The recent US Court decision to give relief to Satyam independent directors/audit committee members has raised both – concerns and hopes. Concerns on corporate governance are indeed ineffective in practice and impossible to enforce, as has long been the suspicion. Hopes are that SEBI’s actions against independent directors and others in several recent cases, are perhaps unwarranted or probably even without legislative sanction.
Recently, the independent directors/audit committee members of Satyam Computers Limited were given relief in a class action suit filed against them in USA, for their alleged recklessness (it may be recollected that, as widely reported, in 2009, in settlement of class action claims, Satyam had paid INR7,797 million and the Auditors had paid INR1,591 million). Would the latest decision change SEBI’s approach ? Will independent directors in India be also treated with the same standards by SEBI or will they continue to be punished, as they have been punished in several recent cases, for alleged negligence, connivance, etc.?
First of all, what does the US decision say? It will be beyond the competence of this author to comment on what the scheme of provisions is in the US in this regard nor is it relevant significantly here. But a summary of some aspects apparent on the face of the decision can be made.
The decision is related to many issues, apart from the role of independent directors, such as whether the US courts had jurisdiction if shares of an Indian company was acquired on Indian stock exchanges. However, the relevant issue for discussion here is whether the independent directors (including audit committee members) could be held liable for loss caused to the investors.
The allegations in Satyam may be recollected. The company falsified its records and showed fictitious revenues, profits and assets. Further, it showed fictitious expenditure through which monies were channeled out in group companies. Loans from related parties were shown to have been taken in Satyam to compensate for the cash shortage. Such funds diverted were used in a related party – Maytas – to acquire huge amounts of immovable properties. Such fictitious amounts rose over the years and in a last ditch effort to cure the fraud, it sought to merge the related party into Satyam and show that the fictitious assets were used to acquire immovable properties and that too at an inflated price. Though this alleged fraud was carried out over several years, neither the independent directors, the Audit Committee members, nor the auditors detected or reported it. The question in the US decision was whether independent directors (including audit committee members) could be held liable for the fraud?
It needs to be noted that the US decision was not given on merits – that is — where the facts of the case were examined in great detail and decision given. The decision was on whether the class action could be dismissed on preliminary grounds that the facts, as alleged, were insufficient to determine reasonable scienter or state of mind/knowledge. The standards for this decision were simple. Are the facts – as merely alleged and not even proved – sufficient to reach the standards of scienter or a guilty state of mind, in terms of recklessness, connivance, etc.?
Thus, the plaintiffs were required to have alleged a certain level of facts which, assumed to be wholly true, should show a level of scienter/recklessness on the part of the independent directors. Several facts were alleged. That the fraud was so huge that it could not have escaped scrutiny of such competent people. That the auditors raised certain red flags in the form of certain internal control systems not being followed. That the independent directors approved the Maytas purchase without sufficient scrutiny. That though the auditors were paid huge amount for “other services”, the independent directors did not question this properly and grasp why the auditors were engaged for ‘other services’. That the norms of corporate governance in India required several things to be done by the independent directors/audit committee members who failed in performing. And so on.
The Court found that these alleged facts were not sufficient to establish scienter/recklessness. Hence, the class action was dismissed. More specifically, it was even observed that the independent directors were more likely the victims of a sophisticated fraud themselves rather than its perpetrators. The Court observed, “The majority of the allegations in the FACC concern an intricate and well-concealed fraud perpetrated by a very small group of insiders and only reinforce the inference that the AC Defendants were themselves victims of the fraud. The strength of this competing inference outweighs the inference of scienter asserted by lead plaintiffs.”
The Court dismissed the case, stating as follows:-
“Having considered the FACC in its entirety, the Court finds that lead plaintiffs have failed to plead sufficient facts to raise a strong inference of recklessness on the part of the AC Defendants that is at least as compelling as the non-fraudulent inference reasonably drawn from the allegations.”
