Dichotomy of letter versus spirit of law: How regulators can deal with the fallout of corporate frauds

A more pro-active approach through a balanced regime can at least help reduce the frequency of book frauds that affect stock prices.
Komal Gadia
Komal Gadia

Each society has set some acceptable legal, social and fairness norms. For corporates in India, such norms are found under laws such as the Companies Act, 2013, the securities laws, laws related to Human Rights, etc. However, like in any other country, in India, such norms have evolved from a principle-based approach to being prescriptive. 

In the last decade, we have witnessed a number of accounting scandals and irregularities in companies such as IL&FS, Crompton & Greaves, the ongoing investigation into the Videocon Group, and now the Hindenburg Research report raising governance concerns over the Adani Group. While a few of these matters are sub-judice and it is unclear whether or not some of the claims are legitimate, the news of possible wrongdoing itself has substantially errored the market.

As a consequence, to combat occurrence of such events in the future, the regulators are forced to adopt an over-prescriptive approach and introduce a new set of onerous requirements, similar to the approach adopted by them in other cases. However, there is a saying that one who is a habitual offender will always find ways to circumvent the law. It is, therefore, only the bona fide class of investors and law-abiding corporates who will suffer and will have to abide by the same. 

Therefore, it is time for the regulators to think differently and adopt a proactive approach to such challenges. The following are a few suggestions in this regard.

1. In the backdrop of an overhauled Insolvency & Bankruptcy Code (IBC), shareholders' democracy may not be truly attainable. Further, the Ministry of Corporate Affairs is also considering allowing the Committee of Creditors (CoC) of a company to sell various assets through different resolution plans. As we know, an overly leveraged company is highly vulnerable to being dragged into IBC proceedings. Once this happens, regardless of good or poor business judgment decisions, under the waterfall payment mechanism, minority shareholders will be ones who will be worst impacted.

Therefore, a company contemplating to raise debt by seeking shareholders’ approval under Section 180(1) (c) of the Companies Act, 2013 should be allowed to do so only with the prior approval of the lenders. To assess the risk, the lenders, amongst others, would need management accounts and cash flow. These statements are already made available to lenders in majority of the cases, on the basis of the covenants under the loan agreement. By conferring responsibility on the lenders, one can cast an insider ownership.

In the future, this may also enable the government to decide priority of payment to such class of creditors against others. The lenders possess  better wherewithal than the minority shareholders to understand the financial implications of an over-leveraged company. They are also the ones who eventually decide the fate of the company, in the event of IBC proceedings. Therefore, it is important that they are held accountable for actions which they are best suited to assess. This will also reduce the frequency of companies getting into insolvency and reduce book fraud.

2. The disclosure and governance mechanism with respect to key managerial personnel (KMPs) may not require a complete overhaul. However, it is recommended that if one is subject to inquiry by the Enforcement Directorate or equivalent agencies, or is being subjected to investigation under criminal laws such as the Prevention of Money Laundering Act, then a disclosure to this effect should be provided to the shareholders in the Annual Report. This will enable the shareholders to take an informed view about the credibility of the management of the company.

Further, the website of the company should on a real-time basis provide details of the KMPs of the company which are subjected to investigation by any of the aforesaid agencies. Moreover, a provision similar to that in Part I of Schedule V of the Companies Act, 2013 should similarly be introduced for the KMPs.

3. To avoid ambiguity, notwithstanding ownership holding, all fund houses and foreign portfolio investors (FPIs) should be mandated to disclose their significant beneficial ownership to the company, in a confidential filing to the regulator. This will ensure a genuine 25% public float in case of a listed entity.

Privacy claims were never an exception to regulatory obligations. Therefore, it is time for our country to take a firm stand like the one taken by the European Union under its privacy law, The General Data Protection Regulations (GDPR), where one cannot claim privacy if information is required for regulatory purposes. If compliance with GDPR is not refused by such class of investors in Europe, then why should India allow exceptions from disclosures to such class of investors, especially when such structures are becoming a conduit to circumvent the law?

4. Under certain stipulated circumstances, the Ministry of Corporate Affairs (MCA) is empowered under Chapter XIV of the Companies Act, 2013 to undertake inspection, inquiry and investigation into the affairs of the company. Often, these are post-facto investigations. MCA should consider and adopt a more proactive approach akin to that of the Reserve Bank of India (RBI). It should conduct an annual audit of companies whose debt-equity ratios are not as per acceptable industry standards for their sector, or if majority of their business is undertaken whether directly or indirectly through related parties or companies of the same group, a small audit firm is undertaking statutory audit of the company. If such company is a listed company, the audit should be undertaken in collaboration with the Securities and Exchange Board of India (SEBI). An enabling provision should be introduced in this regard both under the Companies Act, 2013 and SEBI Act.

While our Prime Minister is making a conscious effort to improve India’s ranking at the World Economic Forum, events described in this article are repeatedly impairing our country’s reputation. At the same time, regulators are being criticized for over-legislating.

The dichotomy of compliance with law in spirit versus in letter cannot be resolved in one day. However, a more proactive approach through a balanced regime can at least help reduce the frequency of book frauds. Therefore, it is time for the country to adopt unique ways to combat such challenges.

Komal Gadia is Assistant Vice President - Corporate Legal Cell of Aditya Birla Group.

Disclaimer: The views expressed herein are solely of the author and do not represent those of the organization she belongs to. This article should not be construed as an opinion on sub-judice matters.

Bar and Bench - Indian Legal news