Class Action V/S Satyam's Independent Directors

Four years ago, on 7th January 2009, Ramalinga Raju, the Chairman of India’s fourth largest IT Company Satyam confessed to having overstated the company’s assets by over $1 billion. The fraud included fabricated interest income, overstated receivables, hidden debt, forged bank documents, fake invoices and fictitious employees.

In 2009, a consolidated class action was filed against Satyam, some of its officers, outside directors, outside auditors, and other entities in the US District Court for the Southern District of New York. The allegations against the independent directors, also audit committee members, were that they recklessly disregarded their responsibilities in the face of extensive information that should have caused them to discover and prevent the fraud. The independent or outside directors, as they are referred to in the US, filed for dismissal of the class action claims on grounds of lack of jurisdiction and the lack of merit and last week they succeeded. To begin with Judge Barbara Jones threw out certain claims on grounds of lack of jurisdiction and in doing so she applied the 2010, US Supreme Court’s decision in the Morrison case. Class Action V/S Satyam’s Independent Directors
Plaintiffs Alleged
“AC (Audit Committee) Defendants were the watchdogs of the company and recklessly disregarded their responsibilities in the face of extensive information that should have caused them to discover and prevent the fraud” THE MORRISON CASE
US Supreme Court in Morrison, 2010
- repudiated the Second Circuit's “conduct” and “effects” tests
- announced new bright line rule defining reach of Securities Exchange Act Section 10(b)
- Section 10(b) applies only to transactions in securities listed on domestic exchanges & domestic transactions in other securities Class Action V/S Satyam’s Independent Directors
Securities Exchange Act
- Rule 10b-5 and Section 10b are Anti-Fraud provisions
- The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security Ernst Badway, Partner, Fox Rothschild, Former SEC Enforcement Secretary
“It is a very interesting decision because over the last several years the American courts have retrenched from their belief that American courts can have jurisdiction over disputes that take place across the globe and with the Morrison case, the court held that unless the transaction occurred in the United States, it occurred or where the conduct occurred in the United States, the dispute would not be allowed to be brought in the American courts. So in many respect the Morrison decision was viewed, at least globally, as an acknowledgement that American jurisdiction ends on our shores and what Judge Jones did was apply that decision and as you are aware that there were three types of securities involved – securities that were traded on the New York Stock Exchange, securities that were traded on the National Exchange in India and also the Bombay Stock Exchange and then Stock options and what Judge Jones did was dismiss the claims related to those shares that were traded on the Indian exchanges and also the stock options as not occurring in the United States. The Morrison decision is applicable to private litigation. It is still unclear whether the Morrison case will apply to Securities and Exchange Commission (SEC) enforcement actions. The Commission has taken the position that they can still file and look at activities occurring overseas as effect in the United States.” The class action sought to establish a securities claim under the Exchange Act on the grounds that the independent directors, as audit committee members, recklessly allowed the Satyam fraud to go undetected, but Judge Jones ruled that the plaintiffs failed to establish either that the directors had any motive or intent to allow a fraud to go on or that the directors ignored any red flags that supposedly should have alerted them to a fraud. Red flags such as the exorbitant fees allegedly paid to the outside auditor PricewaterhouseCoopers (PwC). The plaintiffs alleged – the directors did not investigate these fees sufficiently. Judge Jones ruled that would have amount to negligence at the most; not reckless negligence. The directors were also accused of not taking adequate steps to investigate internal financial reporting deficiencies.  Judge Jones ruled that no facts were offered as to how a more thorough investigation would have led to a discovery of the fraud. The class action also alleged that the directors had rubber-stamped the Maytas transaction decision without inquiring about the justifications for it despite the fact that it reflected an irrational business decision and would have benefited the Raju family directly. But Judge Jones found nothing remiss in the Board’s approval of Maytas merger with Satyam.
