by Analyst
He year that closed brought us peace and hopefully it will be sustainable with a political settlement. Internationally the last year is better known as the year of corporate scandals. Large companies like Enron, WorldCom, Tyco Adelphia and Vivendi were caught fiddling accounts and cheating their shareholders. Here’s what a financial journalist Daniel Gross says about the goings on in Adelphia.

"Adelphia routinely commingled its cash with that of other businesses controlled by the Rigas family and guaranteed billions of dollars borrowed by John Rigas and his three sons-all corporate officers and directors-to buy stock. In 2001, it paid $14.9 million to companies controlled by the family for everything from snow removal to furniture. It lent money to a film production company controlled by John Rigas and his daughter, Ellen. For several years, Ellen and her husband, who also served on the board, lived rent-free in a company-owned Manhattan apartment. As far as the company’s chief financial officer and board were concerned, all these were appropriate uses of Adelphia’s cash. Of course, that CFO was Timothy J. Rigas. And five of the board’s nine seats were filled by Rigas relatives."

The looting of Adelphia is not much worse than what happens in family controlled quoted companies here too.

Their auditors were found fault with for conniving and one auditor was caught shredding documents. Arthur Anderson & Co., the auditors of Enron, were closed down and their directors charged with criminal offences. Several directors were led away to remand with handcuffs. Would this happen in our country where ministers children involved in violence appear in police stations with their lawyers and where accused are taken to courts from remand jail by helicopter?

Our local corporate scene has still to see anything like the exposure of the scandals in USA. It is not that all’s well with our corporate sector. Far from it. It’s just that the network of friends among the CEOs, the directors and the auditors are very powerful. They all come from a small class of men who have gone to the same schools, hob nob at the same clubs. Each scratches the others backs and the poor devils, the investors or the depositors in the banks, are left high and dry when the crunch comes as seen in the unfolding Pramuka scenario.

Capital vanishes before the eyes of the regulators

The regulators have little experience in their tasks and sometimes lack the knowledge of corporate finance and skills in reading accounts. So they don’t see how the capital in the banks is being eroded by bad loans. Pramuka Bank has collapsed and the Central Bank is locking the stable door after the horse has bolted. A series of frauds and dubious banking practices have been uncovered. The CEO was known to have committed similar frauds in his previous assignment and he was facing charges in the courts for such malpractices when the licence was given to him. This was known to the Central Bank but the Bank like Pontius Pilate washes its hands of the responsibility by obtaining a character certificate reportedly from two retired judges. So armed with this dubious certificate to protect its erroneous wrongful decision, it proceeds to give a banking licence. In other countries only a temporary licence is given which is reviewed after a period and converted into a licence. Is anybody to be held responsible? It’s said that the CID has been called in now. But the bird has flown perhaps tipped off by somebody.

Were the culprits responsible for the collapse of the failed finance companies ever punished? Were those who defaulted on loans to the two state banks ever made to pay? Were the bank managers & directors who approved such loans ever held accountable? The two banks were given bonds by the government to shore up their capital. But the government has not insisted on the recovery of the bad loans and the redemption of the bonds. So one state bank repeated the performance and continued to give loans to politically backed crooks masquerading as businessmen.

Other banks also have weaknesses. Is it so difficult to determine the erosion of capital when loan repayments and interest payments are in arrears? The People’s Bank has a negative net worth of Rs. 6 billion. The Auditor General (hats off to Mr. Mayadunne and his staff), in his audit report on the Bank of Ceylon states that the aggregate amount of loans in arrears as at the end of 2001 is Rs. 21.8 billion and interest in suspense at Rs. 16 billion while the equity capital is Rs. 11 billion. Do the private auditors spotlight similar figures in their audit reports? Why not?

There are just two main ways a bank can get into trouble. One is to make too many bad loans. Another is to run out of cash by mismatching the maturities of loans and deposits. By reading the accounts of the private auditors no one can easily spot either mistake. The Banking Act requires that the banks must have their accounts audited but does not say what should be in them. Company law states what must be in the normal company accounts.

Bank supervision

Auditors seem to have no standards to apply to the banks. Couldn’t they have disclosed to the Central Bank the fishy transactions in Pramuka Bank when they carried out the audits? As for the Central Bank, don’t banks have to report in detail to them, although such information is not available to the public? Surely skilled and experienced bank examiners could not have missed the rigging of related party transactions and the capital erosion arising from loans which are in arrears? Pramuka Bank was engaged primarily in straightforward credit extending and deposit taking and nothing more complex as in the case of normal commercial banks. What was needed was intensive credit review to identify the loans in arrears, the testing of transactions and nothing more. Of course special attention had to be devoted to related party transactions and lending to connected companies and companies affiliated to the directors.

The Central Bank already has in place rules regarding these matters. What was required was to verify if these rules were being followed. Was it difficult to recognise signals that the reported information may not reflect the true condition of the bank and that the bank was lying? If the Central Bank realised that the Pramuka Bank was not following correct banking practices (they seem to have realised this later according to the statement issued by the Central Bank) why didn’t it put the public on notice? Why didn’t the Central Bank disclose to the public its examiners’ reports?

Consider the position in America where the Securities and Exchange Commission wants each bank to disclose publicly the distribution of loans, the age composition of bad loans, the maturity structure of assets and liabilities, the loans and advances in arrears and the provisions for bad loans, the details of loans to the biggest ‘connected’ borrowers, full accounting for future obligations and true net profits. Fuller and faster disclosure to the public would have helped the Central Bank to detect early signs of failure. At least it would have helped shareholders, trading partners and depositors to get out in good time.

