Corporate Excellence and Accountability Under the Sarbanes Oxley Act, 2002 Lessons for India
CORPORATE EXCELLENCE AND ACCOUNTABILITY UNDER THE SARBANES – OXLEY ACT, 2002 — LESSONS FOR INDIA
NARESH KUMAR*
INTRODUCTION
In the United States (US) the Sarbanes-Oxley Act, 2002 (Act) came into force the wake of collapse of corporate giants like Enron, Tyco, Quest, Global Crossings and WorldCom and the Xerox fiasco. In almost all the cases, reasons of the fall of multinational corporations (MNCs) were accounting manipulations, failure on the part of auditors like Arthur and Anderson and dereliction of duties by the Board of Directors. The thrust of corporate India has also been to prevent malpractices and shape corporate governance best practices to restore the confidence of investors. To accomplish these objectives, the Companies (Amendment) Bill, 2003, (Bill) based on the recommendations of Naresh Chandra Committee on corporate audit and governance has been placed in the Parliament. On the first anniversary of the Act, an attempt is made to (i) analyse the salient features of the Act; (ii) appraise the effectiveness of the Act in improving corporate governance and preventing malpractices; and (iii) make suggestions for the Indian corporate sector in the light of the lessons learnt for corporate excellence and professional accountability.
THE SARBANES-OXLEY ACT, 2002
Senator Paul Sarbanes, a Maryland Democrat and Rep. Michael Oxley, an Ohio Republican drafted the Act. President George W. Bush while signing the Act on July 30, 2002, proudly described it as “the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt when the Securities Exchange Commission (SEC) was constituted in 1930s”. The main object of the Act is to restore the confidence of investors by providing for effective corporate governance and preventing corporate frauds and misfeasance in companies. The Act provides for improvement in quality and transparency in financial reporting, independent audit and accounting service for the listed companies and increased corporate responsibility.
ANALYSIS
An analysis of the Act indicates the following salient features:
Corporate and Criminal Accountability Act, 2002
The Corporate and Criminal Accountability Act, 2002, has been strengthened by amending the Federal criminal law to impose stringent criminal penalties for: (1) knowingly destroying, altering, concealing, or falsifying records with intent to obstruct or influence either a federal investigation or a matter in bankruptcy; and (2) auditor failure to maintain for a five year period all audit or review documents pertaining to an issuer of securities.
White-Collar Crime Penalty Enhancement Act, 2002
The White-Collar Crime Penalty Enhancement Act, 2002, has been strengthened by amending the Federal criminal law to: (a) establish criminal penalties for attempt and conspiracy to commit criminal fraud offences; and (b) increase criminal penalties for mail and wire fraud. The provisions have been made more stringent to establish a maximum 20 years prison term for tampering with a record or otherwise impending an official proceeding.
*Advocate, Business Laws, M.B.L., LL.B., M.A. Eco., FCS, FICA
Securities Exchange Commission
The SEC has been authorized to sanction funds for:
(i)Additional Staff compensation;
(ii)Enhanced Oversight of Auditors and Audit Services; and
(iii)Additional professional staff for fraud prevention, risk management, market regulations, and investment management.
The Act creates a new SEC cause of action against anyone who is found to have attempted to fraudulently influence or mislead an outside auditor – even if the financial statements are not affected by the attempt. A fraud conviction relating to the purchase or sale of stock can carry imprisonment up to 25 years.
Financial Analysts’ Conflict of Interest
The Act requires that Wall Street analysts must adhere to more rigorous real-time disclosure requirements. Their liability exposure for defaults has increased dramatically.
The SEC has to frame rules for (a) restricting the pre-publication of research reports by persons who are either engaged in investment banking activities or not directly responsible for investment research; (b) limiting the supervision and evaluation of securities analyst to officials who are not engaged in investment banking activities; (c) prohibiting a broker or dealer involved with investment banking activities from retaliating to avoid conflict of interest between the investment banking relationship of the broker or dealer with the subject of the research report; and (d) directing the SEC to adopt rules requiring securities analysts, broker and dealers to disclose specified conflicts of interest.
Enhanced Financial Disclosure
The listed companies are required to provide higher degree of financial disclosures in their financial reports to be filed with the SEC. The report has to reflect all material adjustments that have been identified by an accounting firm in accordance with the SEC Rules and Generally Accepted Accounting Principles (GAAP). The material information includes anything that may be of interest to an investor for buying, selling or holding a company’s stock.
Public Company Accounting Oversight Board
The Public Company Accounting Oversight Board has been constituted on 25-10-2002 for framing rules and adopting standards on auditing, quality controls and ethics. The Board is to (i) oversee the audit of public companies that are subject to the securities laws; (ii) establish audit report standards and rules; and (iii) inspect, investigate, and enforce compliance on the registered public accounting firms, their associates and certified public accountants.
Auditors’ Independence
The Securities Exchange Act, 1934, has been amended to ensure independence of auditors and prohibit them from performing specified non-audit services along with audit assignment. Moreover, the new provisions require prior approval for performing non-audit services that are not expressly forbidden by the Act.
