In 2001, the Enron collapse was a seminal moment in the financial world, highlighting the importance of accounting and corporate governance.
In another case (Enron), the board and its audit committee even included a highly respected auditing expert – a longtime college professor and textbook author – as well as other prominent individuals. Here too, the “honor” of service on the board of a top corporation (according to the famed Fortune 500 listing, the seventh largest shortly before massive fraud was uncovered) dazzled those directors, and this, coupled with the apparent skills of, and aura of mystique attributed to, the company’s top management, served to mesmerize those board members so that they totally abdicated their duties.
Governance failures don’t evolve overnight, and there are several warning signs that need to be noted in order to avoid such failures. These often are found to include:
- Ineffective governance mechanisms – for example, lack of board committees or committees consisting of few or a single member.
- Non-independent board and audit committee members – for example where a CEO fulfilled multiple roles in various committees.
- Management that deliberately undermines the role of the various governance structures by circumventing the internal controls and making misrepresentations to auditors and the board.
- Inadequately qualified members – for example, audit committee members not having appropriate accounting and financial reporting qualifications or experience to analyze key business transactions, family members holding board positions without appropriate knowledge or qualifications.
- Ignorance or inattention by regulators, auditors, analysts, etc., to the financial results and red flags.
In some jurisdictions legislation has been enacted, such as the Sarbanes-Oxley Act of 2002 in the U.S., which has been designed to prevent governance failures by increasing the exposure of errant directors to civil and even criminal liability. For example, in the U.S., board members must obtain so-called “certifications” from the CEO and CFO regarding the absence of fraud and the effectiveness of internal controls over financial reporting functions. These requirements largely rely on an interesting psychological phenomenon: that many would-be criminals will hesitate when asked to formally acknowledge their probity, even as they demonstrate little aversion to spoken falsehoods to board members, auditors and even government overseers.
The widely-reported US$1.47 billion failure of Indian computer services giant Satyam in 2009 is one example of a large-scale, long-running financial reporting fraud (and asset theft) that implicated not only audit failure, by renowned international firm PwC, but also gross neglect of duty by the board of directors.
Satyam (ironically, the Sanskrit word for “truth”) had been cited as an example of India’s growing business sophistication and success. The company had even won numerous awards for innovation, governance, and corporate accountability. In 2007, accountants Ernst & Young had named Satyam CEO Raju the “Entrepreneur of the Year,” and in 2008, MZ Consults cited Satyam for being a leader in India in terms of corporate governance and accountability. Later in 2008 the World Council for Corporate Governance awarded Satyam the Global Peacock Award for global excellence in corporate accountability. Less than five months later, Satyam was revealed to have perpetrated a massive multi-year accounting fraud.
Satyam was found to have violated many fundamental rules of corporate governance, including: not distinguishing the roles of board and management; failed separation of the roles of the CEO and chairman; weak appointments to the board; excessive directors’ and executives’ compensation; and inadequate protection of shareholders rights. In reaction to the revelations in 2009, legislation and regulations in India were enacted and adopted to, inter alia, alter procedures for the appointment of independent directors, enhance certain disclosures such as of pledged securities, require adoption of IFRS (although, as is the case in most frauds, the fault was not associated with which financial reporting standards were used, but rather in the proper adherence to any such standards), and the creation of a new corporate code by the Indian Ministry of Corporate Affairs.
In the author’s experience, and consistent with the observation that “hindsight is 20-20 vision,” most frauds, once revealed, are indeed found to have been rather obvious, and should have been readily uncovered, if not actually prevented, by properly functioning mechanisms of corporate governance. For example, for many of the headline cases (Enron, WorldCom, and Parmalat — all of which were personally studied by the author — and Satyam, Olympus and Toshiba, among many others), transactions and/or account balances that strained credulity should have been challenged by board members, which would have surely truncated the fraud and resulted in management changes.