System failure

Published : Feb 13, 2009 00:00 IST

Satyam Computer Services founder B. Ramalinga Raju is escorted by policemen to the Chanchalguda jail in Hyderabad, on January 23.-MAHESH KUMAR A./AP

Satyam Computer Services founder B. Ramalinga Raju is escorted by policemen to the Chanchalguda jail in Hyderabad, on January 23.-MAHESH KUMAR A./AP

THE fraud at Satyam Computer Services may well turn out to be the biggest of all scams unearthed from the interior of corporate India. As evidence and speculative narratives from the ongoing investigations are leaked selectively to the media, it is clear that there is no single Satyam story.

Through multiple routes involving a large number of related companies and myriad transactions, the promoters of Satyam, led by the companys chairman, B. Ramalinga Raju, are alleged to have siphoned out a huge amount of money from the firm. To cover that up, the accounts were manipulated and documents forged to declare non-existent cash reserves and understate liabilities.

The money that was taken out may have been used, among other things, to acquire large quantities of land in what seems to be a set of speculative real estate ventures that could enrich the promoters family. The two Maytas Satyam spelt in reverse companies were important conduits in this process, but there were clearly many more.

According to reports, the Registrar of Companies has found that Satyams annual report reveals several transactions with subsidiaries and other group companies by way of investments, purchase of assets and other receivables, which point to the concealed transfer of funds out of the company.

Shockingly, one of the allegations made by the Crime Investigation Department (CID) of Andhra Pradesh is that the company had only 40,000 employees on its rolls as against the 53,000 it claimed to have. The remaining 13,000 were merely fake salary accounts through which as much as Rs.20 crore a month were taken out of the company over a period of five years. If true, this involves descent to a level of manipulation and fraud that could make the story much bigger than it already is.

There are reasons to believe that there is indeed much more to be revealed, as the effort at separating truth from lies proceeds. To start with, it now does appear that Ramalinga Rajus confession was aimed at concealing more than it revealed. In particular, two of his claims are now suspect. One is that the process that led up to the claimed Rs.7,000 crore-plus hole in the companys balance sheet was the result of an unmanageable cumulative process that was triggered by a small (even if unwarranted) manipulation of the accounts many years back. This, according to the chairman, put him in a position where he was riding a tiger. However, if the information being yielded by the ongoing investigations is true, it was not a small error but a planned, audacious and outrageous scam, which was expanded in scale over time and eventually led to the companys near collapse.

The other claim that is obviously untrue is that neither he nor the managing director (including our spouses) sold any shares in the last eight years excepting for a small proportion declared and sold for philanthropic purposes. The truth is that the stake of the promoters has fallen sharply after 2001 when they reportedly held 25.60 per cent of equity in the company. This fell to 22.26 per cent by the end of March 2002, 20.74 per cent in 2003, 17.35 per cent in 2004, 15.67 per cent in 2005, 14.02 per cent in 2006, 8.79 per cent in 2007, 8.65 per cent at the end of September 2008 and 5.13 per cent in January 2009.

While the last of these declines was due to sales by lenders with whom the promoters shares were pledged, earlier declines were partly the result of the sale of shares by promoters. The promoters are estimated to have sold around four and a half crore shares in the company over a seven-year period starting September 2001.

It has been alleged that the companys accounts were manipulated to inflate share values so that these sales of shares would deliver large receipts to the promoters. According to one estimate, the promoters could have earned as much as Rs.2,500 crore through the stake sale. Thus, Rajus confession clearly sought to conceal the dimensions of the scam.

Rajus confession is also suspect because it seems to understate substantially the actual profit-making capacity of the company. He claims that the huge difference between actual and reported profits in the second quarter of 2008-09 was because the ratio of operating margins to revenues was just 3 per cent rather than the reported 24 per cent. But even if Satyam Computer Services was cooking its books, it was engaged in activities similar to that undertaken by other similarly placed information technology (IT) or information technology-enabled services (ITES) companies and it too had a fair share of Fortune 500 companies on its client list. It is known that many of these companies have shown operating margins that are closer to the 24 per cent reported by Satyam than the 3 per cent revealed in Rajus confession. Thus in the financial year ending March 2008, the ratio of profits before tax of Infosys was 32.3 per cent of its total income, that of TCS 23.1 per cent, of Satyam 27.8 per cent and of Wipro 19.2 per cent (see separate story on page 25). This suggests that either Raju is exaggerating the hole in his balance sheet or that other firms in the industry are also inflating their revenues and profits.

While the Satyam episode indicates that the latter possibility cannot be ruled out altogether without an investigation, the difference between 24 per cent and 3 per cent seems too large to be the industry standard. It appears that the companys potential is being discounted to make the scam seem smaller than it probably is.

A third reason why the investigations may reveal the Satyam scam to be even bigger than it now seems is the initial reticence of the industry, the government, politicians and sections of the media to believe that this was a scam of the kind and of the magnitude that it now appears to be.

This reticence was implicitly justified with the argument that one bad apple should not be allowed to affect the credibility of the industry as a whole. Protecting the industrys reputation and pre-empting demands for greater regulation and state intervention were visible motivations. The spate of financial scams in the United States, involving firms such as Enron and WorldCom, led to the Sarbanes-Oxley Act, which set new norms and standards for all U.S. public company boards, managements and public accounting firms, with stringent penalties in case of violations. This was what most did not and do not want for the IT industry, which explains the reticence noted above.

