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THE ART OF FRAUD - Satyam Debacle
March, 23rd 2009

Financial markets need stronger rules than exist today. Earlier crises in Indian stock markets were because of manipulation of the markets, using insider information to corner or dump stocks, getting allotments of initial public offerings reserved for small buyers by using fictitious applicants, bank operating systems subverted by bribery or the credulity of bank managements, and so on. But they were all aimed at market manipulation mostly with the aid of brokers, bankers and others. The Satyam incident brought to the fore the possibility of extensive fraud over many years by company promoters and by those who controlled the company even without dominant share-holding. It exposed the futility of all the methods evolved under Clause 49 of Sebis listing agreement to ensure transparency and full disclosure, prevent fraud and manipulation.

In the Satyam case, all the independent directors appointed during B. Ramalinga Rajus reign have resigned. Some have lost their full-time jobs in academia or elsewhere and have stepped down from many other boards. The signing partners of the auditors, Pricewaterhouse-Coopers, Hyderabad, have been arrested and have been in judicial custody for many weeks. Companies related to Sat yam are under investigation and Maytas, the Raju familys real estate and construction venture, is in disarray. The Andhra Pradesh police, Sebi, the Serious Frauds Investigation Office of the Central governments finance ministry, the Registrar of Companies, the Institute of Chartered Accountants of India are some of the investigating agencies that are sifting through what happened. Meanwhile, the promoters, the Raju brothers, are in police custody and, by newspaper accounts, getting special treatment there.

It is reported that over 180 independent directors have resigned from a similar number of companies. At the outset, there were newspaper stories of Satyams reputed independent directors being arrested. There was debate on what these people were doing when Raju was building the biggest corporate fraud so far uncovered in India. The other actors who showed a lack of knowledge, or even suspicion, of what was going on are the many regulators the Registrar of Companies who receives copies of all annual reports and accounts, Sebi, the Institute of Chartered Accountants and the auditors, PricewaterhouseCoopers.

We must recognize at the outset that a clever chief executive can build a ring of collaborators in the company to mislead directors and regulators, as seems to have happened in Satyam. Might there be other companies in India and elsewhere which indulge in similar activities? There is no guarantee that there arent others doing similar things, perhaps on a smaller scale and for shorter periods.

Outside directors spend little time apart from attending board meetings of the companies they are associated with. Clearly, this is not enough, and independent directors must spend a great deal more time. They must meet auditors and managers privately, they must talk to analysts tracking the company, and keep themselves informed about what is being said or written about it. In the boards, they must insist on receiving papers well in advance of meetings and, when major projects are to be approved, have opportunities to consider them in depth with the concerned managers. They must ensure that queries and answers are incorporated in the minutes.

In the United States of America, directors can be held personally liable for frauds of the type that have occurred in Satyam. In India, neither the law nor practice appears to result in such liability. But the directors do have the responsibility of applying themselves to find out as much as possible and to satisfy themselves. Perhaps the duration of board and committee meetings, the time spent outside board meetings with company managers and auditors might also be recorded. High levels of commissions and stock options might deter directors from being outspoken and could be reconsidered. Commissions might be replaced with higher limits of fees for each meeting attended.

Appointment of independent directors is, almost in all companies, an initiative of the owner or controlling group. This is true of government owned and controlled companies and banks, and privately owned or controlled companies, both domestic and multinational. Nominations committees, where they exist, usually follow the suggestions made by the controlling authority. Perhaps such nominations should be from a list given by a regulator like Sebi and be passed by the nominations committee of the board on their own.

There is talk of companies having two auditors so that one can check on the other. This will only take more time away from operating managers and serve little purpose. Better would be for auditors to serve for only three years at a time with any company and for different partners to service the company on the next appointment. The selection of auditors for appointment should be left to the audit committee with no involvement of management. Their income from the company must be monitored by the audit committee over time, in relation to other companies and in absolute terms. The audit committee should interview auditors who want to be considered. Perhaps a list of suitable auditors might be given by Sebi. Independent directors should rely much more on internal auditors, selected by them, reporting to them and working to a plan agreed with them.

Auditors ask all banks and debtors to confirm their balances belonging to the company. In the Satyam case, huge fixed deposits certified by the auditors were found missing. We need auditors to be required to personally verify balances, especially those that account for a large portion of assets. This must apply to other receivables.

The regulator for auditors is the ICAI which over the years has shown itself to be slow in investigating and punishing bad practice or worse by auditors. The regulation of auditors should now rest with a quasi judicial body rather than with the self-regulating ICAI. This regulator might also regulate agencies that rate companies for their credit worthiness or for governance. Stock-market analysts and others recommend investment or otherwise in many companies and get wide publicity. They might have a hidden nexus with the company. They must be regularly checked by the Serious Frauds Investigation Office or a similar body to ensure that they do not.

In the US, the remuneration or compensation committee, consisting of independent directors, decides the remuneration of the CEO and top executives, and is involved in succession planning, the appointment of the CEO, and the relative compensations within the company. It might employ consultants for this purpose. All this has not prevented blatantly extravagant compensations, very lucrative post-retirement or exit benefits, as evidenced recently by banks wanting to be bailed out by the government. In India, the remuneration committee tends to follow the recommendation of the CEO or the controlling group. The remuneration committee should be more proactive than it is.

There are procedural issues as well. The ICAI introduced a rule that asset values must be marked in the balance sheets to their current market value, even when there was no immediate impact if their value was diminished in the market. This results in balance sheets being affected adversely when there is a serious change in the foreign-exchange values of the rupee, or some impairment in value of assets. The ICAI is now considering how the impact can be staggered till it actually arises (when loans have to be repaid or assets sold).

No tightening of the rules can correct a situation in which the controlling management intends to defraud or cheat. Constant vigilance by all concerned is the only answer.

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