A recent SEBI Order debars certain Independent Directors of a listed company for two years from acting as independent directors or members of Audit Committee. This order of SEBI No. WTM/MSS/ ID2/92/2011, dated March 11, 2011 is available on SEBI’s website www.sebi.gov.in. While not the first of such orders, it ought to jolt independent directors out of complacency and impression that because their not being involved with day-to-day operations would help them avoid action in case of corporate frauds or violations. Apart from the debarment, certain fairly harsh words have been used as to their role in that case and there are findings of having committed fraudulent and manipulative acts. On the other hand, there are certain concerns about this order, particularly whether it is an ad hoc exercise of powers.
The requirements of corporate governance has resulted in tens of thousands of persons — most of them highly educated and experienced — being appointed as independent directors of listed companies. By definition, they are generally nonexecutive, since being a paid executive director would mean loss of independence. However, while such an army of independent directors has been created under this requirement, the law governing them remains age-old. Only the nomenclature of Independent Director is new. The role, powers and duties of independent directors are not provided for in the requirements relating to corporate governance framed by the SEBI and placed in the listing agreement as Clause 49. No extra powers or authority is given to the independent directors (though some functions and authority are given to the Audit Committee). Thus, for understanding the powers and duties of an individual independent directors, one has to look at the pre-existing law as contained in the Companies Act, 1956. While this law too does not lay down a specific and detailed framework for non-executive directors, the settled law is that individual non-executive directors are required to be diligent and exercise a level of care than a prudent person may ordinarily exhibit. Further, even these requirements relating to corporate governance have been, curiously, placed not in the SEBI Act or even in any notified regulations or rules, but in the listing agreement between the Company and the stock exchange. This gives these requirements, at best, a semi-statutory cognizance. The violation of these requirements generally results in action against the Company and not against the independent directors.
Expectedly, the other peculiar result is that there are no specific provisions providing for punitive or other adverse consequences for violating the requirements relating to corporate governance. As we will see later, this is perhaps the reason that the SEBI has used its omnibus powers to take action against the independent directors who were allegedly negligent and who even allegedly abetted the fraud.
The preceding paragraphs are not intended to provide for any excuse or leeway for the negligence of any independent directors, particularly a person who is a member of the Audit Committee. It is only to highlight the fairly inadequate manner in which the law has been framed. When a situation has arisen when such law was tested, the SEBI, instead of accepting this inadequate framework and taking corrective action in this regard, resorted to omnibus provisions to take punitive action which most Independent Directors could not even have visualised. Of course, it has to be noted that the facts of the case, if one goes by the SEBI Order, are fairly serious. Let us now consider the details of this case as provided in the SEBI Order.
It has been alleged by the SEBI that Pyramid, the listed company of which the specified persons were independent directors and members of its Audit Committee, overstated its revenues and thus its profits by manipulation of its accounts. The company which is engaged in the business of managing theatres and exhibition of films claimed to have entered into agreements with more than 800 theatres from which revenues flowed into the company. The SEBI recorded a finding that in reality barely about 250 such agreements could be proved and the rest of the agreements did not exist. Hence, it was alleged that the revenues based on such sham agreements were non-existent and through false book entries such revenues were recorded. The accounts based on such overstated revenues and profits were published for the benefit of the public.
SEBI made a finding that the accounts were thus misstated and the question then was, what role did the independent directors play and whether they did not perform their duties as expected of them. This was particularly so, since such Directors were also members of the Audit Committee.
It is worth noting the relevant extracts what SEBI says in its dealing with what it believes to be the role of the Board in general, of independent directors and of members of the Audit Committee :
“5. A company acts through its board of directors. It is the duty and responsibility of the directors to ensure that proper systems and controls are in place for financial reporting and to monitor the efficacy of such systems and controls. While the extent of responsibility of an independent director may differ from that of an executive director, an independent director has the duty of care. This duty calls for exercise of independent judgment with reasonable care, diligence and skill which should be reasonably exercised by a prudent person with the knowledge, skill and experience which may reasonably be expected of a director in his position and any additional knowledge, skill and experience which he has. The audit committee exercises oversight of the company’s financial reporting process and the disclosure of its financial information to ensure that the financial statement is correct, sufficient and credible. It reviews the adequacy of internal control system and management discussion and analysis of financial condition and result of operations. The institutions of independent directors and audit committee have been established to promote corporate governance and enhance the protection of interests of investors. These have a critical role to play in the regulation and development of the securities markets and protection of interests of investors in securities.
6. I note that Mr. K. S. Kasiraman and Mr. K. Natarahjan were independent directors and members of the audit committee at the relevant time. It has been submitted that Mr. G. Ramakrishnan was not an independent director and a member of the audit committee for the entire period. I find that he was an independent director and also a member of the audit committee when quarterly reports of the last two quarters of the year were considered by the Board as well as the audit committee. Further, the quarterly reports of succeeding quarters, when he continued as an independent director and as a member of the audit committee, have indication about the unreliability of the financial statements of the previous quarters.
