India Inc?s transition to the International Financial Reporting Standards (IFRS) offers a timely opportunity to enact rules that enhance the quality of financial disclosure by our firms. The quality of financial disclosure by firms gets shaped by the incentives of managers and auditors.
The experiences of other Asian countries (China, Hong Kong, Malaysia, Singapore and Thailand) illustrate the futility of implementing standards without altering incentives for better financial reporting. Though each country implemented IFRS, the new standards have not led to better-quality financial reporting.
In light of these countries? experiences, transitioning to IFRS would be wasteful without taking the necessary steps to enhance the quality of financial reporting. Such a superficial transition would only enable audit firms to fill their coffers by effecting cosmetic changes. To improve the quality of financial reporting, a relatively easy yet effective step would be to liberalise the rules governing stockholder litigation. Firm managers and their auditors are less likely to obfuscate accounting numbers if they face the prospect of injured investors suing them and the firm for disclosing fraudulent financial information. The rules should be framed such that while meritorious lawsuits are encouraged, strong penalties are imposed on parties that bring frivolous suits with the intention of holding firms to ransom.
To understand the need for such prudent changes, let us first evaluate the costs and benefits of permitting private litigation by shareholders. To deter managers and auditors from indulging in financial sleight-of-hand, we need a system that severely penalises such practices. Seen in this light, the punishment being meted out to the Rajus?imagine the downfall from India Inc?s who-is-who to petty criminals?should serve as a useful deterrent to other closeted fraudsters. While the government and the regulators deserve praise for meting out such exemplary punishment, it is both impractical and costly to expect the government and market regulators to intervene in every instance of accounting fraud. Private lawsuits offer a market mechanism to create such deterrence.
Consider a group of investors that bought shares of a company when the price was, allegedly, artificially high since the company had incorrectly stated material accounting information. In such a transaction, sellers reap an undeserved windfall but cannot be sued because they have not indulged in any wrongful act.
However, this injustice can be redressed by allowing the injured investors to sue the company, its managers and its auditors who are responsible for the misleading statements. But, why should policymakers and market regulators bother if, in a market transaction, one party loses and another wins equally? Policymakers must care because of the effect of such a penalty on the quality of financial reporting. Allowing the injured party to recover their losses from the firm would ensure that the firm makes every attempt to disclose information correctly. Investors benefit from better quality financial information. Further, firms benefit as well from a reduced cost of capital and increased access to global capital markets.
However, as the experience in the US demonstrates, enabling litigation presents costs as well. Easing the rules for shareholder litigation can also lead to frivolous lawsuits, where investors sue with the intention of extorting from firms? deep pockets. Such frivolous lawsuits impose severe economic costs. Firms and their managers may buy insurance to protect themselves against any shareholder lawsuit, meritorious or otherwise. Even forthright managers may refrain from disclosing forward-looking accounting information for fear that they may get litigated if their outlook on forward-looking events does not materialise.
Therefore, given the costs and benefits of easing private litigation, a hypothetical optimal exists for an economy (see figure). To the left of this optimal point, benefits from encouraging private litigation dominate costs from doing the same. India presents such a case since private litigation by injured investors is almost non-existent in our country. Therefore, India certainly stands to benefit from a move to the right towards the optimal point: regulation permitting private lawsuits. However, to the right of the optimal point, costs dominate benefits. Arguably, the US falls in this region. Therefore, to avoid shifting to the right of the optimal point, the rules must stipulate strict penalties for frivolous lawsuits.
The following rules will prevent possible frivolous suits. First, the burden of proving that management intentionally committed fraud must rest on the plaintiff.
Second, if the court finds the suit to be frivolous, the plaintiff must be required to refund the defendant?s legal costs. Third, forward-looking disclosures must be impervious to lawsuits as long as they are accompanied by reasonable caveats. Third, in cases involving multiple defendants, damages must be attached proportionally to the blame that is attributed to a particular defendant. Finally, to reduce plaintiff lawyers? ability to file frivolous lawsuits for their own gain, large shareholders must be allowed to petition the court to be appointed as lead plaintiff.
?The author is an assistant professor of finance at Emory University, Atlanta, and a visiting scholar at the Indian School of Business, Hyderabad