Themes > Current Issues
27.01.2009
The Fraud at Satyam
C.P. Chandrasekhar
The
fraud at Satyam 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 selectively leaked 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 Computer Services, led by the company's Chairman
Ramalinga Raju, are alleged to have siphoned out a huge quantity of
money from the firm. To cover that up, the accounts were manipulated
and documents were forged to declare nonexistent 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 family. The Maytas companies that had titles that spelt Satyam in reverse were important conduits in this process, but there were clearly many more. According to reports, the Registrar of Companies has found that ''Satyam's annual report reveals several transactions with subsidiaries and other group companies by way of investments, purchase of assets and other receivables'' that 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 compared with the 53,000 claimed by it and the remaining 13,000 were mere 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 the ''confession'' by Ramalinga Raju was aimed at concealing more than it revealed. In particular, two claims of the Chairman are now suspect. One is that the process that led up to the claimed Rs. 7,000 crore-plus hole in the company's 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 indeed true, it was not a small error but a planned, audacious and outrageous scam, which was expanded in scale over time, that led to the company's near collapse.
The other claim of the Chairman 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 in 2007, 8.65 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 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 company's accounts were manipulated to inflate share values, so that these sales of shares would have delivered large receipts to the promoters. According to one estimate, the promoters could have earned as much as Rs. 2500 crore through the stake sale. Thus, Raju's confession clearly sought to conceal the dimensions of the scam.
Raju's confession is also suspect because it seems to substantially understate 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 IT or 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 been showing operating margins that are closer to the 24 per cent reported by Satyam than the 3 per cent revealed in Raju;s confession. Thus in 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 that of Wipro 19.2 per cent. 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 company's potential is being discounted to make the scam seem smaller than it is likely to have been.
A third reason why the investigations may reveal the Satyam scam to be even bigger than it now seems is the initial reticence on the part of the industry, 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 did slow the proceedings. 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 industry's reputation and preempting demands for greater regulation and state intervention were visible motivations. It must be recalled, that the spate of financial scams in the US involving firms like Enron and WorldCom led to the Sarbanes-Oxley Act which set new norms and standards for all U.S. public company boards, management, 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 has come to epitomise India's 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 which has 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 liberalization does not work. 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 due 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 company's 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 which provide the 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 of 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 have a major stake. The board included independent directors who are respectable professionals and academics. In addition, the firm's 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 after the sub-prime mortgage crisis when observers asked whether the fact that the rating agencies such as Moody's and Standard and 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 being 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 30 December, 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, 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, does encourage auditors to take the claims of their large clients and the documents they produce at face value, 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 with 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 penalize 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.
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 family. The Maytas companies that had titles that spelt Satyam in reverse were important conduits in this process, but there were clearly many more. According to reports, the Registrar of Companies has found that ''Satyam's annual report reveals several transactions with subsidiaries and other group companies by way of investments, purchase of assets and other receivables'' that 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 compared with the 53,000 claimed by it and the remaining 13,000 were mere 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 the ''confession'' by Ramalinga Raju was aimed at concealing more than it revealed. In particular, two claims of the Chairman are now suspect. One is that the process that led up to the claimed Rs. 7,000 crore-plus hole in the company's 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 indeed true, it was not a small error but a planned, audacious and outrageous scam, which was expanded in scale over time, that led to the company's near collapse.
The other claim of the Chairman 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 in 2007, 8.65 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 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 company's accounts were manipulated to inflate share values, so that these sales of shares would have delivered large receipts to the promoters. According to one estimate, the promoters could have earned as much as Rs. 2500 crore through the stake sale. Thus, Raju's confession clearly sought to conceal the dimensions of the scam.
Raju's confession is also suspect because it seems to substantially understate 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 IT or 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 been showing operating margins that are closer to the 24 per cent reported by Satyam than the 3 per cent revealed in Raju;s confession. Thus in 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 that of Wipro 19.2 per cent. 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 company's potential is being discounted to make the scam seem smaller than it is likely to have been.
A third reason why the investigations may reveal the Satyam scam to be even bigger than it now seems is the initial reticence on the part of the industry, 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 did slow the proceedings. 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 industry's reputation and preempting demands for greater regulation and state intervention were visible motivations. It must be recalled, that the spate of financial scams in the US involving firms like Enron and WorldCom led to the Sarbanes-Oxley Act which set new norms and standards for all U.S. public company boards, management, 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 has come to epitomise India's 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 which has 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 liberalization does not work. 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 due 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 company's 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 which provide the 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 of 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 have a major stake. The board included independent directors who are respectable professionals and academics. In addition, the firm's 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 after the sub-prime mortgage crisis when observers asked whether the fact that the rating agencies such as Moody's and Standard and 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 being 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 30 December, 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, 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, does encourage auditors to take the claims of their large clients and the documents they produce at face value, 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 with 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 penalize 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.
© MACROSCAN 2009