Three Investor Lessons from the Satyam Scandal 29 comments
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The Satyam (SAY) scandal has provided a stark reminder to many about the dangers of investing. There are, however, diverging trains of thought on what to take away from this. One school says that this goes to show that the rest of the world is not that much unlike America and that an Enron or Madoff scandal can happen anywhere. Underlying this belief seems to be the idea that these sorts of scandals are somewhat random and unpredictable.
A second school of thought says this exposes the dangers of investing abroad and particularly in emerging markets where business culture, auditing standards, accounting rules, regulatory structures, and social customs can differ markedly from the United States. The thought here is that the developing world might not have quite as strong checks to insure accuracy of data reported by businesses and that American investors will inevitably experience a lack of awareness of many issues in any particular nation that might differ from the US.
For my money, I am in the latter school of thought. This is not to suggest that one should completely shy away from investing in the rest of the world and the emerging markets; rather, one needs to be aware of the different risks involved by investing in the international sphere.
There are several reasons why I do not view this scandal as simply India’s version of Enron. Certainly, this event has rocked the Indian markets in the same sense that Enron did the American markets, but that does not mean the scandals are necessarily similar in nature and that this could happen in the United States any time. The nature of the fraud involved is key to me. If one were to examine the fraud cases in the United States, a lot of them involve complex schemes and companies taking advantage of auditors’ lack of knowledge about difficult-to-price assets. While auditors might work in particular industries more than others, they still do not have the expert knowledge of asset classes that one who works in an industry every day might have.
Look at a company like Intel (INTC), for instance, that produces high-tech devices that rapidly depreciate in value. From an auditor’s perspective, it might be difficult to tell the difference between a new chip with high-value and an obsolete chip with virtually no value. These types of situations can create opportunities for fraudsters.
While a lot of facts from the Satyam scandal are still missing and I imagine we will learn more over the coming weeks and months, the one particularly frightening thing about this is the seeming ease with which this fraud was committed. This does not appear to be a case of complicated and difficult-to-value assets vexing auditors. Satyam had a cash balance over $1 Billion and 94% of it was fictitious! Surely, one would think, that auditors should have noticed such a large amount of cash that did not seem to exist. Cash is a much more difficult asset to “fake” or create an illusion of heightened value on than microprocessors, oil supplies, or mortgage-backed securities. How could a massive store of missing cash escape the attention of auditors?
If a company could fake this much cash on its balance sheet without auditors even batting an eyelash, could this mean that any company in India is potentially vulnerable? It’s worthwhile to note that as a publicly-traded company traded on an American exchange, Satyam was subject to US Generally Accepted Accounting Principles (GAAP) and Sarbanes-Oxley. Yet, even this did not protect investors. But why?
There’s a whole host of possible reasons and it’s difficult to say what the truth behind the matter is without all the fact. Some possibilities:
(1) Satyam was audited by Price Waterhouse of Hyderabad, India, which is connected to PricewaterhouseCoopers. It’s not clear to me what sort of people would be brought in to do this audit, however. Obviously, you would need people familiar with US GAAP. Was the auditing staff largely based out of India? Or did PwC bring “experts” over from the United States?
There is potential for problems with either option you choose. Would Indian-educated accountants necessarily be familiar with US GAAP and GAAS on more than a shallow level? Keep in mind, these auditors could possibly only use these standards once per year while auditing Satyam. Perhaps an audit, while theoretically falling under American standards, is carried out more closely to Indian standards in actuality.
If Americans were brought in to examine Satyam, would they necessarily have more than a shallow understanding of Indian business practices, regulations, and cultural customs? Would the Americans be “taking the word” of people at Satyam due to their own lack of expertise?
(2) Another possibility is something about Indian business practices and the regulatory environment make it easy to conceal this type of thing from the view of auditors. As a foreigner, one is simply left guessing about conditions in a particular country. An American operates with a lot of assumptions that are mainly based on their own experiences in America; those assumptions may be completely invalid when carried over to a nation halfway across the globe.
(3) Its also possible that auditors or financial institutions were acting in collusion with Satyam. Thus far, there is no evidence of this, but it can’t be ruled out yet. Ironically, this would probably be the least damning of the options because it would suggest that there was a lack of effective checks involved here and this might be remediable. Though, it still might expose the ease with which such collusion could occur overseas.
