Jan 16, 2009

Business - When the dog did not bark

N. Ravi

One lesson from the failure of the watchdogs at Satyam is that continuing with procedures that depend heavily on trust and good faith rather than putting matters beyond any doubt by verification will leave the door open to frauds.

[Detective] Gregory: Is there any other point to which you would wish to draw

my attention?

[Sherlock] Holmes: To the curious

incident of the dog in the night-time.

Gregory: The dog did nothing in the


Holmes: That was the curious incident.

[He goes on to explain later:] Obviously

the midnight visitor was someone whom

the dog knew well.

— from ‘Silver Blaze,’ Arthur Conan

Doyle’s short story on the disappearance of a racehorse and the death of the trainer.

Did the watchdogs at Satyam fail to alert the outside world because the perpetrator of the dark deed was a familiar figure they trusted?

As corporate frauds go, Satyam has taken on the characteristics of both Enron and Madoff. In terms of the size and spread of its operations with thousands of employees, its status as a publicly listed and traded entity, the motivation to boost share v alues by cooking the books and the total failure of internal controls and external checks it would seem to resemble Enron closely. On the other hand, it seems more like the recent Madoff Ponzi scheme in its false and misleading appearance as a highly successful company with a respectable promoter and in the sheer audacity of fraud at the very top that covered up non-existent cash and bank balances for so long till it was revealed by the confession of the chief perpetrator himself.

Accounting scams are of course always the doing of insiders. And when the fraud is at the very top, internal controls are easily overridden. Only the external checks in the form of independent directors and external auditors can provide real assurance to shareholders and investors if they work as envisaged. The scam is still unravelling and there are several hard questions that do not admit of definite answers at this stage. What is clear, however, is that the external checks failed to work as they should have to prevent a fraud of such major proportions that continued for at least seven years in a seemingly well run and well regulated company meeting the standards of both the Securities and Exchange Board of India (SEBI) and the U.S. Securities and Exchange Commission. Often good returns and the appearance of success can serve to mask underlying problems that surface only when conditions turn difficult.

The directors, especially the independent directors, are no doubt brought in by the management and some may not ask hard questions. However, several including some on the Satyam board are respected academics or professionals of standing who do not hanker after board positions but are in fact sought after by companies. They will have no hesitation in asking tough questions and will not be satisfied with evasive or vague replies. Independent directors are supposed to keep a watch on the management and safeguard the interests of the shareholders. Yet, as a class they have no direct knowledge of the operations and depend wholly on the information provided by the management and by the outside auditors. They can at best look for inconsistencies in the information and for trends and operations that do not make business sense and raise the red flag. Yet, when the information provided by the management is blatantly false but has the assurance of accuracy from the external auditors, the books are ostensibly in order and there are no inconsistencies or unexplained deviations from sound business practices, there is little that they can do. Whether or not this was the case in Satyam and whether in fact the directors were as vigilant as they are expected to be or chose to remain ignorant of things they ought to have found out, remain to be seen.

The critical role is that of the external auditors, in this case Price Waterhouse, Bangalore. In the Enron scandal, the accounting firm Arthur Andersen was accused of going along with accounting fraud (as also of obstruction of justice) perpetrated by the company’s top executives who sought to hide debt and expenses in highly complicated off balance sheet partnerships to present a rosy picture of the finances and boost share values. Arthur Andersen went out of existence though it was finally acquitted of criminal wrongdoing. What exactly went wrong in the auditing of the accounts of Satyam and whether the auditors were deceived or were negligent or were party to the wrongdoing are issues that remain unclear at this moment.

Yet, showing fake bank balances and cash — of Rs. 5,040 crore in this case — is perhaps the most brazen of frauds to perpetrate and the easiest to detect as well. The auditors are required to verify the company’s bank balances but Indian practice — unlike the practice followed in the United States and the United Kingdom — allows them to accept certificates from the bank handed to them by the company. It is questionable if an auditor should place such trust in the management when he is supposed to watch over its handling of finances on behalf of the shareholders, the regulator and the general public. As would appear from the Satyam case, this giant loophole allows a dishonest management to forge bank certificates and hand them to the auditor. Good auditing practice requires the auditor to confirm the balances directly with the bank either by asking the board of directors to get the banks to send the statements directly to them or by confirming with the banks the statements provided by the management. If Satyam’s bank balances had been confirmed directly with the banks, the auditors would not have missed the non-existent funds unless the fraud extended to one more level and the banks themselves had been made complicit.

Auditors in practice are brought in by the top management and so have an incentive to cooperate with those running the company. Such a cosy relationship has in the past led auditors to get comfortable with even fraudulent accounting practices found time and again in a company with the result, “The watchdog behaved more like a lapdog,” as American Judge William C. Conner put it memorably of another top accounting firm. Whether in this case Price Waterhouse auditors failed in their primary duty to be vigilant remains to be seen. At a broader level, continuing with procedures that depend heavily on trust and good faith rather than putting matters beyond any doubt by verification will leave the door open to frauds. How fast the Institute of Chartered Accountants of India (ICAI) moves to address the issues raised by the Satyam fraud — for instance, by requiring confirmation of bank balances and the rotation of auditors for listed companies — would be critical if the auditing profession is to remain credible in the eyes of investors and the public. For very large companies with a substantial number of investors, the auditors could even be appointed by SEBI.

Compared with the traditional watchdogs, the markets and the analysts seem to have been somewhat more suspicious of B. Ramalinga Raju’s business practices and questionable governance though even they had no inkling that a fraud of such magnitude was waiting to unravel. It is this scepticism that had long kept Satyam shares trading below the premium that the three bigger IT companies commanded. In 1999, Satyam Infoway, one of Satyam Computer Services’ units, was seen as having grossly overpaid for an internet company, IndiaWorld. The year 2000 saw a questionable related party transaction — the merger of Satyam Computer Services with Satyam Enterprises on terms that were seen as indefensible on business grounds, and Satyam shares took a beating. Then came the now aborted Maytas deals that were widely seen by investors, particularly in the United States, as a way of transferring the cash that was shown to be in Satyam to Mr. Raju’s family companies and taking Satyam itself into the problematical real estate area. While the board including the independent directors approved the deal as making sound business sense, investors revolted, sending share prices plunging. That also sealed the final escape route and ultimately proved to be Mr. Raju’s undoing.

For corporate surveillance to be effective, it is vital that all the offences in Satyam be prosecuted seriously without any hint of softness by the multiple agencies involved. Some of the offences under the securities laws such as insider trading (that could cover even the sale of pledged shares triggered by margin requirements) and use of manipulative and deceptive devices may sound relatively technical. In comparison, offences under the Indian Penal Code such as cheating and forgery are more stark in their description of criminality. Yet, in this case prosecution under ordinary criminal law would probably be the weakest link both because the State police lack the capability to investigate offences of this nature and also because of a lack of commitment and seriousness brought to the investigation.

The tragedy of it all is that the true Satyam without the fairy tales would still have been a great company with substantial capabilities and excellent people. It is a pity that one man’s quest for grandeur and lack of ethical restraints should have brought it to this pass. There is also the worrying but real possibility that the receding stock markets may uncover a few more Satyams, given the feudal business culture in which questioning the top management is considered disrespectful and promoters run companies with large public shareholdings as personal fiefdoms unrestrained by corporate governance and regulatory requirements.

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