Regulating the regulators

The absence of an umbrella regulatory body and poor disciplinary proceedings have left the investors open to the risk of recurring scams.

Print Edition: February 5, 2009

When the Harshad Mehta scam came to light, the newspapers were vociferous in demanding punishment for "those responsible". Ketan Parekh came along a few years later, as did the Global Trust Bank, the IPO scam, the CRB scandal, plantation companies, Satyam… The list is endless. Every time a new regulation or a new moderator is formed to take care of a loophole, it apparently creates another one elsewhere. The investors seem to have lost faith in the regulatory bodies if one were to go by what Bengaluru-based investor Ramakrishna Chamary says, "Those who commit fraud are not punished in any way."

14 cases handled by the Serious Fraud Investigation Office in 2007-8
737 cases filed in 2007-8 against companies involved in fraudulent activities
140 inspections in companies that faced complaints of irregularities

This, despite the fact that the Indian regulatory mechanism is widely seen as being among the world's most stringent. The problem is that there are too many regulators in the market—RBI, Sebi, FMC, Irda, PFRDA and, of course, the Ministry of Finance, to name a few. If there is a pensions problem, for instance, only the PFRDA is in the loop; never mind that the problem could spill over to the mutual fund space.

Since there is no umbrella organisation (other than the Ministry of Finance, if you will) to oversee the activities of individual regulators, it leads to scams and frauds on a large scale. The result? Small investors suffer when companies or specific sectors are found guilty. A few years ago, the Securities and Exchange Board of India, the stock market regulator, introduced Clause 49 of the Listing Agreement (see box) to ensure that the companies adhered to good corporate governance practices in the best interests of the market.

All About Clause 49
In the Listing Agreement between a company and a stock exchange, Clause 49 protects the interests of investors by ensuring good governance practices and disclosures. Here are the provisions of the clause:
• Executive and non-executive directors should make up the board of directors. At least 50% of the board must comprise non-executive directors.
• Independent directors should comprise at least 50% of the board if the chairman is an executive director. If not, the figure should be at least 33%.
• A qualified and independent audit panel should be set up with at least three members. All should be non-executive directors, with the majority being independent.
• The clause defines the responsibilities of the audit panel in all matters of financial reporting and enhances the accountability of top management, especially CEO & CFO.
• The revised Clause 49 clarifies the standards of independence for directors by defining 'independent' and excluding any relatives of promoters, senior management, former auditors or consultants.
• The CEO and CFO are required to certify to the board at least once a year on matters relating to the accuracy of financial reporting, evaluation of internal controls and disclosure of frauds. The board is responsible for the company complying with laws and control over subsidiaries.

Unfortunately, most of the companies consider Clause 49 merely as additional paper work. Howevever, there are a few like Prithvi Haldea, chairman and managing director, Prime Database, and independent director, Nucleus Software, who says, "Our role is to protect the interests of minority shareholders when decisions are taken by the management or the board." Haldea acknowledges that finding the right independent directors is a challenge, but one that will pay off. To help, he has generated a database of those interested in being independent directors (www.primedirectors. com); of the 13,643 profiles hosted on his Website, 3,920 are those of chartered accountants, 1,586 of company secretaries, 649 of cost accountants and 464 of retired civil servants. Such efforts will help only if the companies are interested in finding the right people for the job. However, as Chamary says, "Independent directors are more like an old boys' club and the Satyam board is an example of how, despite the presence of the best minds, investor interest did not reflect in the actions."

An independent director is expected to stand up for the minority shareholders who are not represented on the company boards. Says Omkar Goswami, chairman, CERG Advisory, a research and consulting organisation and an independent director: "In the long term, independent directors need to increase the shareholder's value, ensure that the rights of minority shareholders are not in any way diluted, and monitor companies so that they act in a legal and ethical manner." But as most companies are run by promoters, members of the board are picked by them. And as a substantial amount of money is paid to independent directors, they are more than happy to toe the promoter's line instead of holding out for the investors' interests. "The Companies Act only has a negative list of the kind of people who can't be independent directors," says Haldea.

If the regulators cannot tackle the relatively small problem of independent directors, how can they hope to ensure that small investors do not pay the price for large-scale fraud? Ved Jain, president of ICAI, the statutory body that regulates auditors and accountants, does not agree that the regulators have failed in this regard.

Regulatory Loopholes
While India Inc. aspires to be benchmarked against worldclass bodies, it cannot achieve this without streamlining its regulatory process or enhancing its disciplinary provisions
Sebi (Securities & Exchange Board of India)
Since 1992, Sebi has introduced several stock market reforms, but it has been slow to react on many issues.
Drawback: The body is not proactive.
Result: Scams every few years; the Ketan Parekh fiasco in 2001, the IPO scandal of 2005-6.
Clause 49
The idea was to ensure that the listed companies have good corporate governance.
Drawback: Sebi does not have the teeth to penalise firms that don't comply with its provisions.
Result: Clause 49 is practised in letter, not in spirit.
ICAI Accounting Standards
Indian accounting standards were to be aligned with the International Financial Reporting Standards by 2008. However, Indian company law must be amended, and full convergence can happen only by 2011.
Drawback: ICAI is lenient towards erring auditors.
Result: Action against faulting members often gets delayed. The Global Trust Bank case is still pending.

"(ICAI) has a strict code for its members and those found involved in malpractices have been suspended and action has been taken against them," he says. However, a look at the abysmal record of the institute in punishing errant members tells a different story. The offenders are punished by a disciplinary committee and are invariably let off with a fine of not more than Rs 5 lakh.

There are other problems as well. Multiple regulators and a turf war has hobbled commodities futures trading on the two national stock exchanges. A year ago, the then finance minister P. Chidambaram had said, "The job of a regulator is to ensure that the market is well-regulated. In such a market, there will be periods of volatility. But I think responsible and mature market players will accordingly adjust their activities in the market in order to reduce volatility."

For this to happen, there needs to be a clear, effective regulatory mechanism that has sufficient powers to penalise dissidents. This involves opening up questions about mandate and a need for better harmonisation of principles of regulation across various regulators. Will this happen? We definitely hope so. The problem is in overcoming bureaucracy and the tendency to cling to old ways. Perhaps the latest shake-up, thanks to Satyam, will be the catalyst for change.

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