact that 70% of Indian companies are family-owned or family-promoted make them more vulnerable to lapses?
It depends. The mere fact that a company is family-owned and family-promoted does not automatically make it vulnerable to corporate governance lapses.
It is a fact that most successful companies in the world have started with one or two individuals or family members (e.g., Tata, Bajaj, and Mahindra and Mahindra in India and many in the US), but they are successful due to conformance to corporate governance rules and ethical behaviour. Lapses can occur when there is no respect or commitment to such rules, and not because of family ownership.
Where do you get good independent directors from?
Good question with no right answer. Let us look at the three common sources of independent directors: working executives from other companies, retired executives, and professors from the academic world. Regarding working executives, there is reciprocity in place here, meaning that a CEO of one company becomes an independent director of another company, and vice versa.
Each CEO is sympathetic to the other CEOs due to common problems and issues they all face and operates on a “buddy” system.
Regarding retired executives and professors, most of them have their own consulting practices, and they hope to get a lucrative consulting contract either with this CEO or other CEOs through referrals. Most of the time, board members are mesmerized by the CEO’s power, charisma, and friendship. At the end of the day, it is the CEO who selects and approves the board members he is comfortable with. In theory, shareholders must elect the board members. In practice, board members are selected by the CEO and rubber-stamped by the shareholders. Until the board member selection process changes, there is no assurance of independent directors. There is too much power and risk resting with one person—the CEO. This means, if the CEO is good, his company is good and vice versa. The mere presence of independent directors on the board does not guarantee a fraud-free environment.
Why do these corporate scandals always seem to come at the end of a boom cycle?
Regardless of the nature of economic and business cycles (boom or bust), scandals erupt because of greed at the top; poor financial performance; whistleblowing by employees, suppliers, customers, and investors; and the cumulative effect of bad decisions made by corporate management over the years.
When the credit markets are tight and/or when the stock prices are going down, companies often do not have the financial resources to perpetuate fraudulent activities. This is the time the true financial performance and the nature of fraud emerge.
Unfortunately, investors are concerned about corporate governance issues only when a company’s short-term (quarterly) financial performance expectations are not met or when a fraud is discovered. Investors must demand strict adherence to corporate governance standards all the time regardless of the nature of economic and business cycles.
What should India address to ensure these scandals don’t happen?
Corporations, per se, do not commit fraud. It is the individuals within the corporation that do. Having said that, no single country or no single government can ensure that corporate scandals and fraud are completely eliminated. Despite many government rules and regulations, scandals and fraud still occur frequently (e.g., Enron, Tyco, WorldCom, and Satyam).
The following 10-point checklist might help an individual company and its CEO in India to develop a strong corporate governance mechanism:
1. Set a strong ethical “tone at the top” and enforce a corporate code of conduct.
2. Develop and distribute corporate governance rules and requirements. Seek additional information on corporate governance from Organization for Economic Co-operation and Development (OECD) at www.oecd.org located in Paris, France. OECD brings together various governments of countries committed to democracy and the market economy. Its membership includes 30 countries. India, China, and Russia are not member-countries of OECD.
3. Establish a chief governance officer (CGO) position reporting to the CEO.
4. Establish a robust corporate control system with proper checks and balances in place. Establishing an internal audit function is a part of the control system.
5. Establish a chief risk officer position reporting to the CGO for managing corporate-wide risks.
6. Establish an uncompromised and competent audit committee with strong teeth for financial oversight.
7. Establish a chief internal auditor or chief audit executive position reporting to the audit committee and conducting internal audits.
8. Establish a chief compliance officer position reporting to the CGO in ensuring compliance with all laws, rules, and regulations.
9. Establish a chief ethics officer reporting to the CGO. He or she should conduct ethics training programmes and establish a “hotline” for reporting suspicious fraudulent activities.
10. Raise the professionalism and core competence of key employees by acquiring professional certifications such as chartered accountant for accounting employees, certified internal auditor for internal audit employees, certified fraud examiner for fraud investigators, chartered financial analyst for investment and finance employees, and certified business manager for all supervisory and management positions in all business functions. These professional certifications require strict adherence to code of ethics, which can control the temptation of management and employee fraud.
Why do companies continue to fail in terms of corporate governance, despite such lapses being to blame for big blow-ups (Japan in 1997, Enron, etc.)?
Greed and ego. The CEO or chairperson knows very well about the various lapses occurring in the corporate governance area from all over the world through press and business reports. The CEO committing a fraud assumes that he will not get caught or that he is above the law and therefore creates a culture to enable the fraud.
Earnings management (i.e., cooking the books) and siphoning off corporate funds are becoming very common because the CEO has a dominating personality and both the board members and auditors (internal and external) are weak and not fulfilling their defined roles and responsibilities. In other words, the board of directors has a “fiduciary” responsibility, and the auditors have a “watchdog/gatekeeper” responsibility.