No satyam

At a time when the world is battling a global financial meltdown, India's attention has been drawn inwards over its own 'Enron moment'. As if the financial crisis was not enough to deal a blow to the economics of this fast-growing behemoth of a country, India Inc is suddenly grappling with a USD 1.5 billion scam, the magnitude of which is greater than that of Enron. Satyam Computer Services, a mammoth success story and a prominent face of India Inc till just a few months ago, has now become the biggest corporate scam in India's history. But over and above what was perpetrated within the company's halls, the president of the Federation of Indian Chambers of Commerce (FICCI), Rajeev Chandrasekhar, has termed the whole episode as "a systemic breakdown in audit and board oversight". Thus, one is forced to take in a broad range of possibilities in looking for the culprit – and where to direct reforms.

Ironically, the World Council for Corporate Governance, a not-for-profit aimed at improving the quality of corporate governance worldwide, has ranked Satyam as among the best-run companies in the world, last year awarding it the Golden Peacock Award for Excellence in Corporate Governance. And indeed, with operations in 66 countries, boasting 185 'Fortune 500' companies as customers and 53,000 workers, Satyam was considered a notable corporate success story. That is, of course, until 7 January 2009, when all collapsed as Chairman Ramalinga Raju tendered his surprise resignation, in the process offloading the "tremendous burden" that he admitted to having been carrying on his "conscience". Since 30 September 2008, he confessed, Satyam's balance sheet had carried a cash and bank balance overstated by some USD 1.03 billion; the restated balances actually stood at USD 50 million, as against the official figure of USD 1.08 billion. Raju also noted that this gap was due purely to profit reporting that had been massively inflated over the last several years. What had begun as a marginal gap quickly grew into an unmanageable one. In order to keep the wheel moving, money was raised from all possible sources – even promoter shares were pledged, meaning that the management had put entire investments, both personal and institutional, at stake. "It was like riding a tiger," according to Raju's resignation letter, "not knowing how to get off without being eaten."

The Satyam scandal has made Indian society realise that there are serious loopholes in the country's regulation, audit and governance systems, which obviously have been taken advantage of by less-than-scrupulous businesses. There will always be people out there to outsmart the regulators – as can be seen in the current global meltdown, which began in the US when smart people began to create increasingly complex financial products to run circles around the regulators. It all ended with the wipe-out of financial institutions and the evaporation of significant amounts of public money. In the Satyam aftermath, India's socialists, who had been increasingly gagged by the loud voices of market-economy propagators, have suddenly found a voice, and the hope that someone will now listen when they harp on the perils of capitalism.

Price of independence
One does not have to share a bed with the 'socialists' to concede that corporate governance in India has severe weaknesses. The lapses have their origins in the fact that Indian companies tend to be very hierarchical, with the boss's word being final. Strategic thinking and decision-making are merely parallel activities to action in almost all corporations, with almost no checks and controls. Meanwhile, market regulation remains quite loose, with regulatory bodies unable to play any effective role in punishing non-compliance. Unlike in the United States, financial fraud is yet to be socially regarded as a crime. And the day seems far off when being convicted for corporate fraud can lead to life imprisonment, along with the losing of all of one's assets.

The board of directors of most Indian companies today remain 'single-tiered', with boards and management under the control of a single family. According to one business daily, family-run businesses currently account for a whopping 95 percent of all Indian companies. In 2006, of the 90 companies listed on the Bombay Stock Exchange – and 100 for whom data is available over a five-year period – 48 were family-owned, and only 11 were professionally managed. Another 10 were multinational corporations. Directors are often confused about their actual duties and powers, and rules on conflict of interest are rarely enforced. Importantly, the Southasian history of colonisation, royal rule and zamindari has created a superstructure of belief that the owner is always right, and that everyone else needs to follow his dictate. Individuals who have been appointed to corporate boards as independent directors or auditors have therefore tended to work merely to keep their jobs, no matter if a few rules are bent.

