Role of Various Agencies in Ensuring Ethics in Corporations

by:- Pankaj Singh Chandel

Factors that ensure ethical practices in companies

1. Public opinion2. Role of auditors3. Role of Board of Directors in Ensuring Ethical Business4. Media and business ethics5. Role of Government Agencies in Ensuring Ethical Practices6. Role of judiciary7. Role of SEBI8. Role of whistle-blowing

1. Public Opinion

• Public opinion can initiate new requirements, help crystallization of policy initiatives and force public authorities to create an ethically conducive environment.

2. Defining Auditor

• An auditor is defined as a person appointed by a company to perform an audit. He is required to certify that the accounts produced by his client companies have been prepared in accordance with normal accounting standards and represent a true and fair view of the company. Usually, Chartered Accountants are appointed as auditors.

• An auditor is a representative of the shareholders, forming a link between the government agencies, stockholders, investors and creditors.

Defining Audit

• The Institute of Chartered Accountants of India (ICAI) has defined audit as, "...The independent examination of any entity, whether profit oriented or not and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon”.

• Auditing is the process by which a competent independent person objectively obtains and evaluates evidence regarding assertions about an economic activity or event for the purpose of forming an opinion about and reporting on the degree to which the assertion conforms to an identical set of standards.

There are three types of auditors:Internal Auditors

• Internal auditors are employed by the organization for which they perform audits. Their responsibilities vary and may include financial statement audits, compliance audits and operational audits. They may assist the external auditors in completing the financial statement audit or perform audits for use by management within the entity.

• An organization may have a small or very large internal audit staff. They cannot be independent as long as the employer– employee relationship exists.

• Independent auditors are usually referred to as CPA (Certified Public Accountants) firms. The opinion of an independent auditor about financial statements makes the statements more credible to such users as investors, bankers, labour unions, government agencies and the general public.

Independent Auditors

• Government auditors work in various local, state and federal or Central government agencies performing financial, compliance and operational audits. Local and state governments, for example, employ auditors to verify that businesses collect and remit sales taxes and excise duties as required by law.

Government Auditors

The duties of an auditor are defined under section 227 (1A) of the Companies Act 1956.

It says that an auditor can enquire

1. whether loans and advances made by the company on the basis of security have been properly secured ;

2. whether transactions of the company which are represented merely by book entries are not prejudicial to the interests of the company ;

DUTIES OF AN AUDITOR

3. where the company is not an investment company within the meaning of Section 372 or a banking company, whether so much of the assets of the company as consist of shares, debentures and other securities have been sold at a price less than that at which they were purchased by the company ;

4. whether loans and advances made by the company have been shown as deposits ; and

5. whether personal expenses have been charged to revenue account.

DUTIES OF AN AUDITOR (contd.)

As per the Standard Auditing Practices (2), the auditor

• Is responsible for forming and expressing his opinion on the financial statements. He assesses the reliability and sufficiency of the information contained in the underlying accounting records and other source data by making a study and evaluation of accounting systems and internal controls.

• Determines whether the relevant information is properly disclosed in the financial statements by comparing the financial statements with the underlying accounting records and other source data to see whether they properly summarize the transactions and events recorded.

RESPONSIBILITIES OF AUDITORS

• Has to ensure that his work involves exercise of judgment, as for example, in deciding the extent of audit procedures and in assessing the reasonableness of the judgments and estimates made by the management in preparing the financial statements.

• Is not expected to perform duties which fall outside the scope of his competence. For example, the professional skill required of an auditor does not include that of a technical expert for determining physical condition of certain assets.

RESPONSIBILITIES OF AUDITORS (contd.)

The Enron debacle

• In May 2001, Arthur Andersen connived with its client, Sunbeam Corporation for financial fraud and fudging of accounts.

• In June 2001, an American Superior Court fined Arthur Andersen towards damages to shareholders for certifying false statements of accounts of Waste Management Inc. Three of Arthur Andersen's partners were fined between $ 30,000-50,000 each and banned from auditing work for 3–

5 years.

AUDIT FAILURES LEADING TO CORPORATE SCAMS

• Deloitte & Touche also landed in trouble in 2002 for applying a valuation model for fast-food franchisees, which misled bankers into extending credit to unworthy clients and incurring a colossal bad debt of $ 10 billion.

• In 1999, another reputed US based accounting firm, Ernst & Young paid $ 335 million to a client to settle a lawsuit related to accounting problems.

