Introduction
The recent revelations made by the Hindenburg report on the Adani Group, highlighted the frauds which they allegedly committed, leading to a sharp decline in the stock price of the Adani Group. This saga underscores the importance of devising and adhering to Corporate Governance (“CG”) mechanisms and also highlights the dire consequences of non- adherence to the same. One of the many allegations levelled by the Hindenburg report was the company’s non-disclosures of the Related Party Transactions (“RPTs”). It is the duty of the Independent Directors (“IDs”) and Audit Committee (“AC”) to approve the RPTs. However, it is alleged that some transactions were not considered and recorded as RPTs by the committee, while vetting the financial statement. If the allegations are proven, serious concerns will be raised about the efficiency of the CG structure.
The ID of a company is an external, unrelated party with no personal or financial ties to the company except the remuneration they get for holding the position. The fundamental purpose of appointing IDs is to incorporate an unbiased opinion on business decisions and to inculcate a framework to keep corporate oversight. Section 177 of the Companies act make it compulsory that maximum member of the AC should comprise of ID. And the chairman should also be an ID. It serves as a vigilant custodian of the company’s financial integrity by vetting the company’s financial statements. The members act as whistle-blowers in cases of frauds and are the sentinels of fairness. The IDs and the AC are the two pillars that form the bedrock on which the CG building is erected. Therefore, the efficiency of their work is pivotal for the company’s stakeholders.
The Crucial Timing and Significance of SEBI’s Order in LEEL Electrical Case
Securities and Exchange Board of India (“SEBI”), in its recent judgment in the case of LEEL Electrical, has reaffirmed the role and responsibilities of the committee, which had been discussed in various precedents. In this case, fraud was perpetrated by diverting funds to related parties, misrepresenting financial transactions as well as by fictitious sale and purchase reporting. As per Sections 177 (9) and (10) of the Companies Act, 2013, the committee must report such fraud, but in this case, it was not reported by the AC. The members had resigned on learning about the fraud, when it was reported by the shareholders.
Both members of the AC were fined Rs. 10 lakhs each for not fulfilling their duty. They were not financially educated and experienced. One member was a retired air marshal officer the other was a physiotherapist. They had agreed to hold the position with the assurance that they would handle the accounting aspect. They did not have any knowledge of any financial transactions and meetings of the Audit Committee were done only on paper. Thus, they were not able to recognise the fraud in the first place.
While giving this order, SEBI emphasized on the importance of the AC’s roles and responsibilities and imposed a hefty fine on them, dismissing the excuse of lack of financial knowledge about the transactions. This case raises eyebrows on the appointment criteria of AC members and the role which ID plays when they become part of AC. It also brings into light the crucial question of whether the issue lies in the execution of the law or the law’s effectiveness. The amendment brought through section 149 of the Companies Act 2013 allowed a person to be an ID for a maximum of two terms, where one term will not be more than five years. Therefore, this year, there will be a significant shift in the composition of the AC because of the change of IDs. The concerns raised through this judgment require urgent attention to make changes before the appointment of the new IDs.
Appointment of ID and AC under SEBI Listing Obligations and Disclosure Requirements (“LODR”).
- Appointment of Independent Director
The LODR regulations under SEBI Act, 2015, mandates IDs to have a special resolution of the Board of Directors. Regulation 25(2A) has defined the threshold for the vote that is necessary for approval at 75%. This provision ensures that individuals who have majority support are elected as IDs, highlighting the role played in corporate governance and impartial conduct by the IDs. The amendment provides special emphasis on the case wherein the special resolution fails to gain the 75% majority. The ID is held as appointed when the votes in his favour exceed the votes against him, and he also receives the support of public shareholders. This framework protects the IDs and assures general and public shareholder support for his appointment. The current criteria for appointment of ID might be sufficient for holding a post of ID but it is not sufficient for people who will also be part of the AC. ID is the base, on the basis of which the AC is formed. Therefore, it becomes very crucial to appoint financially educated people to be at the base so that it will lead to a good corporate governance structure.
- Appointment of Audit Committee Members
SEBI LODR Regulation 18(1) states that any listed entity should have an AC comprising of three directors. Regulation 18(1)(b) states that at least two-thirds of the members of the AC shall be IDs, and an independent director shall act as the chairperson of the AC. Thus, there would be an impartial working of the AC, with sufficient expertise in audit matters. It further mandates that the AC members be financially literate, i.e. they must be able to read and understand financial statements. This ensures that a member has experience in accounting or financial management for effective governance and oversight. These criteria should be made more stringent. Stringent criterial will lead to a committee which will be competent to identify the financial fraud of a company. Only ID who holds required amount of qualification should be allowed to form a part of AC.
Pivotal Role played by Independent Director and Audit Committee in Corporate Governance
CG is a pivotal concept that protects investors and monitors the company’s financial activities. Independent directors and audit committee members are the essential parts of the CG structure.
- Independent Director
IDs are referred to as conscience keepers of the company, who are moral guides of the righteousness and turpitude of the actions of others. ID is appointed as a third or non-related party to the company that can give unbiased opinions on various subjects. The SEBI Chairman once described CG as the “steering” of the company. ID acts as a driver who controls the steering.
