R Ravimohan: SOX did not prevent Refco

The creation of rites and rituals surrounding the board of directors can undermine its operations

On October 11, 2005, Philip Bennett, president and CEO of Refco, was arrested and the company put under investigation for improper accounting disclosures, principally for hiding $430 million of debt. Refco Inc is a diversified financial services organisation and is considered as one of the largest global clearing firms for derivatives. Refco now joins the list of infamous US-based companies that have reported financial frauds and improper disclosures. Moreover, the fact that the Refco incident has happened in the post 'SOX clean' corporate environment is why it is so important for us to understand the reasons for this occurrence.

Refco satisfies almost all corporate governance norms and obviously meets all regulatory requirements as well. It is not fully SOX-compliant and has sought time till 2007 to be so, which is apparently allowed under the SOX dispensation. However, it satisfies most of the structural safeguards that governance pundits profess, namely independent directors, rigorous audit committees, code of ethics, compensation committees, self-evaluation by the board, continuing education and training of the board, director attendance at shareholders' meetings, and so on and so forth. Philip Bennett, however, was both chairman and CEO of Refco, as the company does not believe in splitting these posts. Of course, currently Bennett is on leave from the board.

It is widely understood that Bennett had been hiding a debt of around $430 million, with the help of a series of complex transfers between Refco Capital Markets, Refco Group Holdings Inc (a company that is wholly controlled by Bennett), and an external hedge fund. The related party transactions and the debt amount were not disclosed during Refco's IPO earlier this year, therefore falsely inflating the financials of the company.

In recent times, the corporate world has witnessed a series of stern judgements against investment banks, auditors, and boards of directors, pertaining to various fraudulent activities. In the WorldCom case, its former investment banks, auditors, and directors were fined over $6.1 billion just a few months prior to the Refco scandal. The board of directors of Enron settled a case of negligence against them by paying a fine of $168 million (of which, $155 million will come from insurance and $13 million will be paid out of personal accounts!) for letting the Enron debacle happen under their watch. Every scandal has been investigated and it is fair to say that the offenders have been caught and dealt the appropriate punishment.

However, in spite of the above judgements, the Refco scandal did happen. Refco is a repeat of Enron, in that both hid debt though for different reasons. The fact that an executive has the continuing ability to hide a debt size of $430 million is worrisome. None of the systematic solutions has been able to prevent this from taking place. Clearly, from the information available right now, everything points to the fact that Bennett hid the debt and penetrated the fraud on his own without the help of any other individual or firms. This is unlike Enron, where many accomplices were involved in the fraud. If this is true""that Bennett perpetuated this fraud in a single-handed manner""then the case points to competencies as the prime cause of failure rather than motives. It also points to the fundamental flaw in the process of plugging corporate frauds using corporate governance as the instrument. As iconoclastic as it may sound, the usefulness of corporate governance as a tool to prevent fraud needs to be re-evaluated, as also does the need for realistic deliverables of corporate governance principles.

Clearly, corporate governance is not enough to prevent frauds. The elements of good governance, namely transparent disclosures of financial information, systems of checks and balances, independent oversight in corporate affairs, and the deterrent of accountability, are good systematic tools to conduct the operations of a corporate entity. However, there is still huge dependence on the management and staff of the corporate entity to adhere to good behaviour. This huge overlap area, where systems have to depend on the good behaviour of corporate citizens, is unlikely to be successfully monitored by any systematic or structural solutions. Indeed, this internal domain is also so intimately known to insiders and opaque to outsiders that it is likely to provide a viable cover to wrongdoers against the entire barrage of external scrutiny.

Moreover, the creation of so many rites and rituals surrounding the operations of the board of directors""the emergence of the audit committee as a catch-all trash can of all kinds of sundry duties, the concept of lead director that somehow undermines the importance of all other directors, the imposition of governance duties on the independent directors to the extent of ignoring the governance responsibilities of the dependent directors, and the suppression of the powers and the ability of the chief executive to act with trust and support of the board""may undermine the very operations of the corporation that these are expected to be protect. Any further imposition of governance rules as a fallout of the Refco episode will definitely be counter-productive.

Instead, it will be useful to concentrate on a shared vision of good behaviour and value systems. Cumulatively, the structural, systematic, and incentive issues have been addressed adequately. The more amorphous issue of correcting corporate behaviour by constant reinforcement of good values and behaviour is something that should be emphasised. External agencies like Crisil, which perform corporate governance and value creation ratings, and suitable diagnostic studies, are useful in spreading the right message about the serious intent of the governors to institute good governance in corporate affairs. Last, but not the least, explicit and directed sessions with the management team on issues of good behaviour, with the active participation of the senior management in these meetings, will foster the understanding that governance is not a mechanical issue that can be addressed under the SOX or some other regulation of its kind, but is a live, organic, and managerial issue that needs to be constantly tackled on a day-to-day basis.