• Another American auditing firm, KPMG attracted censure from SEC for engaging in improper professional practice. While serving as an audit firm for Short Term Investment Trust, it also made substantial investments in it. Its money-market account, opened in May 2000 with an initial deposit of $ 25 million, constituted 15 of the fund's net assets at one point of time.

AUDIT FAILURES LEADING TO CORPORATE SCAMS (Contd.)

• Sarbanes Oxley Act (SOX) was passed by the US Congress in 2002 with an aim to protecting investors from the fraudulent accounting practices of corporations.

• Establishment of Public Company Accounting Oversight Board (PCAOB)

THE US LAW GOVERNING AUDITORS’ RESPONSIBILITIES

• Till date, four committees played a vital role in framing the responsibilities of the auditors and the audit committees: the R.D. Joshi Committee, the Kumar Mangalam Birla Committee, the Naryana Murthy Committee and the Naresh Chandra Committee. All these committees' recommendations focused mainly on the following aspects of auditing: Formation of the audit committee, their responsibilities, rotation of auditors, prohibition of non audit services and the transparency of financial statement.

INDIAN ATTEMPTS TO PREVENT FRADULUENT AUDITING PRACTICES

• An audit committee is a committee made up of independent directors. It is responsible for the appointment, fixing of fees and oversight of the work of independent auditors. The committee is also responsible for establishing and reviewing the procedures for the receipt, treatment of accounts, internal control and audit complaints

Audit Committee

The audit committee, according to the afore-mentioned four committees, should review the following information.

• Financial statements and draft audit reports, including quarterly/half-yearly information;

• Management discussion and analysis of financial conditions and the results of operations;

• Report relating to compliance with laws and risk management ;

• Management letters/letters of internal control weakness issued by statutory and internal auditors; and

• Records of related pay transactions.

Audit Committee (contd.)

• These committees have also recommended the mandatory rotation of lead audit partner and partner reviewing audit every five years.

Audit Partner Rotation

• Auditors are prohibited from providing non-audit services concurrently with audit review services. Non-audit services include book-keeping, financial and information system design, internal audit, HRD services, investment advice, investment banking services, legal advice, appraisal, valuation and actuarial services.

Prohibition of Non-Audit Services

• Full disclosures of accounts and decisions of management involving the funds of the company to all its stakeholders is a desiderata of good corporate culture. The R.D. Joshi Committee has suggested the imposition of responsibility on auditors to check and, report diversion, under utilization or misappropriation of funds by companies. The Naresh Chandra Committee has recommended that the auditors should disclose implications of contingent liabilities so that the investors and shareholders have a clear picture of these liabilities.

Disclosures

• Under section 539 of the Companies Act 1956, if an auditor is found to be involved in unethical practices, he will be punishable with imprisonment for a term which may extend to seven years and shall also be liable to a fine.

• Under Section 21 of the Chartered Accountants Act, it is said that the auditor will be prevented from exercising his duty and his license will be cancelled by ICAI.

Penalties

The separation of ownership from active direction and management is an essential feature of the company form of organization. To manage the affairs of the company, shareholders elect their representatives called the “Directors” of the company.

A number of such directors constitutes the “Board of Directors”. The board generally has only part-time directors.

3.Role of Board of Directors in Ensuring Ethical Business

• Section 2 (13) of the Companies Act defines a director as follows: “A director includes any person occupying the position of director by whatever name called. The important factor to determine whether a person is or is not a director is to refer to the nature of the office and its duties. It does not matter by what name he is called, if he performs the functions of a director.

• Section 2(6) of the Companies Act states that directors are collectively referred to ‘Board of Directors’ or simply the ‘board’.

Who is a Director?

• They have been described variously as agents, trustees, or managing partners of the company.

• The legal position of the directors as agents and trustees emanate from the fact that a company being an artificial person cannot act in its own person.

• It has become a well-settled fact now that directors are not only agents but also act as trustees as a result of several court decisions in India and England.

Legal Position of a Director

• The directors have certain duties to discharge. These are: (i) fiduciary duties (ii) duties of care, skill and diligence; (iii) duties to attend board meetings; (iv) and duties not to delegate their functions except to the extent authorized by the Act or the constitution of the company and to disclose his interest.

Duties and Responsibilities of Directors

• No body corporate, association or firm can be appointed directors of a company. A director must: (a) be an individual; (b) be competent to enter into a contract; and (c) hold a share qualification if so required by the Articles of Association.