The role of an ID is crucial in the functioning of a company; their responsibilities have been substantiated under section 149(8) of the Companies Act, 2013, and the governing framework has been provided under schedule IV of the Companies Act. Their roles include providing unbiased judgment on the performance of the management and opinion on crucial appointments; they also have to evaluate the performance of the Board and management. They also have to safeguard the shareholders’ interests. At the same time, they have to balance any conflicting interests of the management and shareholders by mediating between them and reaching out for a solution. An ID can also be called to sign the past financial record in the absence of KMP, as was done in the SKS Power Limited case.
- Audit Committee
The AC plays a crucial role in CG. The scope of the AC has changed from the Companies Act 1956 to the Companies Act 2013. The flow is more toward financial reporting, oversight responsibilities, and risk management systems. The AC must also vet the company’s financial statements, internal and external audits, and other checks and balances. Section 177 of the Companies Act lists the rules and responsibilities of the Audit Committee.
In the case of Mr. N. Narayanan v. Adjudication Officer, SC described the role of AC as the watchdog of the company’s financial transactions. While approving financial reports, the transactions mentioned should be verified correctly. Committee members must rely on more than internal auditors or professionals for verification. Financial statements approved by them should be correct and trustworthy. In this case, there were various anomalies in the financial records. It was held that the AC members were responsible for recognising these “red flags” and reporting them, but they failed. The primary responsibilities of AC are reviewing financial statements, reviewing audit strategy, approving RTP, and conducting an inquiry to find the reasons for default in honouring the given obligations.
SEBI’s Stringent Actions Against AC Members in Recent Years
In 2022, in Southern Ispat and Energy Ltd (“SIEL”) case, a major financial scandal came to light concerning the issuance of Global Depository Receipts (“GDRs”). It was found that the Board of Directors utilized the GDRs deposited in the name of European American Investment bank (“EURAM AG”). These GDRs were linked to the company named “Vintage” owned by one of SIEL’s directors. When Vintage defaulted on its financial obligations, EURAM AG used SIEL’s pledged funds to cover the loan which led to serious financial implications for the company. Subsequently, the GDRs were converted into equity shares and then sold off. This transaction was concealed from the public and they were misled into believing they were authentic subscribers of the GDRs, which resulted in significant financial losses to them. When SEBI investigated the matter, it was found that the ID had acted negligently and did not exercise due diligence in flagging any concerns relating to the fraudulent transactions. Thus, SEBI imposed a fine of INR 10 Lakh on the ID for lack of due diligence. This case underscores a critical role that ID has to play in preventing financial frauds within the company.
IICA’s Recommendation on Educating ID
Indian Institute of Corporate Affairs (“IICA”) will soon release a course that will be specifically designed with the intent to educate ID. The need for this course explains the grey area in the appointment criteria of the ID, which becomes more extensive when it comes to AC. This recommendation shows that more than the current financial literacy rate is needed to meet the legislative purpose related to CG.
Although this recommendation ostensibly has positive intentions, several concerns need to be addressed. More than 29,000 IDs are registered with IICA. The feasibility of teaching the entire lot of IDs remains to be determined. Will the company teach all the 29,000 IDs, or will they bifurcate them between two categories, one that is financially educated and one that is not? The follow-up question is how the IICA will differentiate if they decide to. The other questions are about the process that will be followed for teaching the IDs, the time period required for the same, and the evaluation criteria for determining whether the person has achieved the requisite financial knowledge after attending the course.
The solution’s temporary nature is a crucial concern for its practicability. After the retirement of the person who holds the office of the AC, their replacement would need retraining, creating an ongoing cycle. Financial literacy for Audit Committee members is crucial for CG, but this approach is time-consuming and leaves many issues unclear. While IICA’s recommended course may catalyse improved governance, it cannot be the primary solution to the problem at hand. A more sustainable, institutionalized approach is needed to ensure long-term effectiveness in CG.
Recent Trend of increase in fraud
Corporate governance frauds, particularly bribery and corruption have become more rampant. According to a survey titled India Corporate Fraud Perception Survey, 2020, conducted by Deloitte, such risks increased during the pandemic and thus indicate rising levels of corporate fraud.
Despite severe laws to curb the same, various corporate frauds have been witnessed in the Indian nation. Even with corporate governance, financial frauds have increased.
Major corporate frauds marred Indian financial stages since 2008. One of the prominent such frauds came in the shape of the 2009 Satyam Scam, where founder Ramalinga Raju confessed to over-inflating the group’s financial statements to the tune of $1.5 billion. His decisions impacted employees as well as investors, who lost faith in him and were eventually sold to Tech Mahindra in 2010 for stabilization. Later, the Sahara Scam proved that there existed a misappropriation of INR 24,000 Crores through optionally convertible debentures from 2.5 crore investors. SEBI finally stepped in and sought return with interest for the investors who were affected. The action was contested by the Company in the Supreme Court, which in its landmark judgement in 2012 upheld the action by the SEBI that resulted in the arrest of the company Chairman Subrata Roy under Money Laundering charges in 2017.
