Corporate governance: Scandal raises questions about disclosure regime

Early in the New Year, a small, moustachioed and otherwise unremarkable software industry executive shocked India and the world.

B. Ramalinga Raju, the chairman of Satyam Computer Services, India’s fourth largest information technology group by revenue, sent a letter to his board confessing to a crime so spectacular in its scale and brazenness that many could hardly believe it.

“Dear Board Members, It is with deep regret and tremendous burden that I am carrying on my conscience that I would like to bring the following facts to your notice …” Mr Raju began the letter, sent on January 7.

Apparently, Satyam’s balance sheet as of September was the numerical equivalent of a novel – an elaborate work of fiction in which everything from revenue and profits to most of its cash balance of Rs53.61bn ($1.1bn) was an invention. The fraud was carried out over a number of years, Mr Raju’s letter said, raising questions over how the company’s auditor, PWC, and stock market regulators failed to spot the scam.

Mr Raju may have unburdened his conscience with his confession. But in one step he undermined the confidence of India’s once unerringly self-assured business community, which had so far avoided the worst effects of the global slowdown.

“There has rarely been a case of a bull market not having left a few fraudulent residues, but the suo motu disclosure … by Ramalinga Raju, the chairman of Satyam, … must be categorised as the mother of all, at least in the Indian context,” said IIFL, the institutional research division of the Mumbai-based securities house, India Infoline.

“Symbolically, it is akin to the high profile frauds perpetrated by Enron, Worldcom or Parmalat, all of which had overstated profits and the value of assets on books.”

India’s beleaguered stock market has borne the brunt of the revelations. Since December 17, when the first signs emerged that all was not right at Satyam, the Bombay Stock Exchange’s benchmark Sensex Index, has fallen 13 per cent to 8.674.35 points as of January 23. On the day of the confession letter alone it fell 7.24 per cent.

Part of the reason the Satyam fraud was such a shock was that it occurred in in India’s multi-billion dollar information technology outsourcing business, regarded as one of the most progressive industries in the country’s corporate sector.

The episode began when Mr Raju on December 16 suddenly proposed that Satyam acquire the Maytas property and infrastructure companies belonging to his family in a deal worth $1.6bn.

The deal was approved by Satyam’s independent directors. But within hours Mr Raju was forced to abandon the plan after institutional investors launched an unprecedented rebellion against the transaction.

Unbeknown to these investors, Mr Raju was sitting on a time bomb. He had pledged his family’s 8 per cent stake in the company to lenders, which had started selling off the shares as Satyam’s stock fell in line with the broader market.

The Maytas deal was an attempt to cover up the fraud at Satyam. By January 7, the game was up. The lenders had sold almost all of the Raju family’s shares. The company’s share price had fallen to a fraction of its former value. Mr Raju confessed.

The question for analysts now is whether Satyam is an exception or whether, after a five-year stock market bull-run in India’s market that ended only last year, there are other long-running corporate frauds waiting to be discovered.

The scam has prompted calls for the government to tidy up loose corporate disclosure requirements. The most prominent need is to force controlling shareholders to reveal if they have pledged their shares in their companies to lenders.

In a market in which more than half of the key constituents of the Sensex are controlled by families, this is a sensitive issue. But the secretive pledging by controlling shareholders of shares to lenders is a key risk for unsuspecting minority investors. Once a stock that has been pledged hits a certain point, it will trigger a margin call, forcing the lender in question to begin selling those shares. This can collapse the stock price.

“All other disclosure requirements that apply to insider purchase and sell activities should be extended to pledging and loaning of shares,” said Credit Suisse in a report.

Two weeks after the confession letter was released, the Securities and Exchange Board of India, the stock market regulator, made it mandatory for controlling shareholders to reveal their share pledges.

The move was welcomed by the market but experts described it as “too little, too late”.

Professor Sandeep P. Parekh, visiting associate faculty at the Indian Institute of Management, Ahmedabad and former executive director of Sebi, said during his time at the regulator he spent three years developing new disclosure standards that have yet to be fully implemented.

Common complaints about India’s disclosure regime include the absence of a requirement on companies to file full balance sheets along with their quarterly results.

The other problem is enforcement. In the long queue of government investigative agencies waiting to interrogate Mr Raju, who at time of writing was in judicial custody in his home city in Hyderabad, Sebi seemed to be the last in line in spite of its role as the market regulator.

And few believe Mr Raju will see the inside of a prison again once he gets out on bail. Almost no serious white collar criminal in India has ever served time after sentencing because of the country’s laborious court system that can take years to reach a decision.

To be sure, India’s corporate governance system is still regarded as among the best in emerging markets. And investors are willing to vote with their legs. There has been a mass exodus from companies considered less transparent in recent weeks to those judged as following best practice. But the Satyam episode shows there is plenty of work that needs to be done by regulators and policymakers.

“Corporate crime in India can’t be addressed by more laws or indeed more governance,” said Krishnamurthy Vijayan, executive chairman of JP Morgan Asset Management in Mumbai, who says the country has “excellent” governance standards. “I suspect that rapid and forceful action against the perpetrators is the main answer.”

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