Qualifications of Directors

The Board of Directors of a company which includes all the directors elected by shareholders to represent their interests is vested with the powers of management which are:

(a) make calls on shareholders in respect of money unpaid on their shares;

(b) issue debentures;

(c) borrow moneys otherwise (for example, through public deposits);

(d) invest the funds of the company; and

(e) make loans.

Powers of the Board

Directors of a company may be held liable under the following situations:

1. Directors of a company may be liable to third parties in connection with the issue of a prospectus, which does not contain the particulars required under the Companies Act or which contains material misrepresentations;

2. Directors may also incur personal liability under the Act

Liabilities of Directors

a. on their failure to repay application money if minimum subscription has not been subscribed;

b. on an irregular allotment of shares to an allottee (and likewise to the company) if loss or damage is sustained;

c. on their failure to repay application money if the application for the securities to be dealt in on a recognized Stock Exchange is not made or refused ;and

d. on failure by the company to pay a bill of exchange, hundi, promissory note, cheque or order for money or goods wherein the name of the company is not mentioned in legible characters.

Liabilities of Directors (contd.)

1. Ultra vires Acts: Directors are personally liable to the company in matters of illegal acts.

2. Negligence: A director may be held liable for negligence in the exercise of his duties.

3. Breach of Trust: They are liable to the company for any material loss on account of the breach of trust.

4. Misfeasance: Directors are liable to the company for misfeasance, i.e, willful misconduct.

The Directors’ Liability to the Company

The Companies Act imposes penalty upon the directors for not complying with or contravening the provisions of the Act, which include sections on criminal liability for misstatements in prospectus, penalty for fraudulently inducing persons to invest money, purchase by a company of its own shares, concealment of names of creditors entitled to object to reduction of capital, penalty for default in filing with the registrar for registration of the particulars of any charge created by the company.

Liability for Breach of Statutory Duties

In order to protect the interest of a company and its shareholders, the Companies Act has placed the following disabilities on the directors:

1. Any provision in the Articles or an agreement which exempts a director (including any officer of the company or an auditor) from any liability on account of any negligence, default, misfeasance, breach of duty or breach of trust by him shall be wholly void.

2. An undischarged insolvent shall not be appointed to act as director of any company, or in any way to take part in the management of any company.

Disabilities of Directors

3. No person shall hold office at the same time as director in more than 15 companies.

4. A company shall not without obtaining the previous approval of the Central Government in that behalf, directly or indirectly make any loan to

a. any director of the lending company or of a company which is its holding company or any partner or relative of any such director;

Disabilities of Directors (Contd.)

a. any firm in which any such director or relative is a partner;

b. any private company of which any such director is a director or member;

c. any body corporate at a general meeting of which not less than 25 per cent of the total voting power may be exercised or controlled by any such director; or

d. any body corporate, the board of directors, managing director, or manager whereof is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors of the lending company.

Disabilities of Directors (Contd.)

5. Except with the consent of the board of directors of a company, a director of the company or his relative, a firm in which such a director or relative is a partner, any other partner, in such a firm, or a private company of which the director is a member or director, shall not enter into any contract with the company.

a. for the sale, purchase or supply of any goods, materials or services; or

b. for underwriting the subscription of any shares in, or debentures of, the company.

6. A director shall not assign his office. If he does, the assignment shall be void.

Disabilities of Directors (contd.)

The realistic functions of the board are:

a. Confirming management decisions on company matters;

b. Providing constructive advice to the executives on business outlook, new governmental legislation, wage policy etc.;

c. Selecting the chief executives and confirming the selection of the other executives in the company made by chief executives; and

d. Reviewing the results of current operations.

Effectiveness of the Board of Directors

1. An efficient and independent board should be conscious of protecting the interests of all stakeholders and not be concerned too much with the current price of the stock.

2. Another important function of the director is to set priorities and to ensure that these are acted upon.

RESPONSIBILITIES OF DIRECTORS

3. A director is also expected to have the courage of conviction to disagree.

4. Directors have great responsibility in the matter of employment and dismissal of the CEO.

5. One of the toughest challenges confronted by boards arises while approving acquisitions.

RESPONSIBILITIES OF DIRECTORS (Contd.)

6. An efficient board should be able to anticipate business events that would spell success or lead to disaster if proper measures are not adopted in time.