Personal Accountability of CEO and CFO
It has been made mandatory for the Chief Executive Officer (CEO) and the Chief Finance Officer (CFO) of a company to certify that: (a) the periodic reports filed with the SEC are materially correct; (b) the financial disclosures ‘fairly represent’ the company’s operations financial conditions, and (c); they are responsible for evaluating and maintaining adequate internal controls. The penalty in case of false or improper certification ranges from US$ 1 million to US$ 5 million or imprisonment up to ten years or both.
Role of Board and Audit Committee
The thrust is on creation of truly independent board of directors, with wide powers to control the three major functions – audit, compensation and nomination.
The Board has to design and evolve controls for ensuring that the report containing the information related to the issuer and its consolidated subsidiaries is submitted to the statutory authorities within stipulated time. The report has to mention Board’s assessment about the effectiveness of internal controls for financial reporting.
Executive compensation is to be designed to link pay with long-term corporate operating performance. Companies should avoid re-pricing stock options and encourage senior executives to have longer holding periods for executive stock. The long-term ownership of stock promotes sense of ownership and belonging to the company.
The compensation to the CEO has to be approved by a majority of independent directors. Shareholders must approve all stock options grants and incentive compensation.
The Board is required to have a three-tier evaluation process – of the board as a whole, committees and individual directors. The Board is also responsible for evolving and putting into practice corporate ethics in an effective manner.
The Act assigns an important role to the audit committee for reestablishing the credibility of the reporting system. The idea is to make the Audit Committee an independent and knowledgeable body, free from vested interests and not a limb of the Board.
The Audit Committee has been made responsible for compensation and oversight of any registered public accounting firm employed to perform auditor services. A member of an Audit Committee has to be a member of the Board of Directors, but otherwise independent. The term ‘independent’ means that the director should receive no consultancy, advisory or other compensatory fee. The Audit Committee must have at least one financial expert.
The Audit Committee has the right to engage independent counsels and other advisors to carry out its duties and is required to establish a mechanism for employee and investor complaints on questionable accounting or auditing matters.
The compliance officer is required to disclose in his certificate the conclusions reached after discussion with the Audit Committee on all critical accounting policies and practices and alternative treatments of financial information.
APPRAISAL
The Act has brought about a sea change in the way boards and managements perceive their roles and functions. The following corporate governance reforms and practices have significantly improved investors’ confidence and market sentiments:
Securities and Exchange Commission
The SEC has sharpened the rules of the game demanding greater disclosure and accountability on the part of board of directors. The new Chairman Harvey Pitt with William Donaldson made the functioning of the SEC more efficient.
White - Collar Crime Penalty Enhancement Act, 2002
The White-Collar Crime Penalty Enhancement Act, 2002 has included new offences like deliberate alterations, destruction, falsification of documents which intend to impede, obstruct etc., the investigation. The penalty for such an offence is imprisonment upto 20 years.
Proactive Judiciary
There is a major shift in the thinking of the Delaware Courts, which have redefined the fiduciary duties of care and diligence by directors. The Chancery and Supreme Courts of Delaware have imparted spirit to the latter of corporate governance. In the wake of corporate scandals and malfeasance, the burden of proof is shifting to management to prove it is acting accordingly to the accepted standards of corporate governance. The Courts have asserted that the boards of directors must ensure that management is acting in the best interest of the company and investors, otherwise they come to the Courts without the benefit of clean hands. The judgments of the Courts are followed as global best corporate practices.
The Courts have not hesitated in exercising extra-territorial jurisdiction to protect the interest of investors. The foreign companies whose securities are listed and traded in the US come under the long arm of Delaware law. The fact that class actions are proliferating and investors reinforce this and joining together globally to form classes to sue for recovery of damages in cases where management of companies has defrauded investors.
Institutional Investors
The Institutional Investors have also played the role of catalyst for change in corporate governance. The investors like the California Public Employees Retirement System have given the lead, but other global investors like Herms in the UK and Standard Life Assurance in Scotland have also joined in their activist demand. The principal concern of these investors is the protection of minority shareholders’ rights. Whenever the dominant management or promoters act against the interest of small shareholders, there is a much more coordinated global shareholder resistance. The joint pressure from the institutional and global investors is proving quite effective in pressing their demands upon the boards of companies.
Public Company Accounting Oversight Board
The Public Company Accounting Oversight Board is proving a tough taskmaster for auditors. It ensures that the audit is more precise on risk factors and has come down heavily on oversight of auditors and quadrupled jail time for fraud. There is a new trend on maintaining strict professional relationship between the auditors and companies.
Personal Accountability of CEO and CFO
The certification and signing of undertakings by the Chief Executive Officer (CEO) and Chief Finance Officer (CFO) of the company now ensure greater accountability for the accuracy of financial statements of the company and its subsidiaries.
Role of Board and Audit Committee
The Board and Audit Committee now comprise of substantial majority of independent directors. The board is grappling with greater responsibilities of overseeing the policies and practices of management. The independent directors are involved more in the strategic direction of the company and in evaluating its enterprise risk.
