Cracking the Satyam case

It will take more than one winter for the investigators to piece together the disparate strands of the Satyam story. Despite our fascination for quick results this one will likely take time.
That is because the corporate fraud by the management of the IT company was a "control fraud". A control fraud is operated by the guy who runs the company: the CEO. In all control frauds the CEOs deceive the world into believing they run a superbly successful firm, but which is actually spectacularly insolvent. As we find it difficult to imagine what incentive a CEO could have to cheat his own company, it then becomes impossible for us to believe that he could have duped the best accountants and lawyers in the business and then proceeded to even tap the regulators in the process. But that is how control frauds unfold. This is how the Enron unfolded and much earlier, again in the US, the savings and loan scandal erupted in the 1980s; and I am sure this is how the Satyam saga too will unfold in the days to come.
William K Black ,who as regulator, fought off the savings and loan scandal, which too was built on the real estate bubble, was one of the first to explain control frauds. Explaining the mechanism on which these frauds are built, Black says control frauds routinely enlist top lawyers and academics to aid their frauds. Shopping for appraisers is even easier than shopping for auditors and attorneys. The grossly inflated valuations made by appraisers allow outside auditors to rely on them, which in turn provide the cover of apparent neutrality to the control fraud to carry out his loot. So in essence the regulators instead of defending the interests of the investors end up advocating the interest of the client. One should remember that no frauds, in India or abroad, perpetrated by company managements have ever been uncovered by external auditors. When the fraud unfolds auditors often seek reduced liability.
Already the signs are there. In a report to the stock exchanges and the new board of Satyam, the auditors for the last eight years, Price Waterhouse have sought this position. They have said " the representations made by the Chairman and other management to the auditors during the audit now appear to be false and therefore are no longer reliable. On the basis of this new information about material errors and false representations, Price Waterhouse India has withdrawn its opinions on Satyam's financial statements ". So, we have to conclude there is nothing unusual in the way Ramalinga Raju used his control over the firm to buy outside support in the form of influential members in the board of directors and also used the cover of audited records to develop the fraud.
But that does not answer the two big questions. Why did it come unstuck now? An obvious answer could be the developing global crisis that made it simply impossible to raise any loan even on a totally fictitious balance sheet to continue the game any longer. But if that were so, the company could have still survived if it had chosen to by making the gamble bigger. Sure, the later explosion would have been harder for the economy but then, one suspects Raju would not have factored that consideration into his plans. The other question is that of the rationale. In a control fraud the CEO bends the company's core business to develop his plans. Enron for instance was overstating profits where none existed in its energy business. But Satyam was by all accounts a superb provider of IT services. The clients have had little to complain even now. So, the financial fraud that Ramalinga Raju engineered would seem to run independent of the company's core business.
It is these issues which make me feel the questions will take a far longer time to unravel. India is a late entrant to the global market of frauds. We have been conned by share market frauds so far. Accounting fraud is a new game for all of us and most important for our investigating agencies. The tax sleuths who man agencies like the Serious Fraud Investigations Office do not know this business. The other agencies have even more learning to do including the Registrar of Companies. The best management or accounting institutes do not teach frauds with any degree of sophistication. It will, therefore, be a long learning experience for the officials as they try to piece together the trail of several years.
The one blow that control frauds inflict on business is on trust. A modern capitalist economy sees millions of daily transaction that are often based only on verbal and even non-verbal assurances. Economists have found while transforming a communist economy into a mature capitalist economy that while institutions develop, a full blown market economy needs a culture of trust to develop. This takes time to develop. Frauds of this scale hit at those very foundations and so weaken the very basis of an efficient market economy.

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Sebi wants full promoter disclosures on pledging

The Securities and Exchange Board of India (Sebi), the capital markets regulator, on Wednesday made it mandatory for publicly traded companies to disclose any pledges of shares by their promoters, responding to mounting concerns over the risk of investing in such entities.
“Promoters who pledge shares have to disclose it to the company and the company, in turn, has to disclose it to the stock exchanges. If we get complaints that people are not complying with the regulation, we will investigate those complaints,” Sebi chairman C.B. Bhave said.
Promoters of listed firms routinely pledge their equity holdings discreetly to lenders, largely to raise personal loans, a practice that has heightened investment risk on Indian stocks and caused large investors to call for mandatory disclosures of such moves.
Such share pledges diluting the equity of founders could also lead to potential takeover situations.
Satyam Computer Services Ltd founder B. Ramalinga Raju, who confessed on 7 January to having committed accounting fraud to the tune of Rs7,136 crore, was found to have pledged almost all of his equity stake with private lenders to raise cash.
On Monday, Mint had reported that nearly $15 billion (Rs73,650 crore today) worth of promoter shares have been pledged as collateral with lenders, according to a dozen senior executives from the broking, banking and non-banking finance communities. These executives also said that such transactions had also been struck offshore with large global banks, and facilitated by private bankers, while in some cases funds were moved using an illegal money transfer system known as hawala.
The announcement by Sebi on Wednesday, made by chairman C.B. Bhave, aims to curb such practices. Under its new rules, companies are required to make both so-called event-based and periodic disclosures of pledging of shares by promoters.
Event-based announcements will be made as and when a promoter’s shares are offered as loan collateral, while periodic disclosures will require firms to report all such pledges at the end of every quarter.
Bhave did not make clear how these new rules would be implemented, only saying that the regulator would seek details of such activities as on 31 December 2008. He also did not specify a starting date for periodic declarations.
“We have decided to give them (promoters) time,” Bhave said.
Housing Development and Finance Corp. Ltd (HDFC) chairman Deepak Parekh, who has been appointed by the government to the Satyam board, said at an industry conference here on Wednesday that the move to tighten disclosure rules was a “good step forward”.
“It’s positive because in India just because you don’t want to reduce your family holding, you keep borrowing against your equity and keep growing because you don’t want to give up control on the company,” Parekh said.
Experts said promoters could skirt the regulations by exploiting loopholes.
An investment banker at a foreign brokerage noted that share pledges could take place at a holding company level. Holding companies are not required to make such disclosures. “Promoters will now take the transaction one level up,” this banker said.
At least three companies have adopted this structure, replacing the pledged shares of their publicly traded company with the shares they own in a holding company, the banker said, warning that many more could take this route.
Bhave, however, maintained that pledging shares in a holding company may not have the same impact (as pledging shares of publicly traded companies). “Let us first implement this and see what happens,” he said.
Also, in the near term at least, companies that make such disclosures will likely see a slide in their stock price, said analysts and fund managers.
“This will be considered as additional leverage on the company,” said Adrian Mowat, managing director and chief Asian and emerging market equity strategist at JPMorgan Securities (Asia Pacific) Ltd.
“An increasingly obvious risk (in India) is that entrepreneur-dominated companies are vulnerable because of heavy personal borrowing by these entrepreneurs against their own share prices,” wrote Christopher Wood of CLSA Asia-Pacific Markets in a 15 January Greed and Fear report.
The regulator also discussed the issue of peer review by independent auditors for large listed companies, but is undecided on the criteria for it. Bhave also declined to clarify whether the company or the regulator would pay for the additional audit.
The Sebi board also reviewed the progress made so far in the investigations into Satyam Computer.
“We cannot ascertain the size of the scam until investigations are over. We are investigating the books of Satyam to determine the bank deposits of the company. We have not been able to question Mr Raju, but we have gone to the auditors, internal finance department of the firm and questioned them,” Bhave said.
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