Business Ethics & Corporate

Governance
Assignment

PNB Scam: A Corporate Governance Failure

The recent Punjab National Bank (PNB) scam grabbed headlines across all
news media for the sheer size (₹12,000 crores) of the scam and the ease
with which it was conducted. In fact this scam has not been the result of an
isolated incident, but arose from sustained acts of omission or commission.
While the investigation by the CBI progresses in earnest, some of the lower
level facilitators have been caught for the procedural lapses. Although we
are yet to know the entire actors in this episode, as usual the focus of the
media has been on getting hold of the fraudsters. We also do not know how
such a massive scam remained undetected, despite Suspicious Transaction
Reports (STRs) being raised on these transactions. Certainly, some
questions have been asked about the role of the auditors and the failure of
operational risk management. Auditors pointed at the bank’s unwillingness
to dig deeper despite their reminders about similar kinds of frauds a decade
ago.
The recent announcement of the injection of around ₹2 trillion into public
sector banks by the Finance Ministry also raises a greater worry. As a result,
there is an additional burden on tax payers upon these public sector banks,
for there is the issue of sovereign guarantee. So the pertinent question
remains: Should these public sector banks not have a robust governance
mechanism of oversight before any further infusion of the tax payers’
money?
Understanding the Scam
To recollect, the PNB declared in February that they had unearthed a fraud
within their system, wherein the fraudsters were issued Letters of
understanding (LOU). LOU essentially is a bank guarantee against which
another lender gives a foreign currency loan issued by PNB without
collateral. Therefore the fraudsters used the PNB guarantee to acquire
goods at the expense of PNB, without the requirement of any collateral, and
run their business unhindered. When the time for repayment of the
previous LOU became due, they would resort to the same strategy and
repay that amount. So the bank was caught in a vicious cycle of allowing its
funds to be used to run the business of the fraudsters. This raises the
question of how could this not have been detected by the auditors. But as
the previous auditors said, they had detected and reported similar incidents
in 2006 and no action was taken. Indeed after the recent scams it has been
reported that the government is planning to introduce governance to
improve the quality of its credit appraisal systems. But it is important to
understand the possible corporate governance lacunae that may have
helped perpetrate the present scam. In fact, this is the aspect that has
attracted the least media attention.
Corporate Governance Issues
As is commonly known, corporate governance is the system by which
companies are directed and controlled. So it is not about the day-to-day
operational management of the company, but what the board of a company
does and how the values of the company are set by the Board. This means
having the best persons in the Board. There are three issues to be
considered in the case of corporate governance in public sector banks.
First, being a listed entity PNB would have to adhere to Clause 49 (2014) of
the Securities and Exchange Board of India (SEBI) listing agreement. In
fact it is precisely this capability that is enshrined in clause 49 too. As a
responsibility of the Board: ‘Board should provide the strategic guidance to
the company, ensure effective monitoring of the management and should
be accountable to the company and the shareholders’.
More importantly, the Board is also tasked with ensuring the integrity of
the company’s accounting and financial reporting systems, including
independent audit and putting in place appropriate systems of control –
for risk management, financial and operational control,
and compliance with the law and relevant standards.
Second, coming to the rules for composing a Board: Firstly, board shall
have an optimum combination of executive and Non-executive
Directors (NED), with not less than 50 percent of the board of
directors comprising of non-executive directors. Secondly, where the
Chairman of the Board is a non-executive director, at least 1/3rd of the
Board should comprise independent directors and in case the company
does not have a regular non-executive Chairman, at least half of the Board
should comprise independent directors, and thirdly, independent director
means NED, but excludes nominee director.
Finally, the regulation requires a qualified and independent audit
committee. The audit committee shall have minimum of three directors as
members and 2/3rd of the committee members shall be independent
directors. Also, all members of audit committee shall be financially literate
(means the ability to read and understand basic financial statements i.e.
balance sheet, profit and loss account, and statement of cash flows) and at
least one member shall have accounting or related financial management
expertise.
Corporate Governance Practices at PNB
Looking at the website of PNB, the corporate governance and annual
reports, the Board has 11 members with one of them a part-timer. In fact
the website of the bank does not clarify the category into which these
directors fall. Incidentally it is this part-timer (non-official director) who is
supposed to play all the important roles in the audit committee.
It is not our role to cast aspersions on the capability of the
directors nor the efforts they have put in, but to query the
concerns in the light of the emergent scam.
To anyone looking at their website, this addition would almost seem like an
act to be an after-thought of having at least one accounting expert. Similarly
you see the Board being headed by a NED and as a consequence only
1/3rd of the Board needs to be NEDs. However, a cursory look will show that
two of the directors are government nominees. Importantly, as per the
present SEBI listing rules these nominee directors cannot be considered as
NEDs’. In fact NEDs are not passive actors on the board, but have crucial
role to play. NEDs are supposed to constructively challenge and help
developing proposals on ‘strategy’. Similarly, they also have a crucial role to
play in scrutinizing the performance of management systems. Precisely, the
PNB scam shows that the NEDs have failed on all these counts.
Looking at the corporate governance and annual reports of PNB, you find
that the audit committee is not headed by a person having accounting or
financial management expertise. Similarly, the other members seemingly
are no experts in accounting (although this is not a requirement), and the
government nominees are shown as NED’s which against the SEBI
regulation. The audit committee is having another critical element of
corporate governance, and here too the PNB has been willing to
compromise. Now it is not our role to cast aspersions on the capability of
these directors nor the efforts they have put in, but to query these concerns
that seem glaring in the light of the emergent scam.
Stake for Government
At 65 percent the government of India is the largest shareholder at PNB
and certainly this scam has resulted in a loss of tax payers’ money.
However, there seems to be no discussion about bringing in changes in the
corporate governance structure at these public sector banks. The Board at
PNB seems like a place for recycling senior staff from other public sector
banks or government entities. We ought to be thinking whether we have the
best minds in the boardrooms of the banks. As this scam has shown we
cannot have a lax/bureaucratic attitude to the composition of the boards at
these banks. It may not be in the interest of the public and tax payer to keep
these banks in the public sector if these scams go unchecked. Now, for this
to happen it is important prosecute and punish the perpetrators, but
equally important is to have the best practices in place too. It is here that an
effective board is invaluable.