Anatomy of a scandal

The Sanskrit word for truth is satyam, incidentally the name of the Hyderabad-based computer services company that imploded in January having failed to disclose the truth about its financial health. The irony is not lost on India, whose securities markets were badly shaken by the scandal that saw Satyam Computer Services’ market capitalization dive to around $650 million in January, from close to $7 billion in May 2008. With over 90 percent of its customers outside India and 600 clients internationally, Satyam’s fallout will have long-lasting, global effects.

In a confession letter to his board, chairman Ramalinga Raju owned up to years of cooking the company’s books. The revelation sent shock waves through international investment communities. Additionally, local employees, business colleagues and regulators were equally surprised. And a month later, observers were still scratching their heads trying to understand how such a thing could happen under the eyes of a host of players, including highly respected US institutions and their watchdogs.

It could take years for the case to be fully unraveled and for blame to be apportioned. Of more immediate importance to market participants, however, is what will be done to shore up the safeguards that should have protected everyone from such losses in the first place. ‘It is $1 billion US dollars,’ notes professor Vikramaditya Khanna of the University of Michigan Law School, commenting on the size of the misstatements of Satyam’s accounts. An expert on both American and Indian securities law, Khanna adds, ‘That is a big sum; even more so when you think how much that can buy in India.’

The Indian Enron
The Satyam scandal is to India what Enron was to the US, according to Indian media. Like Enron, the Satyam incident riveted financial players on a global level, in this case, from Mumbai to London to New York. Since US investors were already smarting from a series of fraud scandals, attention snapped into focus immediately as Satyam has a cross listing on the NYSE. Trading in its American Depositary Receipts was halted as soon as news of the confessed fraud hit the media, and more than a dozen lawsuits were filed in the weeks following the scandal, with many more expected as details emerge.

So exactly how did such a massive fraud take place? Details are still emerging but company founder and chief executive Raju confessed to feeling boxed into a corner through 2007 and 2008, having feared poor results would lead to a takeover. For several years Raju scrambled to juggle the numbers in an attempt to close the gap between actual revenues and what was being reported to shareholders and regulators. Like most people who attempt this complicated – and illegal – juggling act, Raju was quickly caught up in an ever-expanding chasm. In an effort to conceal his deception and maintain control he appears to have handled the books personally, although there are various conflicting accusations that others may have been involved. In any case it is agreed that his dominant position within the company, and the close attention he paid to financial matters, cowed both his internal financial staff and outside auditors from PricewaterhouseCoopers, according to published reports.

Avoiding ‘being eaten’
Raju made a failed attempt in late 2008 to inject more cash into the ever-increasing gap and hide the losses by transferring assets to firms managed by his sons, but the end was clearly in sight. It was Raju himself who wrote a confessional letter to his board telling them what had been going on. His admission to being unable to keep the Ponzi scheme going was both colorful and conclusive: ‘It was like riding a tiger, not knowing how to get off without being eaten.’

He was arrested within days, along with his brother, who was CEO, and subsequently the company’s CFO and two auditors from PricewaterhouseCoopers.

Even three weeks following the first announcement, the Financial Times devoted dozens of pages to the story and its background. In addition to the size of the fraud and the length of time over which it was carried out, the case has some truly unusual qualities. Akin to spectacular failures like Enron, Satyam appeared to be a pillar of corporate governance. It even won a coveted Indian prize, the Golden Peacock Award, for outstanding governance. After news of the scandal broke the company swiftly handed back the award. But the question remains how a company from India that was meant to abide by the strictest of western governance rules – those imposed by dint of a US listing, making it subject to rules imposed by the Sarbanes-Oxley Act – could avoid being discovered acting so fraudulently under the eyes of the best of regulators.

Rules already obtain
The question of many observers is: How do we prevent such an event from taking place again? Many are calling for an extensive regulatory overhaul, but, as those with experience in scandals explain, more rules are rarely the answer. The most important starting point is more effective enforcement of existing rules. This argument is likely to go on for some time as the public demands action. The first step is to figure out exactly what went wrong and how regulators were able to miss the warning signs for so long.

A host of agencies are investigating, including the Indian national regulator and the SEC, which has sent a team of investigators to India to assist with inquiries. Local press say there is unlikely to be any official joint investigation between American and Indian regulators, even though they tend to cooperate; the SEC regularly conducts special training on American regulatory practices in India. 

Jurisdictional issues have made getting to the heart of things difficult. In late January, the Securities and Exchange Board of India – the regulatory group which is akin to the SEC –said it was having trouble getting past local police who were holding the principals in custody in order to carry out their own inquiry. With courts trying to sort out responsibilities and procedures, the infighting is not casting the regulators a very good light.

 Corporate governance best practice has gotten a black eye, too, insomuch as the company appeared to be in strict adherence with all the relevant codes and its public disclosure was always thorough, or so it seemed. But the foundation was built on shifting sand, the real truth apparently unknown to anyone other than the CEO. Nonetheless, at least one expert does not see dramatic regulatory change coming anytime soon. ‘I don’t expect any big changes to corporate governance rules and regulations,’ says YRK Reddy, founder of the Academy of Corporate Governance in Hyderabad.

