Context
Instances of financial/ accounting frauds and serious corporate governance failures have become endemic in today’s corporate world, leading to huge erosion in shareholder wealth. On most occasions, such irregularities and failures are detected very late, when it becomes impossible to rewind the clock and undo damage that has already been done. Recent cases of financial/ accounting irregularities have demonstrated that several early warning signals (like disclosures made in the ‘notes’ to the financial statements) are often not recognised by the Board of Directors (“Board”) and other gatekeepers of governance – thereby raising serious questions regarding their effectiveness.
Despite the visible shift from ‘principles-based regulations’ to ‘prescriptive regulations’, where the oversight responsibilities of the Board and the other gatekeepers of governance are clearly spelt out in ‘black and white’, such early warning signals continue to get brushed aside. While the regulations are significantly tightened after every corporate scandal, they consistently prove to be inadequate in preventing new financial/ accounting frauds from being uncovered.
The clear shift to a disclosure-based regime (keeping in mind the principle that ‘sunlight is the best disinfectant’) has not been an effective deterrent either. The question that arises is what are the factors that hinder a Board’s effectiveness in identifying early warning signals and picking up sub-sonic sounds? It is critical to bear in mind that the efficacy of any set of regulations, howsoever well-drafted and prescriptive, hinges on the competency of those who are required to implement them in practice.
In this blog, the authors attempt to unpack answers to some of these questions, by identifying certain early warning signals and also investigating the reasons behind a Board’s inefficacy in detecting the same.
What are those early warning signals and sub-sonic sounds that Boards should capture?
If we decipher some of the recent instances of accounting/ financial fraud, it appears that in many instances, there were a common set of early warning signals and sub-sonic sounds that escaped the Boards’ attention.
Set out below are some of these early warning signals:
- Disclosures made in the ‘notes’ to the financial statements, which is perhaps the first indicator of any accounting irregularities;
- Number and frequency of whistle-blower complaints;
- Quality and timeliness of disclosures made by the management to the Board, Audit Committee etc., and whether agenda items are added at the last minute;
- Qualified Audit Report on the financial statements;
- Frequent resignations of CFO, Compliance Officer, statutory auditor, and internal auditor;
- Spikes in certain kinds of revenue expenditure;
- Frequent changes in revenue recognition policy;
- Real estate transactions with related parties.
While there cannot be an exhaustive list of such early warning signals, one must not lose sight of the fact that ‘time is of the essence’ in identifying such sub-sonic sounds within the Company – and that is where the Boards seem to be failing with an alarming regularity. But, if we dig deeper, there are certain key structural, organisational as well as behavioural factors that hinder the Board’s effectiveness in identifying these early warning signals.
Challenges to Board Effectiveness
Asymmetry of Information
Given that the independent directors (IDs”) and other non-executive directors (“NEDs”) (including the investor nominees on the Board) are not involved in the management of the day-to-day affairs of a company, they have to naturally depend on the MD&CEO, CFO and other senior management team members for providing them with all information that is necessary to objectively evaluate the health of the company.
In addition to the management team, IDs and NEDs also have to heavily rely on the findings of the internal auditor (for aspects such as internal financial controls) and the statutory auditor (with regard to disclosures made in the notes to accounts, compliance with accounting standards, etc.).
While even the independent directors/ non-executive directors have information rights under Section 128 of the Companies Act, 2013 (“Act”), in reality, they depend heavily on the quality of information that is shared with them by the management. If vital information is withheld and only ‘good news’ is shared with the directors, the oversight responsibilities of the IDs and NEDs can be severely constrained.
Further, on many occasions, information on key proposals, such as M&A transactions, divestments, internal restructuring, diversification of business, major capex proposals, related party transactions, etc. are presented to the Board at the very last minute, without providing the directors with sufficient time to scrutinise aspects relating to valuation and other key risk factors.
Personality of the Chairman – Does he encourage candid discussions?
The challenges that arise due to information asymmetry get exacerbated if the Chairman of the Board does not create a conducive environment for the directors to ask ‘inconvenient questions’ and raise ‘uncomfortable issues’ at the Board Meeting. When the Chairman fails to promote free and frank exchange of views at the Board Meeting, permits introduction of agenda items at the very last minute and sets unrealistic timelines for approval of accounts and other key proposals – it can impede directors from candidly putting forth their concerns.
Along with restricting the flow of ‘relevant’ information from the management to the Board, this also results in a situation where specific concerns raised by individual directors are not brought to the attention of the entire Board – and are often left unaddressed at the Board Meeting. Hence, even if an individual director has, after hours of independent scrutiny, managed to capture a ‘sub-sonic sound’ within the company, his ability to convey this formally to the Board is dependent on the kind of ‘environment’ and ‘Board culture’ that is set by the Chairman.