Satyam Computer Services was ranked number four among companies in an industry that epitomises Indias post-liberalisation success and has been uncritically celebrated by the government, sections of the media and part of the vocal elite. It was an industry that was often presented as one that adheres to modern best practices with regard to governance, accounting and disclosure and includes firms (like Satyam) and individuals that had received awards for entrepreneurship and good governance. A leading player in that industry could not be easily recognised as having been involved in massive financial fraud without triggering demands for regulatory rethink.

Moreover, this is an industry that not only received tax and other concessions from the government but built close relationships with politicians and successive governments, which bestowed recognition and access to leading actors of a kind that was not afforded to successful industrialists in the past. There is therefore an element of complicity of the state in the acts of the industry, which can be justified when the industry delivers growth and employment but is an embarrassment when events such as the Satyam fraud occur. This seems to have resulted in a lack of alacrity on the part of State- and Central-level investigation and regulatory agencies to set about the task of unravelling the scam.

But given the scale of the scam at Satyam, what is surprising is that the transactions did not raise suspicion much earlier. This does suggest that the system of corporate governance that has been in place after liberalisation is not working. It should be obvious that in a private enterprise system filled with joint stock companies, there could emerge a difference in the interests of the managers or managing promoters, on the one hand, and shareholders and other stakeholders, on the other. In the event, there is the danger that managers and/or promoters may function in ways that financially benefit them at the expense of the returns earned by the shareholders or the security of other stakeholders.

Governance structures are meant to prevent this. One way in which this is done is through the capital market, which is seen as a monitoring and disciplining mechanism because it serves as a market for corporate control. Bad managements trigger stock price declines, leading to their replacement owing to pressure from existing shareholders or from new shareholders who exploit the lower share values to acquire an influential stake in the company. In practice, this kind of monitoring rarely works either because incumbent managements reveal partial or incomplete information or because minority shareholders would find it difficult and costly to fully monitor and discipline managers who put the companys revenues and profits at risk.

Moreover, shareholders are beguiled by high stock prices, since they buy into the idea that high and rising stock prices are a sign of both good performance and good management. If accounts are manipulated and revenues and profits inflated, the stock market performance of the company improves, and that improvement serves to conceal the fraud that is under way.

Advocates of regulatory forbearance under a reformed and liberalised capitalism argue, however, that the system has fashioned a governance structure that is explicitly aimed at ensuring compliance and disclosure. That structure is multilayered, consisting of boards of directors, which include independent directors expected to represent the interests of the minority shareholders and society at large; auditors who are expected to ensure that the books that provide information on the performance of the managers and the financial health of the company are in order; regulators who ensure that guidelines with regard to accounting standards, disclosure and good management practices are followed; and agencies that can investigate and prosecute in case fraud of any kind is suspected. This, combined with international accounting standards and disclosure norms that are ostensibly followed by IT companies (since they serve international clients and are listed in international markets), was seen as insuring against fraud.

What has shocked observers is that the decision of the promoters of Satyam Computer Services to manipulate accounts, defrauding its investors in the process, was neither sensed nor detected at all levels of governance. There are a number of factors that seem to underlie this overall failure.

To start with, there was total failure at the level of the board and the auditors. This huge fraud, which occurred over many years and ostensibly left a hole of more than Rs.7,000 crore, was completely missed by a high-profile board, which even agreed to allow the promoters to use its non-existent reserves to buy up two unrelated companies in which the promoters had a major stake. The board included independent directors who are respectable professionals and academics.

In addition, the firms auditors, PwC, one of the big four, failed to detect manipulation of this magnitude, despite the fact that it included claims of huge cash reserves that did not exist. As many have rightly argued, even a minimum of diligence would have proved this claim regarding reserves to be false, leading to a detection of the scam.

The question that arises is whether self-regulation failed because these individuals and entities were paid by the company to undertake their role. A similar issue came up in the U.S. after the sub-prime mortgage crisis when observers asked whether the fact that the rating agencies such as Moodys and Standard & Poor, which were to serve as monitors of risk, discounted risk and gave high ratings because they were paid by the firms whose securities they rated.

According to reports, independent directors in Satyam Computer Services were paid huge fees for their professional services, varying from Rs.12.4 lakh to Rs.99.48 lakh in 2006-07, in the form of commission, sitting fees and professional fees (Satyam directors remuneration, Business Line, December 30, 2008). This gives rise to the criticism that the practice of managements paying independent directors (and paying them well) could lead them to take a soft view of matters and not take their monitoring and correcting role seriously.

Further, the lack of adequate caps on revenues obtained by auditors from their clients also creates a problem. The search for large fee-incomes and competition between auditors to increase market share do encourage auditors to take at face value the claims of their large clients and the documents they produce, dropping the minimal checks which would possibly have revealed the Satyam fraud. Here again, the fact that the monitor is paid by the monitored seems to be a major source of the problem.

In the event, the system of self-regulation designed by the reformers, on the grounds that bureaucratic intervention is inimical to innovation and efficiency, ceases to work. That system operates in the belief that boards, auditors, shareholders and norms and guidelines are enough to ensure that managements adopt good practices, and regulators should come in principally when fraud is detected, to investigate and penalise so as to set an example. Experience across the world has shown that such optimism is not warranted.

Thus, the Satyam episode is not just the result of individual greed. It is also the product of the celebration of profit-making irrespective of magnitude, of the belief in markets and the discipline they impose, and of regulatory dilution and regulatory failure.

It is this which raises the possibility that Satyam may not be an isolated bad apple, but an instance of something that could recur.

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