7. The directors have a duty to act bona fide for the benefit of the company as a whole.

8. In recent times, those who advocate reform of laws governing corporate practices stress the importance of reformulation of the concepts behind these laws.

RESPONSIBILITIES OF DIRECTORS (Contd.)

• The board of directors, including chairmen and managing directors, consisted of family members with a couple of directors from funding financial institutions and perhaps a couple of outside passive directors.

• In such cases the Board nods its head for all decisions of the CEO who may promote his/his family interests and may not be interested in promoting long-term share-holder value.

FAMILY-OWNED BUSINESSES AND BUSINESS ETHICS

The media can play a role in ensuring ethical business by affecting reputation in at least three ways.

1.It can drive politicians to introduce corporate law reforms or enforce corporate laws.

2.It could affect reputation through the standard channel that most economic models emphasize.

3.It affects managers' and board members' reputations in the eyes of shareholders and future employers, and society at large.

4. Media and Business Ethics

• Shareholder Activists and the Press

• Institutional Investors

• Private and Government regulators

• The Press vs. Other Mechanisms For Addressing Ethical Problems

Corporate Ethics and the Press

• A number of humanities and social science scholars view advertising as intrusive and environmental and its effects as inescapable and profound. They see it as reinforcing materialism, cynicism, irrationality, selfishness, anxiety, social competitiveness, sexual preoccupation, powerlessness and loss of self respect. These are strong indictments which imply that advertising is a powerful force.

ETHICS IN ADVERTISING

• Information.

• Values and life-styles.

• Creative experience.

Defenders of advertising argue that it has a beneficial effect on several basic areas :

• Deception• Fear factor• Advertising to children• Materialism• Promoting stereotypes• Advertising alcoholic beverages• Competitive advertising• Increasing costs• Exploiting visual appeals• I’m the best• Absence of full disclosure• Use of celebrities• Fantasy and reality

Adverse effects of advertising :

The code of the Advertising Standards Council of India expects, inter alia, that there will be :

a. No offence to generally accepted norms of public decencyb. Truthfulness and honesty in claims and representationsc. No indiscriminate use of advertising for products which are

hazardous to society or to individuals.d. References to eminent personalities/political figures and the

use of national emblems are not normally permitted.e. Comparative advertising should respect the principles of fair

competition generally accepted in business.

ADVERTISING STANDARDS

In India, the Department of Company Affairs (DCA), the Ministry of Finance, the Commerce and Industry ministries have powers to oversee corporate activities and take corrective action against corporate misdemeanors. Additionally, there are regulators such as SEBI, RBI, TRAI, IRDA, which as public authorities have the power and responsibility to monitor and supervise companies.

5. Role of Government Agencies in Ensuring Ethical Practices

• One of the areas in which the judiciary has been very active is to find out whether any legislation that is passed or practised, is in tune with the basic structure of the Constitution.

6. Role of Judiciary

Establishment of SEBI: set up on 12 April 1988 by the Government of India; given legal status by the Securities and Exchange Board of India Ordinance 1992.

Basic objectives:

• protection of investors' interests in securities

• promotion of the development of the securities market and

• regulation of the securities market

7. Role of SEBI in Ensuring Ethical Corporate Governance

SEBI has been clothed with the following powers:

a. To promote fair dealing by the issuers of securities and ensure a marketplace where companies can raise funds at relatively low cost;

b. To provide a degree of protection to investors and safeguard their rights and interests and

c. To regulate and develop a code of conduct and fair practices by intermediaries

7. Role of SEBI in Ensuring Ethical corporate governance (Contd.)

Initiatives of SEBI in the following areas:

• pricing of preferential share allotments

• take-overs

• Insider trading

• Information disclosure

• promoter’s contribution and lock-in

• Need for corporate governance for security markets

• Appointment of committees

• Clause 49

7. Role of SEBI in Ensuring Ethical corporate governance (Contd.)

Grounds for whistle-blowing:

• Internal: to make the product safe or change the process

• Governmental: faulty design, decisions, which will affect the public

• External: Individual user who runs the risk

8. Role of whistle-blowing

1. Motives are moral

2. Exhausted all existing internal procedures and failed to get the moral error corrected

3. Employee has reached the last and sixth stage of Kohlbergh’s six stages of evolution – the stage of universal ethical principles.

WHEN IS WHISTLE BLOWING PERMITTED?