Indeed, many fraud cases revealed serious loopholes in the internal bank governance system. The PNB and Nirav Modi scam sent shockwaves across the nation, especially the finance sector. Nirav Modi and his uncle Mehul Choksi managed to siphon overseas credit amounting to INR 14,000 Crores through fraudulent letters. It brought forth glaring loopholes in the internal controls of Punjab National Bank, leading to in-depth analyses over the bank’s operations. Furthermore, The Yes Bank Crisis highlighted corporate governance failures, as its non-performing assets surged in need of INR 20,000 crore from the government and investors, forcing the management to be restructured. In the Adani Hindenburg controversy, The Adani group, a leading business house, has found itself facing controversy following allegations of market manipulation and accounting irregularities by the Hindenburg Group.
These allegations had negative impacts on the market and led to a loss of value. This incident has reopened scrutiny on corporate governance in India and has raised grave questions regarding the oversight of the regulators, corporate ethics, and investor confidence in the financial markets. The above cases showcase that even though there has been as presence of the internal management in the banks, and the stringent laws in place; the scams are still prevalent and the same needs to be addressed by the policymakers in the appointment of the ID and AC members in order to avoid such scams in the near future.
Need of Whistle Blower Mechanism for Private Companies
Rule 13 of Companies (Audit and Auditor) Rules 2014 prescribes steps that should be followed if the auditors have reasonable reason to believe the occurrence of fraud or the likeliness of its occurrence. However, as seen in the LEEL electrical order, an AC member tried to avoid liability by resigning from the post. There have been various incidences where AC members resigned from the post when they felt mismanagement or less transparency in the company. Recently, Nisaba Godrej (VIP Industries) resigned from the ID post of Independent Director, citing accountability issues. The role of AC is to report the crime/fraud to the authorities. Instead, people are running from their responsibilities. NFRA, in the June 2023 Circular, also reported that auditors are following their responsibilities to report fraud to the authorities.
No formal and separate law regulates the ‘whistleblowing mechanism.’ Although Section 177 (9) and (10) of the Companies Act provide a mechanism, no separate legislation governs it. The Whistle Blowers Protection Act of 2011 only covered public sector companies or public servants, in its ambit. The Narayan Murthy Committee recommended that the whistle-blower policy be compulsory for the listed companies, but the recommendation was never implemented due to the backlash by the companies. Currently, each company makes its own whistle-blower mechanism. Currently, no rules exist for private companies and new startup industries. Therefore, the whistleblowing mechanism’s Role is crucial in private companies and the startup industry. The research compared whistle-blower policies of the top 100 listed companies. Through the research, it was concluded that there is a difference in the qualities of the policies of each company. Therefore, there is a need to present a formal structure governing the whistle-blower system catering to all types of companies.
Recommendations
The SEBI has adopted an unequivocal stance that ACs cannot escape liability by claim lack of knowledge of the Act. Although the orders of the court align with the legislation’s objectives, but the appointment criteria breaks the equilibrium. Lack of efficiency is the primary issue that leads to an increase in the number of frauds. This vacuum was created due to the inefficient appointment criteria and lack of formal laws regarding whistle-blower mechanisms. The given problem can be solved by reforming the appointment criteria of AC members. An increase in efficiency can be achieved by including one member in the audit committee who is financially educated, like the external member of the audit committee. This suggestion will also impact the appointment criteria of ID because ¾th of the AC are ID; therefore, to bring fundamental change in AC, the ID should also be changed. Therefore, the appointment of one financial expert as an Independent Director should be mandated and such financial expert so appointed, should also be transferred to the AC, officiating as its Chairperson. The appointment criteria for the ID should be the same as those for the external auditor. The inclusion of a financially knowledgeable person will lead to an increase in the efficiency of the whole committee. An already experienced or knowledgeable person will be more efficient and diligent with his work and will also be aware of his rights and liabilities.
Conclusion
There has been a change in the market in the recent years. India has seen a huge increase in startups and there is also substantial increase in the numbers of unicorns. As every coin has two sides, the growth of business causes a corresponding increase in the cases of fraud. Increasing people’s participation is accompanied by the risk of losing the money due to fraud by big companies. Therefore, CG plays an essential role in protecting the trust of the investor and maintaining good market health by protecting the interest of the investor and also maintaining trust of the people in the market causing an inflow of the money in the market. The allegations made on the Adani group which involved severe allegations of stock price manipulation and unreported RTPs raises eyebrows regarding the transparency and efficiency of the ID and resignation of ID without reporting the fraud as seen in the LEEL Electrical order creates a lacuna of trust which can only be filled by the increase reporting of instances of fraud by the ID. In the present time, as discussed above, the current system is not efficient enough to cater to the needs of the present evolving market. Therefore, inclusion of one more financial expert member in the AC and the establishment of a formal whistle blowing mechanism, will lead to increase in efficiency of the CG system which will help in efficient growth of the Indian Business Market.
This article has been authored by Om Chandak and Revant Sinha, 3rd year law students at Maharashtra National Law University, Mumbai.