Class Action V/S Satyam’s Independent Directors
Judge Jones
- No facts suggesting that the AC Defendants benefited personally from the Satyam fraud; Lead Plaintiffs have failed to establish motive
- Combining the handful of fruitless propositions Fruitless propositions asserted by Lead Plaintiffs does not raise a strong inference of fraudulent intent Class Action V/S Satyam’s Independent Directors
Red Flag: Excessive fees paid to PwC India
Lead Plaintiffs: Directors negligent in not investigating sufficiently
Judge Jones: Even if there was a duty to investigate further, failure to investigate constitutes negligence at most Class Action V/S Satyam’s Independent Directors
Red Flag: Deficiency of internal audit controls
Lead Plaintiffs: Directors reckless in not taking steps to investigate & correct them
Judge Jones: No facts regarding the specific deficiencies referenced or about how more thorough investigation into these deficiencies would have led to discovery of fraud Class Action V/S Satyam’s Independent Directors
Red Flag: Proposed Maytas acquisition
Lead Plaintiffs: Rubber stamped management’s plans and approved maytas acquisition without inquiring about the justifications for it
Judge Jones: Board meeting minutes demonstrate that Directors asked informed questions, received reasonable responses from management, and approved the transaction with several caveats... Warren, Senior Partner, Weil, Gotshal & Manges
“Number one, she said, the directors asked the right questions. Number two, she said they got reasonable answers and directors are entitled to rely on management, but most important – and you tell me, maybe you have seen it, but I sure haven’t. The fact of the matter here is the directors voting on this transaction specifically said that they wanted additional, independent valuation of this transaction and expressly conditioned their preliminary approval on getting those valuations and being satisfied by them and indeed expressly reserve the right to revoke any approval if they weren’t satisfied with those valuations and that’s exactly the kind of further information or second look that I would think people would applaud a board for doing.” Badway: I have been personally involved in cases where board of directors has made a decision in less than a half a day and that decision has been upheld with all types of legal scrutiny and then I have been involved in other cases where the board of directors had taken months-upon-months and in one case over a year to come to a decision – they were sued and they were ultimately found liable. So, it is difficult to look at it just from the perspective of just looking at it for one day and making a decision. You have to look at the business judgment that was involved in how they made this decision and that’s what judge Jones did. The courts cannot replace their judgment with the business judgment of the board of directors of any company. Judge Jones ruled that the majority of the allegations in the class action complaint concern an intricate and well-concealed fraud perpetrated by a very small group of insiders and only reinforce the inference that that the AC defendants – that is the independent directors or the audit committee members- were themselves victims of the fraud. Class Action V/S Satyam’s Independent Directors
Judge Jones
‘The majority of the allegations in the FACC (class complaint) concern an intricate and well-concealed fraud perpetrated by a very small
group of insiders and only reinforce the inference that the AC Defendants were themselves victims of the fraud.’ Class Action V/S Satyam’s Independent Directors
Lead Plaintiffs
MPERS (USA): Owned Satyam common stock
MPS (UK): Owned Satyam ADS
SKAGEN (Norway): Owned Satyam ADS
Sampension (Denmark): Owned Satyam ADS
IBEW (USA):  owned Satyam ADS
Aberdeen: Owned Satyam common stock
Brian Adams: ESOPS Class Action V/S Satyam’s Independent Directors
Audit Committee Defendants
Mangalam Srinivasan, Fellow, Kennedy School of Government
Krishna Palepu, Professor, HBS
M Rammohan Rao, Former Dean, ISB (Audit Committee Chairman from 2007)
T R Prasad, Former Cabinet Secretary, GOI
V S Raju, Former Dean, IIT Warren: Most obviously this was a situation where a handful of insiders had carefully crafted, executed and carefully concealed fraud that is Ramalinga Raju’s confession letter said the directors didn’t know about. Second, the company had a Big Four audit firm- PwC-as their independent outside auditors and there is no question that the auditors, either outside auditors nor internal audit, had alerted the directors whether on the audit committee or otherwise to any kind of wrongdoing and the court found there were not so called red flags that the directors knew of much less ignored and if you take the totality of that – I think the conclusion that the directors as victims of this is inescapable. Badway: Judge Jones’ decision is certainly not out of the ordinary. It is in the long line of cases that have held the same way. I believe and I am only purely speculating now that if Judge Jones was presented with allegations from the plaintiffs that the outside directors were aware that the memos – that the invoices have been fraudulent or that they had got some indication from say a whistleblower that the invoices in the contracts had been inflated and that the company had been hiding these issues then the outside, independent directors would have been less likely to have succeeded in this particular case. Doshi: And so Judge Jones has cleared Satyam’s independent directors of any reckless negligence that could have contributed to the fraud. I suppose that’s good news not just for them, but for all independent directors. Warren: This is a decision that recognizes that you don’t blame – much less impose the liability- on your directors when there is a management fraud to begin with and where the outside auditors don’t alert you to the fraud. I think if the judge had come out any other way, somebody would have to think long and hard before being willing to be a director because that would almost be saying that the directors are the guarantors or they are the insurers – and they are not, they are directors. Badway: They still have an absolute obligation to the company to make sure that with the business that the company is engaging in is appropriate, legal and meets all standards regardless of the jurisdiction in which they are in. Essentially, they cannot stick their head in the sand. They have to pay attention to what’s going on. They have to inquire and they have to ensure that they make appropriate business decisions. Doshi: Now this analysis would be incomplete if we didn’t get you can Indian legal perspective and so I spoke to Pallavi Shroff, Senior Partner, Amarchand Mangaldas. Pallavi had aided in the quick government takeover of Satyam and its subsequent sale to the Mahindra Group. She says it is a good judgment that applies a high standard of proof and that India would do the same even after the new Companies Bill becomes law. Shroff: If you do all the right questioning, the right answering you can make yourself familiar with the company, but ultimately don’t forget, Independent Directors attend four board meetings in a year. So, how much more can you ask; you can defer issues, you can ask questions, but that’s about it that you can do. So keeping that focus in mind, I think this is a good judgment. I think what is important is – she has not gone by the sentiment or perception, she has gone by the actual standard of proof that is required in proving such cases and let me tell you the standard of proof that she states in her judgment is pretty much the standard of proof that we would have in India. If you look at the judgment and you look at the new Companies Bill and the liability of directors, there is not that much of a difference. If you had knowledge, of course you have to be held liable, but it does not mean that you have to go and discover frauds like an investigative officer or do a forensic investigation right there. Doshi: Satyam’s independent directors are home free; at least in the US. So far in that country Satyam has paid USD 125 million to settle one class action. PwC has paid USD 25.5 million to settle another. PwC has also paid SEC and Public Company Accounting Oversight Board (PCAOB) a USD 7.5 million penalty – all this while India has done nothing.