Moreover, in situations where the Chairman is a ‘powerful personality’, a single director may be reluctant to bite the bullet all by himself, by asking ‘inconvenient questions’ and seeking granular details from the management on key financial/ accounting aspects.
Overall Organisational Culture and ‘Tone at the Top’
The tone at the top sets forth a company’s cultural environment and corporate values, and defines the management and Board’s commitment to being ethical[1]. The ambience instilled by the upper echelon of leadership establishes the organisational milieu and core principles, and shows the ethical stance of the management and the Board. A crucial determinant is the governance gatekeepers’ capacity to carry out their supervisory duties, without the fear of any backlash.
Time Commitments
The conflicting time-commitments of IDs and NEDs, who serve on multiple Boards, also acts as a hindrance for them to ‘deep-dive’ into the affairs of the each of the companies. Lack of familiarity with the complex business models also results in a situation where early warning signals (especially on aspects such as disclosures made in the ‘notes’ to the financial statements, revenue recognition policy etc) are not captured within the nick of time.
Ineffective Board Committees
Under the current regulatory framework, a lion’s share of the burden is taken up by the Audit Committee, whose responsibilities with regard to approval of financial statements, related party transactions, inter-corporate loans and investments, etc. are spelt out in prescriptive and granular detail under the Companies Act and the LODR Regulations.
However, one must not lose sight of the cardinal principle of ‘collective responsibility’ of the Board, as enshrined under Section 179 of the Companies Act – and the role of any Board Committee is to supplement and not supplant the Board. For matters that fall within the specific domain of a Board Committee, the Boards are tending to show excessive deference to the Board Committee’s views and are reluctant to independently scrutinise such matters.
To illustrate, with respect to approval of the financial statements, the Board often defers to the Audit Committee’s view, resulting in a risk that key disclosures made in the financial statements, and the ‘reasonable estimates’ and ‘judgments’ made by the management under various Ind AS Accounting Standards may not receive adequate scrutiny before the entire Board.
Such reluctance to independently scrutinise matters that fall within the domain of a Board Committee is perhaps another reason why ‘sub-sonic sounds’ escape the attention of the larger Board.
Further, while the directors sign the Directors Responsibility Statement under Section 134(5) of the Companies Act as a matter of routine, no objective evaluation is made with regard to compliance with ‘true and fair view’ and applicable accounting standards, adequacy of internal financial controls, and whether adequate accounting records are maintained to safeguard company assets and prevent fraud/ other irregularities.
Concluding Thoughts
While domain knowledge and technical skills are important, Corporate India needs wise directors. The subject of Board effectiveness requires a deeper thinking and serious introspection by the Board members. While the regulators have done a commendable job to prescribe various cognitive aspects to ensure independence of the Board, the behavioural aspects remain largely unaddressed. The Board members need to have ‘pigeon-like ability’ to pick up sub-sonic sounds in the organisation. Most of the times, the governance failures can be detected well in advance, if the Board is alert and is willing to take up issues which may not sound as music to the ears of the operating management.
The COVID-19 pandemic highlighted that an invisible virus can seriously threatens people, societies, and nations. In governance too, invisible threats can be just as menacing as the visible ones. In any discourse on corporate governance in India, emphasis is often on the visible aspects such as legal, accounting, tax, risk, liquidity management, asset-liability mismatch, related party transactions and so on. However, the less visible behavioral aspects of governance, such as board dynamics, overbearing influence of some directors on the Board, inadequate listening, inability to ask inconvenient questions are just as crucial and merit greater attention. Neglecting these invisible threats can lead to corporate failures rooted in behavioral aspects.
There is also a debate in some circles about the potential value of appointing an ‘observer’ to the Board, someone who can assess the cultural aspects and group dynamics of Board meetings and advise the Chairman on necessary corrective actions. Their status notwithstanding, Directors are human beings who are susceptible to subjectivity and behavioural bias. It is challenging to train them on Boardroom decision-making. The regulators alone cannot fix this problem. It is, therefore, imperative that corporate India takes steps to work in this direction and make a tangible difference in improving the effectiveness of the Boards. Given the zero tolerance of the regulators and the judiciary to any corporate failures, the Boards have little choice but to wake up and take remedial actions.
[1] See, for instance, Corporate Finance Institute, Tone at the Top, available at Tone at the Top – Definition, How To Improve, Example (corporatefinanceinstitute.com).
