(Weekly Organ of the Communist Party of India (Marxist)
January 25, 2009
The Satyam Scam
C P Chandrasekhar
AS the investigation into the corporate fraud that occurred at Satyam Computer Services proceeds and early findings are selectively leaked to the media, it appears that there were many facets to the fraud that was committed. Among the allegations, two have been emphasised in media reports. One is that the company’s accounts were manipulated to inflate share values, so as to benefit the promoters. The other is that money may have been directly siphoned out through means such as fake salary accounts and transactions with sister companies.
Circumstantial evidence for the first does exist. According to observers 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 to find money to cover up the gaping hole in the Satyam balance sheet created by the fraud, earlier declines were partly the result of sale of shares by promoters. The promoters led by the then chairman, Ramalinga Raju are estimated to have sold around four-and- a-half crore shares in the company over a seven-year period starting September 2001. According to one estimate, the promoters could have earned as much as Rs. 2500 crore through the stake sale. This evidence has made Raju’s confessional statement that triggered the current investigations suspect, since he stated that “neither myself, 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.”
Needless to say the money received from sale of shares must have helped the promoters to expand their empire, by financing the activities of a large number of companies they own and control. These include the two Maytas (or Satyam in reverse) companies involved in the real estate and infrastructure business that the promoters unsuccessfully sought to merge with Satyam Computer Services.
As far as the second of the allegations is concerned, it has been reported (Business Standard January 21, 2009) that with regard to the alleged diversion of funds for the benefit of promoter companies, 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.” This too could have resulted in the use of the profits earned by Satyam Computer Services for the benefit of the promoters who are only minority shareholders in the company.
These allegations suggest that Ramalinga Raju’s confession could be false on another count: the claim that the actual revenue earning capacity of the company was much lower than reported. According to Raju, the profits of Satyam in the second quarter of 2008-09 was much lower than reported because the ratio of operating margins to revenues was just 3 per cent rather than the reported 24 per cent. This is indeed difficult to believe. Satyam Computer Services was engaged in activities similar to that undertaken by other similarly placed IT companies and 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 reported 24 per cent than the confessed 3 per cent. This suggests that either Raju is exaggerating the hole in his balance sheet or that other firms in the industry are inflating their revenues and, more importantly, profits as well. The possibility of some inflation by others cannot be discounted given the importance of stock market valuations and the fact that the tax regime for the IT industry was such that inflating revenues and profits did not result in higher tax payments. Allegations are already being made about Educomp. But the difference between 24 per cent and 3 per cent seems too large to be the industry standard.
But given the scale of the scam at Satyam, what is surprising is that the transactions did not raise suspicion. Satyam Computer Services remained a leading player with substantial investor support. The failure to detect a scam of this magnitude does imply that the system of corporate governance after liberalisation 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 the 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.
However, capitalism it is argued has designed 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 inflate revenues and profits, 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 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 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, 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.
The problem is also related to economic liberalisation, liberalisation, which affects the system of corporate governance as well. Liberalisation moves the system in the direction of “self-regulation”, since it sees bureaucratic intervention as being inimical to innovation and “efficiency”. Boards, auditors, shareholders and norms and guidelines should serve 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 even in developed countries has shown that this need not work. It is even less likely to do so in countries where the regulators are understaffed and their staff inadequately trained and underpaid.
Thus, the Satyam episode is not just an isolated instance of malpractice which must be dealt with in isolation. It is also the product of an institutional and regulatory environment that provides the space for one Satyam and, therefore, possibly for more such Satyams.