7. I find that the noticees overlooked numerous red flags in the trend in revenues, profits, receivables, advances, etc. which could not escape the attention of an independent director, who is also a member of the audit committee. For example, profits tripled in the quarter ending June 2007 over the preceding quarter. It doubled in the quarter ending December 2007 over the preceding quarter. The quarter ending March 2008 reported a loss of Rs.3.11 crore compared to a profit of Rs. 29.87 crore in the preceding quarter. Similarly, though the number of screens in theatres increased from 487 as on September 30, 2007 to 655 as on December 31, 2007, security deposits with theatres during the same period increased disproportionately from Rs.36.05 crore to Rs.170.38 crore. Such aberrations in financial figures would alert any person of ordinary prudence. The appropriate questions at the right time from the noticees would have unravelled the fraud being played by the company on the innocent investors. By failing to ask the right questions at the right point of time, I find that the noticees have failed in their duty of care as an independent director. They failed to review, as members of the audit committee, the internal control systems, which generated misleading financial statements. I find that the noticees were either too negligent to notice the aberrations in performance of the company and the fraud behind such aberrations or acted as shadow directors of the board/ members of the audit committee. In either case, they facilitated the company to make false and misleading disclosures and thereby created artificial prices and volumes in the securities of PSTL in the market, to the detriment of innocent investors. I, therefore, conclude that the charge of disclosure of false and misleading statements, as alleged in the SCN against the noticees, is established. Thus, the noticees are guilty of violating Section 12A of SEBI Act, 1992 and Regulation 3(b), 3(c), 3(d), 4(1), 4(2)(e), 4(2)(f), 4(2)(k), 4(2)(r) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003.
8. Such conduct on the part of the noticees is disgrace to the institutions of independent directors and the audit committee of a listed company. This cannot be viewed lightly and warrants regulatory intervention. Therefore, in exercise of the powers conferred upon me u/s. 19 read with Sections 11, 11B and 11(4) of the Securities and Exchange Board of India Act, 1992 and Regulation 11 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003, I hereby restrain Mr. K. S. Kasiraman (Permanent Account Number: AFPPK3572B), Mr. K. Natarahjan (Permanent Account Number: ACJPN0418I), and Mr. G. Ramakrishnan (Permanent Account Number: AAEPR2014F) from being an independent director or a member of audit committee of any listed company for a period of two years from the date of this Order.”
This case is obviously an extreme one where, in a sense, like the Satyam case, serious allegations and findings of fraud were made and expectedly, the question would be how could such serious alleged frauds have escaped the attention of such directors. Or, worse, whether they actively abetted such frauds. This is more so, when they were also on the Audit Committee. However, such an extreme case cannot make and define the law for other cases particularly if there are lesser violations or for areas the facts are less clear.
It is also seen that the SEBI does not have any direct and specific powers to deal with non-performance of duties by the independent directors or for their being negligent. In fact, the SEBI has used its omnibus and comprehensive powers u/s. 11, 11B, etc. to take action against such Independent Directors. The issue is whether it is appropriate to use such powers in this manner creating an impression that the SEBI can act against anyone for anything that it perceives to be wrong or irregular without either defining what is right and wrong conduct and specifying clearly the consequences therefor.
Curiously, the SEBI has held that the Independent Directors are guilty of several provisions of the SEBI FUTP Regulations relating to fraud, price manipulation, etc. The Order, however, does not deal with each such clause separately and establish how it was violated. It is one thing to hold Independent Directors responsible for being negligent or passively not performing their duties and it is totally another thing that they were active participators or abettors of the fraud, etc.
It may be recollected that in an earlier case of an alleged massive fraud, the SEBI had made a similar order debarring the independent directors in that case. However, the Securities Appellate Tribunal (Appeal No. 347/2004, dated 8th December 2005) reduced the period of debarment and found that the SEBI had neither alleged nor established any aiding/abetting by the independent directors to the alleged fraud. It also noted that the independent directors were passive and had no active role in perpetrating the alleged fraud.
Of course, this is not to question the power of SEBI to take such action. As discussed in an earlier article in this column (December 2010 issue of BCAJ), the Bombay High Court in Price Waterhouse & Co. v. SEBI, [(2010) 103 SCL 96 (Bom.)] upheld the power of SEBI to take similar action against auditors and the ratio of that decision should apply directly in facts of the present case. Having said that, recently, questions have been raised (a subject that merits a separate discussion) whether the SEBI indeed has power to ‘punish’ persons under such general and omnibus powers.
To reiterate, a precedent against errant independent directors was needed and this Order does provide one. Having said so, one cannot help observing that the system is skewed against the independent directors. On one hand, by misplacing the requirements of corporate governance in the listing agreement and by not giving any specific right to individual independent director or even to them as a whole, the SEBI has not given them any teeth to really do their jobs well. On the other hand, their obligations, formal and otherwise, are significant. It could thus create difficulties for conscientious Independent Directors in their functions. And since independent directors are really the essential core of good corporate governance, the absence of a proper legal framework for their role, powers and duties is a serious vacuum that, if not filled, will make the requirements of corporate governance ineffective.