The Nomination Committee, composed entirely of independent directors, plays an important role in search for new directors. The Audit Committees, also composed entirely of independent directors, are responsible for recommending compensation for auditors and consultants to shareholders for approval. There is greater independence of the Audit Committee from the board.
Whistle Blowing System
There is apparent trend of preventing economic crimes by encouraging “whistle blowing system” by Multinational Companies (MNCs). They are providing a forum for employees to report what they reasonably believe is a federal securities violation. Companies like Johnson & Johnson, Heinz, General Electricals, Bayer, Xerox, Castrol, Citibank have put in place a system and process to report any irregularity by any employee direct to the Board of Directors. Employees can report irregularities in the company by using a hotline or toll-free number from any part of the organization, which will help the board or an ombudsperson take up the matter. On reported, the Board considers cases and appropriate action is taken. Employees are encouraged to come forward and blow whistle. In some companies complaints and concerns are received and processed by the Corporate Ombudsperson’s Office. Some of the companies have set up a hotline with external agency to which any employee can call and report any accounting irregularities. The backbone of the system is ensuring confidentiality and protection of the employee who discloses information or assist in detecting and stopping fraud. Consequently, corporate malfeasance reports no longer hit the headlines.
Code of Ethics
Reputed companies have their codes of ethics and social responsibilities and provide detailed information of discharging responsibilities as good citizens. The reforms in corporate functioning recommended by the Conference Boards’ prestigious Commission on Public Trust and Private Enterprise have become norms. Groups such as the International Corporate Governance Network (ICGN), which met in Amsterdam, representing more than US$ 10 trillion assets, are pressing companies to be more accountable to society.
SUGGESTIONS
It is suggested that in the light of the experience of the Act in the US, following reforms should be introduced in India for achieving corporate excellence and accountability:
1.Enactment of laws on the pattern of the Corporate and Criminal Accountability Act, 2002 and White Collar Crime Penalty Enhancement Act, 2002 for investigation and prosecution white collar corporate crimes.
2.The judiciary should play a proactive role for speedy trial of corporate frauds and award deterrent punishment to unscrupulous management found guilty of corporate offences.
3.The liability of directors under the Companies Act for their non-compliance of statutory provisions and fraudulent practices should be strict as that of an ‘occupier’ under the Factories Act. The listing agreements with stock exchanges should also provide for strict penalty in case of misstatement or false information in quarterly reports.
4.The institutional investors should effectively discharge their responsibility in protecting the interests of small investors by bringing in class action.
5.The independent character and role of the Audit Committee under Companies Act and Listing Requirement need to be strengthened. The practice of the boards of family managed companies appointing their friends as non-executive directors should be stopped because the decision whether a director is independent or not is left to the Board of Directors.
6.Warning system like ‘whistle blowing’ can be an effective anti-corruption tool. Indian Companies should encourage employees to directly inform top management about anything wrong observed by them in the company. On reported, a committee of officers and workers, including women representatives, should look into cases and grievances.
7.Strengthening the independence of auditors and segregation of audit and non-audit practices. Management of a company should be prohibited from influencing auditors in discharge of their duties. At the same time, only those auditors having arm’s length relationship with the board of companies should be appointed as auditors and they should be prohibited from providing non-audit and tax audit services.
8.There should be greater self-discipline and emphasis on codes of ethics and social responsibilities on the part of companies. In the ultimate analysis the society has created business institution for its welfare and it has to discharge its duties and responsibilities as good corporate citizens.
CONCLUSION
The Act is becoming a global benchmark for internal best practices in corporate governance. It has prompted companies to take a fresh look at the system of disclosure, internal controls and accountability. Listed companies, including foreign issuers, now have much greater disclosure in financial reporting, audit committee independence and internal control. There is general consensus that the Act has strengthened good practices in corporate governance. At the same time, the interpreting and enforcing agencies of the Act have become strict in their functions.
It is high time for the Indian corporate sector to draw lessons from the experience of the functioning of the Act in US in order to cope up with the ongoing global reforms in corporate sector, regulatory framework and governance practices. A good beginning has been made by introducing the Companies (Amendment) Bill, 2003, containing significant provisions for greater disclosure and responsibility of the board of directors. The Securities and Exchange Board of India has also been given more powers to investigate and prosecute wrong doers and offenders for their misdeeds and crimes in the securities market. It is also heartening that reputed Indian companies like Infosys and Wipro have already taken a lead in promoting standards of openness, transparency and accountability in corporate affairs. In line with ‘whistle blowing’, employees are encouraged to raise concerns about any malpractice, impropriety or wrongdoing without any fear of victimization so that it can be nipped in the bud. At the same time, the interests of employees informing malpractices are protected and safeguarded. Indian companies are understanding that adoption of global best practices will require massive change in the way members of boards are chosen and their functioning. Obviously, better corporate governance is imperative for higher economic value addition to company and return for shareholders.