Download - 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.