Can a corporate fraud, such as the one unearthed at Satyam Computer Services, have a positive outcome for investors? The answer is yes. The scam’s magnitude and the delay in detecting it had the regulators sit up and take notice.

The new Companies Act 2013, which has taken effect from April 1, has plugged many of the loopholes that made the Satyam scam possible and has done quite a bit to empower small investors. Take, for instance, the inability of Satyam shareholders to file class-action law suits.

While US investors who had bought American Depository Receipts (ADRs) of Satyam walked away with $125 million after the company’s Chairman admitted to cooking up the books, their Indian counterparts had no such option.

Now, thanks to the new Companies Act, Indian investors have a way to file class-action suits. This is just one of the many proposals in the new law that empower minority shareholders.

Auditor accountability Remember the fictitious ₹5,500 crore cash in the Satyam balance sheet that went undetected?

Naturally, everyone wondered how the auditors missed such an obvious issue and questioned the audit process. After all, the audited report of companies is what investors, big and small, look into when making investment decisions. Even in unlisted companies, these reports are relied on by banks and other lenders. New rules have, therefore, been added to ensure that auditors are made more accountable to boost investor confidence.

For one, listed companies have to rotate their auditors and cannot engage with the same one beyond five years. And the audit firm has to be replaced after 10 consecutive years.

Wonder why it matters? About half of the BSE 500 companies were audited by the Big Four firms (PwC, KPMG, EY and Deloitte) and their subsidiaries, according to data from the Indian Institute of Corporate Affairs. The bulk of those who used other auditors were either public sector companies or banks.

So, having a new pair of eyes to inspect the books will help enhance audit quality.

Not just that, audit firms were also offering non-audit services such as taxation, payroll or internal audits to their clients.

It is easy enough to see that billing a company for a range of other services creates a conflict of interest and reduces auditor independence. The practice, in fact, seems quite prevalent — around 80 per cent of the BSE 500 companies in 2008 faced this conflicting situation, says a report by the National Stock Exchange.

Recall the most recent National Spot Exchange episode where the auditors ‘withdrew’ their audit report after the scam broke out. In the past, auditors had no obligation to blow the whistle on a company they audited, apart from the declarations in the annual report.

Now, detailed rules are set down for auditors to report fraud or omissions by the company. Auditors are required to report any irregularities they notice to the board or the audit committee. After a 45-day period for response, a report must be sent to the Central Government within 15 more days.

If the auditor fails to inform about the fraud, he may be penalised and fined up to ₹25 lakh.

Related party It is quite a common practice for Indian companies to sew up deals with group firms, promoters, relatives or the top management, to the detriment of minority shareholders.

Companies may hand out loans and guarantees to directors, managements or their relatives at low or zero interest rates. Or, as it happened in cases such as Fortis Healthcare and Gujarat NRE, they may buy a promoter-held company at a high valuation. All these come at the expense of the minority shareholders, who have no say.

The new rules require a special resolution to be passed by the Board when any arrangement is made with the related party.

A special resolution requires three-fourths of the votes to be in favour, whereas an ordinary resolution can be passed if the ‘yes’ votes are more than ‘no’ votes. Importantly, the persons interested in the transaction have been barred from voting, so that other shareholders can vote out any unfavourable proposal.

The Board’s report must also provide the details of such contracts, along with the justification.

Director’s role Closely allied with this issue are the ties between the directors and the promoters of companies. Quite often, executives give themselves hefty pay hikes in good as well as bad times, with no apparent linkage to performance. To the dismay of investors in Hindustan Construction Company, the Board of Directors voted to double the pay of its Managing Director Ajit Gulabchand to over ₹10 crore in June 2013.

The company was undergoing the corporate debt restructuring (CDR) process and reported losses totalling around ₹360 crore in 2011-12 and 2012-13.

Now, the rules require Central Government approval for key management personnel compensation in cases where the company does not have enough profits.

The new rules also define the term ‘independent director’ and require that listed companies have at least two independent directors on their Board.

Also, one director may be appointed by the small shareholders. The selection process, roles and expectations from the directors are given in detail and there are limits on the number of companies where one can be a director. Strict penalties will be imposed for non-compliance. For example, if a director or key management personnel engages in insider trading, they may be imprisoned for up to five years.

But what happens if the director refuses to play second fiddle to the promoters? In the past, many directors who noticed issues chose to resign and move on quietly. For instance, three of Satyam’s directors resigned before the accounting fraud came out into the open and no one was wiser about why they quit.

This may all change, as the new rule requires the directors to state the reasons for leaving and if they do not disclose issues, will be held liable for problems for the period when they were members of the Board.

Exit options In the past, while directors had quick exit options in a conflict, retail investors were stuck with bad deals.

Take the case of the investors in the IPO of pharmaceuticals manufacturer Brooks Laboratories in 2011. They thought that the company was raising ₹63 crore to set up a unit in Gujarat and to meet working capital needs. But the Board had passed resolutions for inter-corporate deposits and quietly siphoned off the IPO proceeds to other entities. Besides outright fraud, in many cases companies raising public money change the purposes for which the money is raised, or venture into new areas that they never mentioned in their prospectuses. Small investors who put in the money are often left in the lurch.

Now, if a company wants to deploy the offer proceeds in a project which it had not disclosed at the time of the share sale, it would need to be passed through a special resolution.

Dissenting shareholders will be given an exit opportunity at an adequate price.

Besides IPO, another common situation where minority shareholders ended up in a tight spot, referred to as ‘squeeze out’, was when a company wanted to reduce its share capital. In the past, no exit option was provided to those who dissented.

For instance, Elpro International, which makes electric surge arrestors, decided to reduce its share capital by 25 per cent by extinguishing shares. Only 112 of the 3,835 shareholders voted in favour of this move. However, due to many shareholders not voting, this turned out to be a majority vote.

The Bombay Stock Exchange objected saying that the price of ₹183 offered to the shareholders to sell their holdings, was too low. But the court ruled in favour of the company on the principle that a small dissenting section cannot hold up the decision of the remaining shareholders.

Shareholders now have a way to exit in such situations without a long-drawn battle and also get a fair price in the bargain.

The new rule requires that during delisting or capital reduction, minority shareholders must be given an offer, which would be a price determined by a registered valuer.

More monitoring But what good are elaborate rules when no one is checking whether companies abide by them or not? The ground reality in India is that the laws are quite elaborate, but there is no monitoring on compliance, or penal action in case of a breach.

The new rules are expected to give regulators more teeth in ensuring compliance through new agencies and stricter penalties.

The first forum a small investor can take his grievance to is the stakeholder relationship committee. To ensure better monitoring of accounting and auditing standards, a new body called the National Financial Reporting Authority (NFRA) will be set up.

While the full details are yet to be finalised, the NFRA is expected to have similar powers as a civil court in investigating and imposing penalties.

Related story: >Missing a few tricks

(Write to us: Have something to say about Portfolio? Write to us at >blportfolio@thehindu.co.in)

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