Cases of Corporate

Governance Failure

Definition of Corporate Governance

According to the Cadbury Committee Report,

“Corporate governance is the system by which business corporations are directed and controlled.

Board of Directors is responsible for the governance of their companies. The shareholders’ role in

governance is to appoint the directors and the auditors and to satisfy themselves that an

appropriate governance structure is in place.”

Need of corporate governance

The need for establishing good corporate governance practices by introduction of governance codes,

designing laws and regulations and reworking theories has been felt since last few years because of

the benefits associated with it. The important benefits which can be derived are mentioned below:

1) Safeguards the money of investors: Many investors all over the world have lost money in

primary as well as secondary markets due to inadequate financial and non-financial

disclosures by firms. Good corporate governance ensures transparency and adequate

disclosures which are necessary to make an informed decision by the investors and

safeguard their money from unscrupulous promoters.

2) Ensures success of the corporate: A corporation is a congregation of various stakeholders

such as employees, investors, customers, vendors, government and society at large. For the

growth and success of a corporate it is important that interests of various stakeholders do

not come in conflict. Good governance practices and transparent structures ensure

openness, integrity and accountability. In such situations decisions are taken to ensure a fair

deal to all stakeholders and, thus, the success of the entity.

3) Gives ease of access to cheap funds: good corporate governance procedures include putting

a check on insider trading, handling of investor grievances efficiently, disclosure of interest

by management in financial and non - financial deals and similar practices. Such practices

enhance the credibility of the entity and help to gain as well as maintain the confidence of

domestic and foreign investors and financial institutions, which provide long-term funds at

reasonable cost.

4) Lays foundation for good corporate citizenship: good corporate governance aims at

enhancing welfare of all the stakeholders and creating sustainable value for them and also

maintaining a balance between economic and social benefit. Adoption of these good

practices converts any entity for being a mere ‘corporate’ to a good ‘corporate citizen.’

5) Attaches global Perspective: In an era in which trade barriers have being progressively

removed and capital flows are crossing shores, good corporate governance is an important

consideration for foreign institutional investors and also for those who bring in foreign direct

investment. These inflows are very important for economic growth of any country.

Corporate governance has, thus, become a critical area of focus for various stakeholders

including government and market participants.

HARSHAD MEHTA SCAM

Background

In 1991, the Congress Government introduced a number of economic reforms. There was optimism

about Indian economic growth both within the country and among the developed nations of the

world. The Bombay Stock Exchange Sensitive Index (BSE Sensex) was rising tremendously. This rise

was attributed to the liberalization of Indian economy and the positive impact of opening of various

sectors of Indian economy

At that time, there was no system of online trading for either the government securities or the

corporate securities. The buying and selling of securities was undertaken through brokers. The

turnover in government securities market (which was inter-bank) was 3 to 4 times higher than

corporate securities market and the cost of funds in the former was substantially less than the latter.

This difference provided a possible arbitrage opportunity. Moreover, banks were not allowed to

invest in capital market directly and hence, they required brokers to carry out their capital market

operations.

Description of the crisis

Harshad Mehta, along with some other brokers, devised a modus operandi to entice banks to

provide him funds to invest in capital market in return for a reasonable amount of profit. Banks

profitability at that time was impacted due to RBI's tight credit policy and they were in a rush to

make some quick profits.

1) Harshad Mehta used ready forward deals of banks to embezzle funds secretly. Under ready

forward deal, banks used to buy and sell securities for very short duration (16 days) through

brokers the buying bank used to transfer money to brokers' account to enable him to get

securities for it. These funds were diverted by Harshad Mehta temporarily to capital market

to rig the prices of select securities, sell it at when price becomes high and pocket the

difference. A part of profit was given to bank too.

2) Another instrument used to misappropriate funds was through use of fake bank receipts. A

bank receipt is an acknowledgement issued by the bank selling securities to the bank which

has bought securities. No physical transfer of government securities is undertaken. Bank

Receipt is a confirmation of the sale. Mehta used fake bank receipts issued by Bank of Karad

and the Mumbai Mercantile Cooperative Bank to raise money from banks and divert it to

capital markets. This led to a major jump in the BSE Sensex.

3) Sucheta Dalal, an investigative financial journalist, exposed the securities scam through her

column in Times of India newspaper.

Aftermath

1) After the exposure of securities scam, the banks started demanding their money back and

the BSE Sensex dipped. Many investors lost their savings. The Janakiraman Committee

Report of RBI estimated that the scam wiped off 4025 crore rupees from the Indian capital

markets

2) Criminal as well as civil cases were filed against Harshad Mehta and his associates.

