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 25-102002 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.
imprisonment upto 20 years.
The penalty for such an offence is
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
inform
top
management about anything wrong observed by them in the company.
Companies
should
encourage
employees
to
directly
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 nonaudit 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
company and return for shareholders.
addition to