Is it true that even some quoted banks have been caught up in the Pramuka Bank losses? Is it true that the Public Trustee deposited the funds of the Dalada Maligawa in this mushroom bank?

As for the public sector of course there is little point in talking knowing the widespread corruption therein. The government should review the regulatory failures of the Central Bank and investigate whether the private auditors knew more than they cared to tell. The Indian government has laid down by law what auditors must include in their reports in addition to the bland certificate that the accounts reflect a true and fair view of affairs.

The capital of the Pramuka Bank would have been wiped out long before it got into trouble but nobody, not the Central Bank, not the auditors, disclosed it to the depositors. Instead a false picture was given to the depositors. So the depositors will lose much of their money.

Outdated Bankruptcy Law

They will get a part but given our long drawn out bankruptcy proceedings they will have to wait till the cows come home. We have a thoroughly outdated bankruptcy law. But it suits the debtors, the company directors, the auditors and lawyers. The secured creditors like the banks take the first bite, foreclosing under parate execution. Other creditors like the suppliers, unsecured creditors and even the employees are thrown into the frying pan while they wait for the never never liquidation. The practice in developed countries is to appoint as liquidators solicitors and accountants to prevent cowboys spiriting away the little money available for the creditors.

Some one said "Capitalism without bankruptcy is like Christianity without hell". So a new bankruptcy law is a matter of urgency. But the simplified Company Law drafted by a UN expert is still to enter the statute book. Vested interests will oppose any change to the status quo because they make money from it. The professionals who service business, some economists say, are if not exactly parasites draw parasitic incomes. UK Company Law and Bankruptcy law have been amended several times in the last two decades. UK company law provides the offence of wrongful trading for which directors would be personally liable if a company continues to trade with the directors knowing that it has no money to pay its debts. So honest directors would like to move for voluntary liquidation. But under our outdated company law the directors cannot do so without being contributories to the company’s debts.

Nor does our bankruptcy law recognise the need for re-structuring of companies faced with uneconomic cost structures, which render them uncompetitive. A company here cannot file for re-organisation without going through much delay and hassle. A new insolvency law and a new bankruptcy court to implement it is a sine qua non for a better corporate sector. The creditors should be able to file for bankruptcy and force a company into liquidation. Meanwhile the government should expedite the payment of bills to suppliers. The small and medium enterprises are squeezed by the government as well as the large companies who forcibly obtain extended credit. They should at least have the option of a quick bankruptcy proceeding against such wilful debtors.

Auditors Responsibility

What about the responsibility of the auditors? Arthur Anderson the audit firm that passed the false accounting at Enron were forced into liquidation and its directors charged for criminal offences. In USA a company can be charged under the criminal law and not only under the civil law. When a company goes under in the developed world, the aggrieved investors sue the auditors as well as the directors asserting that they have a ‘joint and several liability’ for the debacle — that is that they together have caused damage and are each liable for the whole of it. Shareholders tend to pursue auditors as a matter of course and the courts award damages against them. So much so that the audit firms converted themselves into limited liability companies to avoid putting their personal wealth at risk. When will our courts take cognisance of such judgments?

Shenanigans of Directors

Corporate Boards are supposed to monitor and supervise the Chief Executive officers of the companies. The Asian Wall Street Journal some years ago classified directors of boards as follows: 10% are crooked, 15% are incompetent, 25% stay past their time and are doddering old men, 25% are good and 25% are excellent. These statistics of course referred to USA. They also determined in the survey that 4% of the CEOs are routinely removed for unethical conduct while 6% escape and ruin their companies. How many CEOs have been removed in our corporate sector? The same article classified the boards as follows:

1. The Do Nothing Board — where the outside members listen to the managers presentations, ask a few questions and go home.

2. The stacked board — outside members are also paid as consultants or paid for some other service to foster their loyalty to the management.

3. The ignorant board — some members ask questions taking up most of the time for their self education or self expression.

4. The gutless board — The CEO is known to be incompetent but the members are afraid to get rid of him thinking that they will find him too costly to replace or that they will lose business by getting rid of him. Such board members will sooner change their wives than their CEO.

5. The furtive board — The company is going downhill but you would ignore it and draw your allowances meanwhile.

6. The gullible board — The CEO and the managers will be accepted at their face value and the board will do everything to please them without scrimping on the money they ask while assuming that all is well because the management is supposedly honest and competent.

The missing moral values?

Adam Smith never thought that there would come to be a breed of men who are so greedy, so dishonest as not to have any qualms about robbing other people’s money. His economics assumed that society would continue to be based on moral values. He never envisaged a total breakdown of all moral values. He assumed that when men pursued their self-interest they would still subject their conduct to the prevailing moral values. He was the Professor of Moral Philosophy.

But as William Ropke points out things have changed. "The market competition and the play of supply and demand do not create ethical reserves; they pre-suppose them — these reserves have to come from outside the market — self discipline, a sense of justice, honesty, fairness, chivalry, moderation, public spirit, respect for human dignity — all these things people need to possess. They are indispensable supports which preserve both the market and competition from degeneration". Few CEOs today seem to believe in all this. Neither capitalism, socialism nor any other ‘ism’ can survive without moral underpinning for society whether it is USA or our own country.