KINGFISHER AIRLINES

Background

Kingfisher Airlines (KFA) was started its operations in 2005. It was a wholly owned subsidiary of

United Breweries Limited. The UB group flamboyant chairman Vijay Mallya tried to redefine the

entire experience of flying by introducing many first-time services for its passengers such as in-flight

entertainment system, exquisite cuisine and lavish airport lounges. The air fares were kept very

competitive and were not sufficient to cover the high cost being incurred per passenger. KFA

acquired Air Deccan, a low-cost airline in 2007 and also acquired Air Deccan's international flying

rights. Mallya started international flight services in 2008.

Description of crisis

1. Mallya mantra was fast track growth for his airline. KFA became a full-service airline, low

cost carrier and was operating on international routes within less than four years of its

operation

2. Expansion was not financed through revenues but loans from banks. Ever since the airline

commenced operations in 2005, it had been reporting losses. After acquiring Air Deccan,

Kingfisher suffered a loss of over 1,000 crore for three consecutive years

3. The expected growth did not come. In domestic market no-frill carrier competitors gave a

tough fight to KFA

4. Global melt down, high ATF prices and the merger of two thinly capitalized entities resulted

in huge debt burden. In 2011, KFA acknowledged its cash flow problems for the first time

and in January 2012, State Bank of India, its largest creditor declared the loan to KFA as a

non-performing asset.

5. Employees went on a strike for non- payment of salaries and aviation regulator the

Directorate General of Civil Aviation-suspended its flying license in October 2012 after KFA

failed to address the Indian regulator's concerns about its operations. Fuel dues and Aircraft

lease rental dues were not paid

6. Court cases were filed by employees, creditors and tax authorities against KFA.

7. In February 2016, the State Bank of India (SBI)-led consortium of seventeen lender banks

moved the debt recovery tribunal (DRT) to attach defunct carrier Kingfisher Airlines

promoter Vijay Mallya's passport but he left India on March 2, 2016 before this could

happen

Major Governance Issues

Now defunct Kingfisher airline is a perfect case of corporate governance failure Some of the key

problems in its corporate governance were:

1. BOD failed in its fiduciary duty: The board of directors was constituted to meet the legal

requirements but was dominated by the Chairman and Managing Director Mallya. It failed to

give a strategic direction to KFA and failed in its duty of cure

2. Unethical conduct: Mallya had no experience of running an airline He did not involve

professionals to run the company as he did not want to dilute his control. He lavishly spent

money on Formula one team, owning IPL team and sponsoring soccer teams. Mallya was

known as King of Good Times For his flamboyant lifestyle. To fulfil his ambition of beating

the competition, he made strategic errors. His move to buy a stake in Air Deccan surprised

many industry experts" as both these airlines were operating at different ends of the

spectrum, KFA with differentiation strategy and Air Deccan with cast leadership strategy.”

3. No heed was paid to audit abjections: The management and Audit Committee did not pay

attention to audit objections raised by auditors in September 2011. The auditors, B.K

Ramadhyani & Co., had raised questions on accounting method used by the airline to

calculate costs incurred on maintenance and repairs of aircraft. According to them it was not

in accordance with generally accepted accounting standards prevalent in India.

4. Executive compensation: Kingfisher employees were probably much better paid as per

industry norms. As per a report, (which appeared in India Today) KFA's CEO Sanjay Agarwal

was second-highest paid among all his peers at Vijay Mallya-led UB Group and among the

country's three listed airlines also, Kingfisher CEO Sanjay Agarwal's pay package was the

second highest in the fiscal ended March 31, 2012, as per the remuneration details provided

in their annual reports despite the fact that the airline was facing rough weather.

Aftermath

The CEO of KFA resigned in February 2014. Mallya was arrested in London on April 18, 2017.But has

been granted bail. His extradition hearing has been fixed for June 13, 2017.

SATYAM SCAM

Background

Satyam Computer Services Limited, an IT services company based out of Hyderabad, India, was

incorporated in 1987. It was listed on BSE and NSE. It was India's fourth largest outsourcer. In 2008

Satyam's revenues crossed $2 billion. In 2009, World Bank barred Satyam from doing any business

with it on the grounds of data theft and bribery to staff. Later in the year, the company decided to

buy-out Maytas Infra- a company owned by then promoter Chairman, B. Ramalinga Raju's sons. But

the deal could not get approval of board members and investors. Satyam's shares plunged to a

record low. Raju resigned and confessed to Rs7000 crore accounting fraud resulting in

overstatement of profits and window dressing by inclusion of fictitious assets in balance sheet

Description of Crisis

1. The con game might have started in April 2002, when Satyam issued ADRS to lure foreign

investors.

