An article written in 2009 post publication of my book Corporate Disclosures 1553-2007
This is the time for questioning. After the disclosure of the self-confessed fraud in Satyam, almost every individual involved with the company has been questioned – the promoters, the Chief Financial Officer, the auditors and the independent directors. As the individuals are being probed, the sanctity of some of these roles itself surprisingly has not come under the scanner. In fact the popular belief holds more discerning individuals occupying the position of independent directors and auditors could have prevented this fraud. Could this be true?
While there is a professional body to qualify the auditors, govern their conduct and set auditing standards, the institution of independent Directors is not so well regulated. Given this it is worth examining how the concept of independent Directors evolved in the corporate world and will they stand the test of time.
The First Company
Muscovy Company or the Russian company is popularly acknowledged as the first Joint Stock Company in the world. Formed in the year 1553 in London, its had the monopoly to trade with Russia. This company defined three qualities required for Consuls, as the Directors were then called. To qualify as a Consul, an individual had to be ‘sad’, discreet and honest. As the shareholders were not directly connected with day to day management, the requirement of honesty from the Directors was to be expected and so too was discretion; as information is often a competitive advantage in business. But what was the objective behind specifying ‘sad’?
‘Sad’ as the word was understood in the 16th century meant satisfied. It is with great foresight that the drafters of the charter for the Russian Company placed sad as the first of the three qualifications for the Directors. Representing the interest of the absent shareholders in day to day decision making, Directors had to put their own interest on par or behind the interest of the shareholders. A satisfied appetite was surely a guarantee to ensure this. Like the rats’ plan to bell the cat, certain strategies are easier to articulate than to execute, and finding a ‘sad’ Director, ranks high up this list of strategies, easy to articulate, tough to execute.
The requirement to obtain Charters from the parliament to incorporate limited liability companies ensured that the number of companies did not proliferate in the 17th and the 18th centuries. It was only in the second half of the 19th century incorporation of limited liability companies by registration was permitted. Promoter driven, the primary requirement from Directors was their ability to contribute to furthering business interests. The needs of the absent shareholders were soon pushed to the background. It was only a large corporate fraud in 1938 in the United States of America that brought back the interest of the absent shareholders to the center stage and with it independent Directors.
Two Similar Frauds, Seventy Years Apart
The 1938 Boston fraud and the 2009 Hyderabad fraud have a minimum of four common features. Both the companies were listed in the NYSE, both were audited by Price Waterhouse, both were involved in multi-year frauds involving fictitious assets and to conclude both the companies were managed by siblings.
Looking at the differences, to start with, McKesson and Robbins, the Boston based pharmaceutical company was managed by four brothers, in contrast Satyam was managed by two brothers. While the Satyam fraud was self-confessed, the Boston police uncovered the massive fraud when they investigated the four brothers who were living under a false name. Investigation into the company revealed 20% of the assets reported in the balance sheet amounting to $18 million were missing. The brothers had created a fictitious International Division. The balance sheet of the company reflected nonexistent debtors of $9 million and missing inventory of about $10 million.
The brothers had fabricated invoices, advices, shipping and other documents using fake names. In addition they had created forged contracts, guarantees and credit reports. The quality of the façade they created is evident in the shipping documents that showed transport of goods from Canada to Australia by road.
The sensational nature of the fraud, combined with the high media coverage brought the credibility of the audit profession into limelight. This prompted SEC to investigate the event for identifying remedial action. The investigation found the audit done by Price Waterhouse was in line with the scope of work defined in their audit contract and the auditing standards of that time. But the audit scope was defined by executive directors, the brothers, which did not require the auditors to visit the branch offices. SEC found both, the then prevailing standard of auditing practices and the basis for defining audit scope inadequate.
Strengthening the auditing practices, SEC made it mandatory for Auditors to require obtaining confirmation of balances from Debtors and observing inventory verification process mandatory. Regarding auditor appointment and defining audit scope, through NYSE and Accounting Series Release 19 it was recommended that Auditors would be appointed only by a special committee of Non-Executive Directors, who would also define the scope of audit. This defined a role for the Non-Executive Directors.
The Birth of Independent Directors
Non-executive Directors soon evolved into Independent Directors; the impetus was to protect mutual fund investors in USA. The Investment Companies Act, 1940 that regulated mutual funds, limited the representation of affiliated parties in the Board of Directors to less than 60%. The balance 40% would be made up of ‘unaffiliated directors’. Explaining the need for unaffiliated Directors the act used the term independent for the first time with reference to Directors. While unaffiliated Director was not defined, the act defined an affiliated Director. Affiliated directors were investment advisors or officers or employees of the Mutual Fund. It was only in 1970 the term independent director was clearly defined.
The 1970 amendment to the Investment Companies Act, 1940, defined an interested person. An interested person was defined ‘to include persons who have close family or substantial financial or professional relationship with the investment companies, their investment advisors, principal underwriters, officers and employees.’ Anyone other than an interested person was an independent person, who was qualified to become an independent Director, a long journey to define a ‘sad’ Director.
After defining the independent director, the movement to accommodate them on the Board was not a smooth journey. It took more than twenty years and multiple corporate scandals across continents before independent Directors assumed majority vote in the boards of public limited companies.
Late 1960s and early 70s saw a spate of corporate scandals in the United Kingdom. This led to introspection among the industry and government to find solutions to improve the corporate governance practices. Comparative studies of corporate governance practices in continental Europe, where corporate scandals were less evident, formed part of the alternatives considered. The committee appointed by the Confederation of British Industries under the Chairmanship of Lord Watkinson recommend appointed of non-executive directors to the Corporate Boards.
The PRO NED Initiative
The Labor government had appointed a committee under the leadership of Lord Bullock to inquire into the system of industrial democracy. In their review they found in about 25%of the companies there was not a single non-executive director, and in 39% of the companies there was only one non-executive director. In response Lord Bullock recommended the ‘2x+y’ formula for board composition. This formula envisaged equal number of representatives from the shareholders and the employees and a smaller number of independent directors to break any deadlock. It is possible that the threat of mandated employee participation in the Corporate Boards prompted the formation of ‘Promotion of Non Executive Directors’ (PRO NED) initiative in 1982. The London Stock Exchange, Confederation of British Industries, the Bank of England, and other financial institutions jointed hands in the PRO NED initiative to push the door open for non-executive directors to enter the Boardroom.
The role of independent directors who form only a sub-set of Non-Executive Directors gained prominence as the Audit committee grew in importance. The landmark event was the recommendations of The Cadbury Committee in 1992, appointed on the back of a string of corporate scandals in UK involving among the other entities BCCI, the bank. The Cadbury Committee recommended the Audit Committees of the Board of Directors to have a minimum of three independent, non-executive directors. In theory, independent directors protect shareholders from management abuse. The experiences of the last two decades reveal independent directors in practice have not protected the shareholders from financial fraud, misappropriation and misreporting. The massive corporate scandals of the twenty-first century in the United States and Europe does indicate that we need to look beyond and supplement independent directors to enhance the quality of corporate governance. Is the alternative to be found in stakeholder representations on the Board that the PRO NED Initiative successfully avoided? Only time will tell. But I think we definitely need to look beyond the concept of Independent Directors.