Strong on paper
There are many quandaries for those piecing things together as to how public policy might be altered. Jayanth Varma, a professor of finance at the Indian Institute of Management, states that this situation has a catch. ‘Had it not been US-listed, we would have said that we are behind in X,Y and Z. But it is difficult to say what India is missing and make the change. The independent board didn’t help, US GAAP didn’t help. This is the difficulty the reformers are facing,’ he says.

Not only is there damage to India’s securities trading and regulatory prestige, there are over 40,000 employees at Satyam, which now operates under a government-appointed board. These employees are rightly worried about their future. Curiously, the exact number of workers is among the many outstanding questions. India’s Economic Times reported in late January that Satyam’s CFO, Srinivas Vadlamani had confessed to investigators that some 10,000 artificial jobs were created at the company.

After first standing by its reported 53,000 workers, the company modified its stance to say it was working with its new auditors to verify a head count. Nevertheless it argued that a 43,000 staff figure reported by some media sources ignored many contract and related workers. The Economic Times reported that Vadlamani told officials who were interrogating him that there were fake jobs and they had been created so large amounts of money could be drawn from fictitious salary accounts. Though Vadlamani claimed that the fake jobs were created beginning in 2004, investigators believe they may go a lot farther back and are poring over books from 2001 onward.

A coordinated response
Now that many facets of Satyam’s failings have been exposed, damage control has kicked into high gear. Although by mid-February the scandal had not caused the massive loss of business that some had initially feared, managers and staff went to work immediately to contact and reassure customers. Senior staff flew across the globe to many of the nearly 70 countries where the firm operates. A spokesman says only two major accounts have cancelled, while the company was reported separately to have added 15 new customers. Figures were not available at the time of writing on the revenue implications of the changes on the customer front.

By February 12, the newly appointed chairman, Kiran Karnik, declared that the company was financially stable and reiterated it was able to pay salaries, mainly from receivables. He also told the media that Satyam had secured bank loans of $123 million. ‘We have ensured financial stability,’ he was quoted as saying. ‘This is the first step and a very necessary step, though it’s not a sufficient step. We have put out the fire and now we are looking at what we need to do to stabilize the company on an ongoing basis.’

Karnik also told the media that efforts to sell the company would move ahead quickly, whether or not a full accounting review had been completed.

Meanwhile, at company headquarters in Hyderabad, the new board and company leaders appointed to replace the top executives have taken on a battle-ready mien. The corporate website has been brightened and a special section has been established to knock down rumors and to display forthright messages that deal with the scandal.

‘Ensuring continuity of service is the board of directors’ top priority,’ reads one entry, ‘and Satyam is working diligently to ensure all our customers’ goals and needs are being met.’ Beyond the announcement from State Farm Insurance that it was severing ties, ‘all the other client names that have been mentioned by media are pure speculation – most clients have reaffirmed their support to Satyam.’

Going forward
The effects outside of the corporation are of a magnitude never before seen in India. But the jury’s still out on the impact to India’s securities business. ‘We are still waiting for all the facts to come in,’ says Khanna. ‘One of the things to note is that so far in India we have only heard of the Satyam fraud, so the concern is: What is the impact on the Indian market? Unless we see a lot more companies or at least some more companies having a similar problem, it wouldn’t appear to be a system-wide concern.’

For the local subsidiaries of US companies in India, there is unlikely to be immediate fallout, although investigators are examining relationships between Satyam and a long list of clients, mainly to assess whether any were involved in supporting the fraudulent reporting of money flows. Cisco Systems was prompted to issue a statement after reports that a joint venture was being reexamined. The company said it did not expect any ‘material’ impact from the investigations of Satyam Computer, adding however that, ‘as any prudent company, we are evaluating appropriate risk mitigation strategies.’

Looking beyond the stunned markets to the larger corporate arena, Khanna, like a number of others, feels the big spotlight will be on regulators. ‘I think one potentially interesting issue to be looking at is how the enforcement authorities handle this, primarily because this is going to be the first large-scale corporate fraud we’ve seen in India. … Most of the other kinds of frauds that we have seen in the stock markets in India have been where stock brokers have been engaged in fictitious trades or churning, or something like that,’ he says, adding that ‘this is more – at least allegedly – about serious governance lacunas and potential siphoning off of assets in gigantic proportions.’

Sector-wide response
It is this area of governance that poses the biggest problems going forward since it is ultimately up to the individual companies to act on it. Worried about the effect of the Satyam scandal on the Indian information technology and outsourcing industries, India’s National Association of Software and Service Companies, a trade group, says it will bring new focus on good corporate governance and ethics to its member companies. It announced the establishment of a new Corporate Governance and Ethics Committee.

But like other such groups, it has no power to enforce compliance. Khanna underscores the conundrum: ‘Getting to a level of fraud that is zero might be exceptionally difficult. There will very likely to be some, however small, possibility that fraud can occur.’