It’s Catch 22 for independent directors

Sai Venkateshwaran | Updated on March 31, 2013


Under the Companies Bill, independent directors have a duty to flag unethical behaviour, and report confirmed or suspected fraud. But will they have the appetite for it?

India is no longer a stranger to corporate frauds, with instances such as Satyam and, more recently, Reebok rearing their head. There are probably several others that haven’t been characterised as frauds. If one were to look at companies that have raised public funds through deposits, investment schemes or even IPOs, and subsequently gone sick or bankrupt, it may indicate another type of fraud, perpetrated on investors or minority shareholders.

Regulatory response

In response to these issues, Companies Bill 2012 has introduced several new provisions that intend to curb abusive practices and deter frauds. The Bill has introduced a wide definition of fraud, which includes any act, omission, concealment of fact or abuse of position with intent to deceive, gain undue advantage, or injure the interests of the company or its shareholders or its creditors or any other person, whether or not there is wrongful gain or loss.

There are penalties prescribed for fraudulent acts in addition to liability, including repayment of debt, imprisonment ranging from six months to 10 years, and a fine up to thrice the amount involved in the fraud. In cases involving public interest, the minimum imprisonment is for three years. Further, those responsible could be personally liable, without any limitation of liability, for the losses or damages caused by the fraudulent act.

The Bill also proposes setting up the Serious Fraud Investigation Office as a statutory body with significant powers, including arrest, to make fraud a cognizable offence.

What is a fraud in this context?

The most commonly understood types of fraud are intentional misstatements — resulting from fraudulent financial reporting and misappropriation of assets. However, the Bill seeks to also cover other matters, including abusive related-party transactions.

At every stage, right from setting up, to finally winding up the company, there is increased focus on whether any of the company’s acts have fraudulent intent. Under the Bill, in any return, report, certificate, financial statement, prospectus, statement or other document, a statement that is materially false or omits any material fact is construed as fraud.

For instance, inducing investors through misleading statements or concealment of facts in a prospectus could be considered a fraud. Further, knowingly or recklessly making a statement or forecast which is false or misleading, or deliberately concealing material facts to induce another person to enter into an agreement to obtain credit from a bank or financial institution, or acquire or dispose or subscribe to securities, or accept deposits from the public are considered fraud.

Checks and balances

The Bill proposes fraud detection mechanisms, including requiring all listed and other specified companies to set up a whistleblower system for directors and employees to report their concerns, together with adequate safeguards against victimisation of whistleblowers. It also requires an auditor to report to the Central Government if there is reason to believe that a fraud is being, or has been committed against the company by officers or employees.

Further, the Board of directors should ensure the effective implementation of policies and related controls for safeguarding assets, and prevention and detection of frauds and errors, irregularities, and so on.

The Bill empowers shareholders to claim damages or demand other suitable action from the company and its directors through class action suits for fraudulent, unlawful or wrongful act or omission.

Role of independent directors

With these changes, the onus is on independent directors and the audit committee to prevent and detect fraud. The audit committee should now ensure that there are adequate deliberations before pre-approving any related-party transaction, and its subsequent modification, if it is not in the ordinary course of business or at arm’s length.

The audit committee should also ensure adequate internal financial controls to detect frauds and errors. According to the Bill’s the Code for Independent Directors, the independent directors should report concerns about unethical behaviour and confirmed or suspected fraud. They should safeguard stakeholder interests, particularly minority shareholders, and balance the conflicting interests.

Where necessary, they should consult outside experts at the company’s expense. This could see directors reaching out for professional help in discharging their enlarged and onerous responsibilities.

Way forward

There is growing awareness of the need for prevention and speedy detection of frauds, as also punishment for those guilty.

This would also lead to significant and, possibly, prolonged litigation to either prove or disprove fraud. Companies and, specifically, their independent directors would now proactively carry out anti-fraud risk-assessments and seek professional advice for forensic studies in suspected fraud situations.

However, the key question remains — do independent directors in India really have the appetite to take on these responsibilities and the associated risks?

The author is Partner and Practice Leader, Financial Reporting Advisory Services, Grant Thornton India LLP

Published on March 31, 2013

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