As it turns out, at Satyam almost no rules were adhered to in the first place. Chief Financial Officer Vadlamani Srinivas has placed the blame for the fraud on Chairman Raju and Satyam's auditor, the London-based PricewaterhouseCoopers (PwC). Indeed, the part played by the latter has only reinforced the realisation that little of what has taken place in Satyam can be blamed solely on characteristics of the Indian system. "The auditors never pointed out any deficiencies," Srinivas said. "The bank deposits were handled directly by Raju, and I was specifically asked not to look into it." As far as the accounting is concerned, whether or not there was manipulation of accounts is a matter of judgment. But the fact remains that there were grave slips on the part of the external auditors, who seem to have abandoned all accountability towards financial mobility that society demands. An auditor is a public watchdog of sorts, and PwC was found severely wanting.

The financial crisis in the US, which has now led to the omnipresence of the term 'global meltdown', was created by the nexus between supposedly independent watchdog institutions such as audit firms and credit-rating firms. As it turns out, these agencies have become increasingly over-reliant on what is often referred to as 'management opinion'. Auditors started making their jobs easier by taking letters from management that literally protected the auditors from any problem that could arise in the future. If they could not verify bank deposits, then they simply took a letter from management saying that the deposits were indeed in the bank. The practice of shifting the blame to auditing, a profession that only just started being regulated, did not help matters. In the quest of keeping their own profits soaring, these firms evidently did not particularly mind being in the company of companies that were quietly asking for skewed profit graphs. It is believed that PricewaterhouseCoopers received audit fees from Satyam that amounted to three times the industry benchmark. Indeed, the entire matter could spell the end of PwC, as it is hard to imagine how it will retain credibility after this episode. Some years back, a competitor, DSP Merrill Lynch, had found serious accounting issues when Satyam approached them for help with a merger; PwC, meanwhile, found nothing for years.

According to Indian regulations, in situations where the chairperson of a board is a non-executive director (an individual appointed to the position who is an employee of the company), at least one-third of the board needs to be comprised of independent directors, or those who do not represent any interest of the company. In cases in which the chairperson is an executive director, at least half of the board is stipulated to be made up of independent directors. In the case of Satyam – whose chairman was very much executive director – questions have been raised regarding the role of at least two of its 'independent' directors. These include the inventor of the Pentium chip, Vinod Dham, and Krishna Palepu of the Harvard Business School. Admittedly, these are individuals with excellent credentials. Nonetheless, there are now concerns that both of these directors could have been too close to Chairman Raju, and might have been part of the cover-up.

The question again shifts back to the basics. Can supposedly independent directors, who enjoy the perks of the company and get paid for sitting at board meetings, be expected to act independently? This is a crucial point: are today's 'independent directors' truly strong enough to stand up to their companies' boards and management? In some cases, should active investors be considered more effective than independent directors in keeping a company running on the straight and narrow? For that matter, is it fair that professors, legal experts and audit-firm partners are often acting as independent directors on the boards of some dozen-odd companies simultaneously? Can they be expected to devote the time required, and do they even have the knowledge and expertise to understand and detect frauds of Satyam-sized magnitude? These issues ultimately boil down to the very real question of whether, if truly independent directors are what the system requires, there are actually enough independent, qualified individuals to fill the boards of these thousands of companies that make up the Indian business world. And a principle that applies to India, of course, would apply to all the economies of Southasia.

There are clearly some disconnects in how corporate governance is understood. There seems to be an unwillingness on the part of major institutional investors to view good-governance practices as the pathway to wealth creation. The institutions do not seem to exhibit the sensitivity expected of them as investors of public funds, by demanding corporate transparency and accountability. To a large extent, they are also driven by a speculative mindset to maximise profits on the stock markets. Unless this attitude changes, and independent directors put their foot down for the sake of profits and long-term growth, they will not be taken seriously. Rather, they will continue to be considered as little more than boardroom intruders – to be tolerated only for the sake of compliance with corporate-governance regulations.

