Tuesday, 7 February 2012

Development in Corporate Governance After Satyam Scam


The Satyam scandal has shocked India. It is being called India's Enron. Many in the financial circles are dismayed that the biggest-ever corporate fraud in the country could have escaped unnoticed for so many years. It has brought into question the levels of corporate governance in the country, and has cast an ugly shadow on the once shining image of Indian industry overseas. The National Stock Exchange has excluded Satyam, which has received several prominent awards for corporate governance in the past India has seen corporate scandals in the past, but never one of this magnitude. A software company, touted as a success story, the 4th largest software company in India and one that services around 1/3rd of the Fortune 500 companies, the events of the past one month have been a total shock. They have called into question the entire range of issues related to ethics, corporate governance, fiduciary responsibilities, professional auditing, and so on. 

The Satyam scandal highlights the importance of securities laws and corporate governance in emerging markets. Mounting evidence suggests that weak corporate governance slows economic development. There is a broad consensus that emerging market countries must strive to create a regulatory environment in their securities markets that fosters effective corporate governance. India has managed its transition into a global economy well, and although it suffers from corporate governance issues, it is not alone as both developed countries and emerging countries experience accounting and corporate governance scandals.


Corporate governance is important for economic development. Research shows that the ratio of stock market capitalization to GDP in countries that rank in the highest quartile for corporate governance is four times higher than stock markets that rank in the lowest quartile for corporate governance. Poor corporate governance significantly hampers the ability of businesses to raise capital and impedes economic growth. Effective corporate governance provides for more efficient allocation of resources, as the return on assets in countries with the highest levels of corporate governance is double that of the return on assets in countries with the lowest levels of corporate governance. India has been proactive throughout its past 20 years of economic liberalization in bringing regulations to help foster effective corporate governance that contributed to its economic growth.

India immediately portrayed the Satyam scandal as an aberration to try to salvage the remaining confidence in its capital markets. Several commentators, however, claimed that the scandal was not an aberration, but a sign of governance issues in India. 


After the Satyam scandal, investors and regulators called for strengthening the regulatory environment in the securities markets. In response to the scandal, the SEBI revised corporate governance requirements as well as financial reporting requirements for publicly traded corporations listed in the country. The SEBI also strengthened its commitment to the adoption of International Financial Accounting Reporting Standards. In addition, the Ministry of Corporate Affairs is devising a new Corporate Code and is considering changing the securities laws to make it easier for shareholders to bring class action lawsuits.

1. Governance Reform – Independent Directors

The Satyam scandal reinforced the Indian regulators' commitment to continue the process of corporate governance reform. Even before the Satyam scandal broke, India was in the process of updating its 1956 Companies Act, which sets out key Indian corporate governance rules. The SEBI is considering several proposals ranging from mandating increased due diligence on transactions to increasing personal liability of board members. If reform continues on its current course, reform within the 1956 Companies Act will make it easier for shareholders to sue officers and directors of corporations. The SEBI is also considering making publicly listed companies carry director and officer liability insurance to protect shareholders from damages. Additionally, the SEBI proposed creating a law that provides whistleblowers with protection for reporting fraudulent activity. Finally, the SEBI revised takeover regulations to increase disclosure in takeovers.

2. Disclosure of Pledged Securities

After Satyam, the SEBI increased disclosure obligations of promoters and controlling shareholders. Before the Satyam scandal, promoters[2]and controlling shareholders were not required to disclose to investors if they had pledged their stock. Pledging stock is the process whereby a person offers his or her stock to a bank or other institution as collateral for a loan. The problem with a controlling shareholder pledging stock is that once the stock drops below a certain level, the drop will trigger a margin call. After receiving a margin call, the person who pledged the stock must provide additional collateral. If the person cannot provide additional collateral, the lender will liquidate the stock that the person posted as collateral, potentially causing a significant decline in a company's stock price. This hurts minority shareholders who are unaware that the controlling shareholder had pledged his or her stock. Two weeks after Satyam's collapse, the SEBI made it mandatory for controlling shareholders to disclose any share pledges.

3. Increased Financial Accounting Disclosures

The SEBI also recently proposed requiring companies to disclose their balance sheet positions twice a year. Pre-Satyam, the regulations only required disclosure of balance sheet positions once a year. The increased reporting of companies' balance sheets will provide investors with more information on the stability of a company's financial position. The increased reporting requirements of balance sheets will probably eventually lead to the requirement that companies provide a statement of cash flow in its biannual reports as well. Increasing both the frequency and detail of disclosure will help provide for a more robust market check—e.g. investors will be able to police companies better and pay more attention to accounting irregularities. For example, increased frequency of disclosure of Satyam's balance sheet could have led to an investor discovering, and pressing the board to investigate, the claimed large cash deposits in non-interest bearing accounts more quickly.

4. IFRS (Adoption of International Standards)

Satyam strengthened India's commitment to adopting International Financial Reporting Standards ("IFRS") by 2011. Currently, Indian Generally Accepted Accounting Practices and the IFRS differ significantly. Globally, more and more countries are moving towards IFRS, as currently more than 100 countries require, permit, or are converting to IFRS. Adopting IFRS will facilitate investor comparisons of financial performance across country lines and will increase confidence in the accounting numbers.

5. Creation of New Corporate Code - Ministry of Corporate Affairs

In addition to the new SEBI regulatory requirements, the Indian Ministry of Corporate Affairs is drafting a new corporate code for Indian publicly listed companies. Adherence to the Code will be voluntary; however, every company that deviates from the code's requirements must disclose the deviations to the ministry. The Ministry of Corporate Affairs anticipates that the new code will impose more stringent disclosure obligations than the SEBI currently requires.
The Ministry of Corporate Affairs recently proposed a new law that would make it easier for Indian investors to form class action lawsuits against fraudulent actors in the company. Indian Corporate Affairs Minister, Salman Khushid, stated that he envisioned drafting the law to provide investors with a claim similar to the shareholder derivative suit[3] that U.S. law permits. Indian law currently creates obstacles to investors filing class action lawsuits. The Ministry of Corporate Affairs hopes that this new law will provide Indian citizens with the confidence to invest in the financial markets.

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