Saturday, January 10, 2009

Observations from Satyam Scandal

A few general observations about the developments surrounding superstar IT company Satyam

1. Fraud and felony are inevitable accompaniments in any easy money era like the equity and real estate bubbles of the past decade. Once the market momentum, which helped conceal the misdemeanour, slackens, the reality invariably bursts into the open. In fact, I have been surprised that the present bubble and recession has not thrown up its fair share of defrauders.

However, now the skeletons are slowly tumbling out of the cupboards. First came Bernard Madoff (more here), then Sonja Kohn and the latest, our own Ramalinga Raju of Satyam (Mostly Economics has an excellent post, calling it India's Enron and Satyam a giant Ponzi scheme). Do not be surprised if more big names achieve noteriety as the crisis unravels.

2. The enquiries and post-mortem should now go beyond Raju and his family to study the role of auditors, the famed Price Waterhouse Coopers (it certified the company had $1.1 billion in cash when the real number was $78 million), the independent directors (esteemed individuals all, two of whom continue to cling on), the regulators (Satyam is a BSE 30 and BSE 50 company), co-promoters and partners (in Satyam and other deals of the company, notably the ubiquituous IL&FS) and the many others whose lack of vigilance or willingness to abet laid the stage for the fraud to go this far. It is impossible to have acted the way Raju did and hidden the skeletons for so long without accomplices.

3. The Satyam scandal and the lead up involving the failed bid to takeover Maytas Infrastructure and Maytas Properties, both run by the sons of Ramalinga Raju, raises concern about the way family businesses are run in the country. Though many of these firms are ostensibly professionally managed, the family members' writ runs large. Relatives of the promoter hold crucial management positions and sizeable stakes in these companies, and though foreign investors have begun to push for more outside representation on boards and for families to give up controlling stakes they hold, the progress has been slow.

4. Questions are bound to be raised about the other recent spectacular stories of small family run firms rising to the stature of national leaders within a short span. In this decade, we have seen the stunning emergence of big brand behemoths, from almost thin air (or almost), especially in the infrastructure space. There have been allegations that many of these firms owe their rise to political patronage and are characterized by poor governance, lax accounting controls and a lack of transparency.

This sector is especially vulnerable to such practices since most of the big-ticket projects are public infrastructure projects, have long gestation periods, and are invariably heavily leveraged with often marginal promoter's equity. Under the guise of PPP, these projects have benefitted from government subsidies by way of cheap land and tax and other concessions, all of which have had the effect of glossing over the weaknesses and magnifying the attractiveness and profitability of these projects.

Further, though many of the big investments are yet to become fully operational, the promoters have capitalized on their initial deals to capture projects elsewhere. It was widely perceived that the venture was successful once the project was grounded. The recent past has seen a mad rush by small-time players and bigger ones diversifying from unrelated areas into infrastructure, and the feeling was strong that there were plentiful low lying fruits to be plucked.

The opinion gained currency in corporate board rooms that if a company had big time ambitions, it had to have a presence in infrastructure and real estate. And within infrastructure too, it was felt as being strategically imperative to have a presence in all the spaces - roads and bridges, airports and ports, telecommunications and electricity etc. The huge and rapidly expanding market in these sectors and possibility of capturing easy gains, coupled with the attraction of political patronage eased entry had emboldened many of the firms to venture afar into the sector. Virtually all the infrastrucure majors today have presence across the broad infastructure space.

5. How this development will affect the software industry, especially given the Satyam debacle and the high-profile incident of World Bank barring business with Satyam for eight years, remains to be seen. Doubts will be raised about whether Satyam will have the same impact on the outsourcing industry as Enron had on the energy trading business. I am inclined to believe that despite the extent of the Stayam scandal, this fear may be misplaced, and the impact on the software industry is likely to be marginal, at the worst.

6. As Raju writes in his letter, the original sin of cooking up figures to keep pace with the market expectations led to more and more manipulations. He wrote, "What started as a marginal gap between actual operating profit and the one reflected in the books continued to grow over the years. It has attained unmanageable proportions as the size of the company’s operations grew over the years".

In this context, it is important that auditors and regulators become vigilant about the fact that with the margins in the software industry coming down steeply in the coming years, there will be pressure on the software firms to dress up their balance sheets to meet market expectations. Indian software majors and the markets will have to quickly get used to the reality that the massive double digit profits are a thing of the past.

7. The World Council on Corporate Governance recently awarded the Golden Peacock Global Award for Corporate Governance to Satyam. Ramalinga Raju was awarded the Entreprenuer of the Year Award in 2007 by Ernst and Young. Another parallel with Enron is that it was famously selected the most Innovative Company for six consectuve years by Forbes inn 2000-06, before the Enron scandal exploded. Will the financial media be chastened by the experience and start taking such awards with a pinch of salt?

8. As an update, following the Rs 7000 Cr scandal, in a virtual nationalization of a private company, the Government has taken management control of the embatteld Satyam COmputer Services, disbanding the existing Board and deciding to appoint ten new independent directors to run the company till further course of action is finalized.

This bailout raises questions about the need to have a bankruptcy clause like the Chapter 11 in the US, which while penalizing the management and shareholders offers a lifeline for independent restructuring of a crisis hit company, without any tax payer cost. It would avoid the Government having to step in and bail out the "too big to fail" companies.

Update 1
CK Prahalad (full interview here) and Varun Arya calls attention to the incentives, managerial and others, that drive companies to indulge in dressing up their balance sheets. As Prof Arya says, for all its hifalutin about core values and corporate governance, companies adhere to the core values as per their convenience and compromise as per the convenience, and all these generally go for a six when they come into conflict with personal inerests or goals of decision makers. As Prof Prahalad says, "Incentives totally based on quarter after quarter profit growth irrespective of market conditions, can create a culture of growth at any cost."

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