Green-eyed lessons
Where does plain old greed come in with regards to the Satyam scandal, and others like it? Questions are being asked about the Raju family's intentions in the first place. His brother, B Suryanarayana Raju, is believed to have been a key player in the fraud to which Ramalinga has confessed. He is alleged to have masterminded the screening of the evidence and shifting of documents related to lands purchased in the name of several group companies floated by his family members, all with funds siphoned off from Satyam. But did the family, from the very outset, intend to gain widespread trust and then amass wealth through fraud? Or was it that the family merely lost control over its greedy members, and could not say 'stop'? In most cases of corporate fraud around the world, the companies are rarely created with the intention of defrauding shareholders. Rather, over a period of time, the corporate governance gives way and less-than-reputable owners are enticed into dipping into the whirlpools of cash. Otherwise, how could a group of such high professed ideals – one that believed in such noble ideas as emergency help networks with help lines and ambulances, a group that could convince former Indian President A P J Abdul Kalam and other luminaries to sit on its not-for profit boards – find itself today a veritable eyesore of India's growth model?

The argument is put forward every so often that the capitalist model tends to work better when both greed and ambition are present. There is, indeed, a thin line between the two. The drive for profits and the ambition for growth in revenue push enterprises to innovate, work hard and give better deals to their shareholders. However, in that quest of delivering growth, one is never sure where values will be compromised, and it is the probity of the board of directors that will ultimately deliver lasting growth and be true to shareholders. The management at the iconic Satyam – which had the privilege of being the first Indian company listed on the elite US NASDAQ exchange – did not realise that its ambition had turned into outright avarice. When a company pursues ambition, the resulting dynamic creates healthy returns; but when individuals' greed sets in, and drives the others unchecked, these returns vanish.

A single scandal like that of Satyam cannot allow us to fall for the instant condemnation of the entire market economy, as opportunist politicians in different parts of Southasia have tried to do. Indeed, the corporation is a machine of healthy growth that helps economies beyond the individual shareholders. There is no other phenomenon in modern economic history that comes close these companies in terms of wealth creation. The rapid transformation of India has been based on wealth that has been created amongst the millions of its people that rode on the stocks of successful companies such as Satyam. Ten years ago, perhaps a Satyam fiasco could have consumed the momentum of the stock market for years to come. But today, the markets, regulators and system in general have each proved mature enough to take corrective measures, and to be able to allow Satyam to revive with a new set of owners, managers and independent watchdogs. The Satyam fiasco was an early warning, and hopefully the response has been such that the possibility of such scams in the future is considerably reduced.

There are previous examples for all to see. Globally, markets have matured as a result of learning from successive crises, be it the 'dot com' bust, the derivates fraud of the British trader Nick Leeson or the Enron debacle. Indeed, in terms of percentage of the market, there is today less fraud amongst the global corporate players than there was five decades ago. India, too, has recovered from the shocks of the Harshad Mehta scam and others of the 1980s. There is good reason to assume that it will get over the Satyam fiasco, too, and fairly quickly.

For this to happen, however, it will be important for the Indian authorities to initiate action against the two sectors that have been directly responsible for the fiasco, by way of dereliction of duty. First, the Securities and Exchange Board of India (SEBI), the market regulator that failed to see through the falsified financial statements, must be forced to develop the necessary expertise to analyse financial data. Second, PwC, the audit firm that seems to have worked hand-in-glove with Satyam in the commission and omission over seven years, must be held to account. There may be a need to heed the call that auditors of large companies be given three-year terms in rotation. Ultimately, the goal has to be to limit, as far as possible, the undue influence of promoters on auditors.

The recent spate of massive, high-profile scams in the US and other Western countries could lead some to claim that, with the Satyam mess, India has finally 'arrived' on the stage of global finance. This is certainly a roundabout way of reading the scandal. But for the Southasian neighbours of India that are waiting for their corporate sectors and capital markets to mature, what has happened in Satyam constitutes a crucial wake-up call. Given a certain situation, any business would want to make the most money possible in the easiest way. For this reason, it is up to the regulators that create the legislative and institutional framework to be able to learn from such scams, and to seriously undertake to plug the loopholes in their own systems. And just as 'scam' is a term linked to corporate fraud, 'regulation' is the means to get out of the situation created by greed. If the word satyam means truth, the case of Satyam has unveiled an uncomfortable departure in the other direction. Hopefully we will all learn from it.