Govindraj Ethiraj: A Corporate Governance Failure

DOUBLE EDGE

More than a decade ago, I interviewed Adrian Cadbury, successor to and chairman of the Cadbury Schweppes confectionary group. We were not discussing dark chocolates, rather the subject of corporate governance with which he had become indelibly identified with, ever since he penned the famous Cadbury report on corporate governance in 1992.

Mr Cadbury's visit and interactions with Indian industry triggered the first serious discussions on the subject of corporate governance. All in all, it seemed like a promising new way of looking at the evil that was single promoter-run firms in India then, who, among other things, ran their companies like fiefdoms and were loath to give up control even if their shareholdings were low.

Recognise that it was a not so competitive environment, the grip of the license raj was still fairly firm and companies and their promoter/founders could pretty much do what they wanted, with public money. The real pain of liberalisation was yet to set in and the Infosys way of boardroom discipline was some way from making its presence felt.

Till Enron imploded in late 2001, except for a few stray references here and there, Cadbury's report and all that it contained appeared to have been either internalised or consigned to the archives of corporate history.

As Enron unravelled, attention returned to the subject. The near draconian Sarbanes-Oxley Act followed and back home too, it appeared like boards and CEOs were going to treat their shareholders with far more respect than ever before and the only risk that a firm had to reckon with was in the marketplace.

Until now. History it seems is repeating itself. Indian companies have exposed themselves to billions of dollars worth of forex derivative contracts over the last few years. Precise numbers are hard to come by and will perhaps never will. What is clear is that companies have taken financial risks they could or should have avoided.

What is clearer is that there was no compelling reason to take these risks. And to that extent, it's a failure of corporate governance and must be treated and then addressed as such. There is of course the other issue of how the Institute of Chartered Accountants or the accounting regulator figuring out how to treat derivative losses as they stand on scores of balance sheets today.

How did it happen? I am not sure but a good question to ask is when. My understanding is that companies have been steadily stepping up their exposure to currency swaps and the like for at least four years now. Over time, as the stockmarkets (which bolster sentiment) have held their own and the prospect of any downside risk appeared more and more distant with every passing day, chief financial officers (CFOs) of companies have got braver.

One key driver appears to be the desire to cut down on interest costs. Not surprisingly, banks have played a role here, structuring products that got more exotic by the day. One consultant I spoke to said he challenged most CFOs to make "head or tail" of the complex derivative contracts that they had signed, on behalf of their companies. Maybe shareholders are also at fault for not asking but the fact is that no one paid attention or more likely didn't care as long as the bottom line was fine.

Ramesh Lakshman, an accounting and derivatives expert I spoke to, started off with an example: "If a company entered into, let's say, a transaction to convert a local currency borrowing into the Japanese yen or Swiss franc borrowing through the swap route, then the company is inducing a risk into the system where there is not." No two ways about that.

Lakshman goes on to say that managements ought to have, in the interests of corporate governance, clearly informed their boards of all foreign exchange exposures, the risks arising out of that and the measures to mitigate them were something to go wrong.

Moreover, he says, under the relevant Securities & Exchange Board of India regulations, in the absence of an applicable standard in India for derivatives, the companies' Audit Committees should have examined international standards and disclosed the losses in the Governance report and indicated that these would have been provided for had the country adopted international standards as applicable.

Or, in the absence of these standards, the company should have stressed that the losses are not provided for in the books. The companies should have also mentioned that they were signing up products which were prima facie speculative in nature to derive benefits from their reading of the market. It might also be worth wading through, he says, what companies have said in their "Management Discussion & Analysis" reports, which specifically call for details of such investments.

It's possible many companies did keep their boards informed and made the appropriate references in their balance sheets. Though this does seem unlikely, even if they did, then as I mentioned earlier, no one was watching. It's also possible that some companies are in violation of law. Either way, shareholders must perhaps shoulder some part of the blame.

To conclude, is this another Enron waiting in the wings? Not quite but it does raise some fundamental questions on what companies do with their shareholders' funds. It's also about how when the good times roll, everyone forgets to look at the figures closely. There is something in the original Cadbury committee definition of corporate governance. If I remember correctly it said, "Corporate governance is the system by which companies are directed and controlled."

govindrajethiraj@gmail.com