2. SCSL's chairman Raju used to maintain two sub-accounts under a single bank account which

was in the name of company. The main bank account was maintained by Raju and his

confidants. They used to get two set of statements and genuine set was kept by them. The

finance team was given the other statements by the promoter himself

3. Fake invoices, in the name of genuine clients but with an overstated amount, were

generated by using in-house software

4. Non-existent/fictitious cash and bank balance was shown in the balance sheet through fake

fixed deposits. The accounts department used to accept the FD receipts given by Raju and

his team and it never verified the cash at bank directly with bank.

5. Publication of fudged accounts for many years led to substantial increase in stock price of

the company and promoters sold some of their shares at these high prices. Thus, cheating

the innocent investors.

6. A web of more than 350 companies of the group was used to divert funds from Satyam.

7. Raju told the investigators that by selling Maytas Infrastructure and Maytas Properties to

Satyam for an estimated 7800 crores, he tried to replace fictitious assets with real ones. But

the proposal fell through and Raju resigned.

Major Governance Issues

Few months before the Satyam Scam broke out, the World Council for Corporate Governance chose

Satyam for prestigious "Golden Peacock Award for Excellence in Corporate Governance". It is

certainly a strange paradox. After the scam broke out multiple flaws in corporate governance came

to light. Some of these are:

1. BOD failed in its fiduciary duty: Satyam's BOD never questioned Raju on murky group

investments. Though there were six non-executive directors on the BOD, they failed to check

Raju's misdeeds.

2. Dubious role of auditors: The auditors were paid very high audit fee as compared to other

auditors by the companies in the same industry? They skipped basic audit procedures like

confirming bank balances independently, proper vouching of invoices and even debtors'

contraptions were not obtained. PWC failed in their duty as an auditor

3. Concentration of power in the hands of Chairman: Raju was responsible for maintaining

complete details of Satyam's accounts and minutes of Board's meeting since 2002. He

himself handed over the bank statements to accountants and auditors. Concentration of

power in Chairman's handled to revenues, operating profits, interest, liabilities and cash

balances being grossly inflated to show company in good health.

4. Unethical conduct: The promoters incorporated more than 350 companies. There were

several transactions in the form of inter-corporate loans and investments within group

companies. They connived with some top executives and auditors to misrepresent facts and

present manipulated accounts to shareholders, BOD, stock exchanges, investors, bankers

and other stakeholders. Raju and other promoters got involved in insider trading.

Investigators also came across evidence of inclusion of fake employees, the actual number

of employees was found to be 40,000 against 53,000 claimed by SCSL. Raju had been alleged

withdrawing an amount of Rs 20 crores every month for paying salaries to these 13,000 non-

existent, fictitious employees.

Aftermath

1. In April 2009, 46% stake in Satyam was purchased by Tech Mahindra and both the

companies legally merged in June 2013,

2. The consequences were faced by wrongdoers and Indian Government acted proactively to

protect the interests of investors and reputation of IT companies.

3. In 2016, Raju and his associates were sentenced to seven years of imprisonment by the

court as they were found guilty of window dressing of accounts.

4. Price Waterhouse Coopers, auditors of SCSL were fined $ 6 million by the SEC, US for

professional misconduct. The Disciplinary Committee of ICAI found the four auditors of PWC,

who audited Satyam's accounts, guilty of gross negligence in discharge of their duties. They

have been debarred from practicing as Chartered Accountants.

5. The Indian Government and SEBI have taken a slew of measures to improve corporate

governance standards in India

COMMON GOVERNANCE PROBLEMS NOTICED IN CORPORATE

FAILURES

CRISIL has analysed the reasons of corporate failures. Its analysis has revealed that they are largely

attributable to shortcomings in corporate governance practices. The broad areas of failure are:

➢ Accounting frauds carried out in collusion with statutory auditors.

➢ Lack of independence of the board with board members having significant financial linkages

with the companies.

➢ Insider trading.

➢ Disproportionate compensation paid to executive board members and senior management.

➢ Fiduciary failure by the board to exercise care and diligence in approving proposals, even

though all the information was provided by the management.

➢ Weak internal control mechanisms and lack of supervision.

This governance issues are common to corporate failures whether in India or anywhere else in the

world. Regulations are evolving to address them.