There are some important points to note here. Firstly, this was a private action for damages, and not an action by a regulator against persons having certain statutory obligations. Secondly, certain actions were already taken against the company and its auditors and settlement for compensation was made. Arguably, the provisions of law and standards of proof required for fraud/negligence/recklessness, etc. are different in the US as compared to India, even though some of the obligations of the independent directors in the Satyam case were traced to Indian laws. Further, what are the obligations of persons under US law and how are they deemed to be contravened are also different. The specific allegations made in the class action is also to be seen in this context.
Nevertheless, it makes a difference that the actions/ omissions of the independent directors were held as not to constitute recklessness/scienter and it has some relevance in general times in India too. This is because, unless it is alleged and found that the independent directors did not comply with specific obligations under law, the issue before the Indian regulator would be similar – and that is, did the independent directors do their duties correctly? Interestingly, to the best of the author’s knowledge, there are no findings made as of today for any of such independent directors in the Satyam case. And it would be interesting to see whether what finding SEBI makes against the same independent directors who are given relief by the US Court.
However, it is also noteworthy for comparable or even lesser levels of manipulations in several cases, SEBI has taken stringent actions against independent directors, members of audit committee, CFOs, etc. For example, in several cases (Bharatiya Global Infomedia Limited, Pyramid Saimira, Tijaria Polypipes Limited, etc. as also discussed earlier in this column), independent directors and audit committee members (and even CFOs/CSs) have been strongly acted against by SEBI. The question that will be relevant is whether such actions were correct in context of the US decision. Or whether, in India, even the Satyam independent directors would be held liable.
On balance, this author submits that the US decision should be taken in its context and will result in change in India’s approach
Having said that, there are some basic wrong things that exist in the Indian framework for corporate governance. Firstly, and perhaps most importantly, they are contained in Clause 49 of the listing agreement, which is not a law, but an agreement. Moreover, it is an agreement between the stock exchange and the company. Of course, recently, violation of the listing agreement has been made punishable. However, still, it is a legally bad place to be for a provision that is meant to have such significance.
Secondly, while a significant level of obligations are laid down on independent directors in Clause 49, their rights are fairly marginal and difficult to enforce, particularly when one compares the powers of auditors under the Companies Act, 1956. Often, the only recourse left for an independent directors is to resign or otherwise report what he has already found to be objectionable.
Thirdly, this weak basis of law making causes problems even for SEBI. It really does not have any specific powers – as it has for various other ills – for taking action against errant companies, independent directors, etc. Thus, it uses its generic powers – which are meant to be used in exceptional cases – and debars them. While it is true that SEBI as an expert body needs certain wide and discretionary powers to take action in the face of newer and innovative types of market manipulations, corporate governance is fairly old now for resorting to such actions.
Finally, the scheme of law leaves the investors uncompensated. Whether it is Satyam, Pyramid or other cases, it was the investors who were left stranded with their shares devalued, as they assumed that SEBI had put in an effective system of corporate governance, where there are responsible persons to carry out the safeguards. The weak basis of law which, at best, punishes the independent directors by debarring them, does not help the investors recover their losses.
There is another dimension too. The general principles and even the concept of corporate governance are borrowed from the West where the management is with executives whose total holdings is usually in single digits. In comparison, in India, companies are promoter controlled, usually families and who often hold 35-50% and even more of the company. The concept of independent directors, etc. are relevant where shareholders holding 90% can appoint such people to safeguard their interests. While in India, if such concepts are blindly introduced for similar purposes, they would be – and indeed they are often – defeated by promoters, having full power to appoint people who are favourably disposed to them and the inherent power to remove them.
In the end, it seems that a transparent, effective, and comprehensive scheme of law governing corporate governance relevant to Indian realities, is needed. In this context, then, it is sad that neither the concept paper on corporate governance recently issued by SEBI nor the Companies Bill 2011 addresses these fundamental issues. The result then is likely to be a false sense of security, which would often be taken away by scams and which would be acted against by SEBI using its discretionary and arbitrary powers.