These are just a few possibilities. I am sure there are many others and it all cuts into the harsh reality of investing: we are all making decisions based on limited information. The best we can do is maintain awareness of this and seek out investing strategies that minimize the effects of this. With that, I offer these thoughts on investing:
(1) When Investing in Emerging Markets, Be Aware of Heightened Risks from Greater Uncertainty
Personally, I have never analyzed any companies in India and do not have that much knowledge of the Indian market. However, I do examine a number of companies from China. One thing I’ve found is that the financial statements are not necessarily as illuminating as they might be for American companies, even when they are prepared in accordance with US GAAP. This goes back to a previous thought: accountants in foreign nations may not necessarily have that great of an understanding of American standards, culture, and laws. While this is true in an auditing capacity, it’s also true in an in-house capacity. A company may hire accountants who have limited understanding of American standards and culture.
On that note, one thing I’ve personally noticed from examining Chinese solar companies is that the financial statements for some of the companies are extremely difficult to understand and gather important information from. I found myself particularly vexed reading through Yingli Solar’s (YGE) 20-F filing. Due to this, I have shied away from Yingli personally. This does not mean that Yingli is a bad investment --- merely that I made a conscious decision based on a general feeling I got from reading the financial statements that the company might not have totally understood American investors. If this was the case, it was also possible the company did not fully understand American accounting standards. Based on this, I assigned a higher level of risk to Yingli.
I don’t mean to single out Yingli, as it may indeed be a great investment and I have encountered some very smart investors who think highly of the firm, but my thought was that if I was having particular difficulty understanding their disclosures, maybe I should steer clear rather than *assume* that everything was alright.
(2) Different Countries, Different Rules, Different Cultures, Different Education
Every country has its own set of laws and customs. However, most of us are not lawyers. Instead, we gain our understanding of the law through observation. We have a sense that something is not legal. We have a sense of what is acceptable and what is not. Those standards do not necessarily carry over to every nation. This might seem somewhat obvious in a way. What might be less obvious is that people born in another nation might have a completely different way of learning and a completely different education.
This becomes especially important when we are talking about accounting and auditing. Are Russian accountants necessarily well-schooled in American accounting standards? I have no clue how one becomes an accountant in Russia, but I imagine they have their own procedures and their own system of education and that it differs in many respects from the system here in America. If a company in Russia is traded on an American exchange, how does it find the accountants who are to do the American reporting? Are Russian accountants simply given a two-week crash course? Is an American brought over to teach others? Are Americans running the whole operation? As mentioned earlier, no matter which way you look at it, there are a potential host of problems.
The main takeaway here is to simply be aware that other nations operate differently and even abiding by American standards does not necessarily mean that all differences immediately disappear.
(3) Diversify, Diversify, Diversify!
The most important takeaway here is that investing involves a lot of uncertainty. No matter how skilled or knowledgeable you are in finance, accounting, business, or the particularly industry you are looking at, there is always something out there that you did not know about and that you will not anticipate. The best way to deal with this uncertainty is to mitigate the risks by diversifying your portfolio. This is true even if you are investing only in American companies, but I think it’s even more true when investing in emerging markets.
A few parting notes: while I would not necessarily discourage anyone from investing in emerging markets, I will suggest that it might be prudent to have a great deal of reluctance towards investing in India for the near-future. Until we know how the Satyam fraud went undetected by auditors for so many years and until we see some evidence that this is not happening all over India, I would veer away. Naturally, anyone is free to disagree with my assessment.
Finally, a lot of what I have offered here is speculation about what might be happening in overseas companies and auditing firms. If anything is not factual, feel free to inform me. My bigger point here is that sometimes, we don’t know all the facts. All the same, we should seek as many of those facts as we can get.
Disclosures: No position in SAY or any Indian/emerging market ETFs.
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This article has 29 comments:
Which markets have caused the biggest global damage todate? American or Emerging? For all you know, the troubles Satyam is in may have been caused or exacerbated by failure of US institutions. India and China are better regulated and don't enjoy the "free markets" luxury that the US enjoys.
(2) Different Countries, Different Rules, Different Cultures, Different Education. SAME GREED, SAME FRAUDS.
(3) Diversify, Diversify, Diversify!
Of course, this doesn't help much from an investing standpoint, other than the warning of "buyer beware". Oh, and diversify!
You're absolutely correct on Madoff. However, the thing people are missing --- Madoff ran a private investment firm --- not a publicly traded company. He was not audited by a Big 4 accounting firm, he was not required to file a 10-K report with the SEC, and he didn't have people constantly critiquing his accounts.
The hedge fund industry was/is notoriously underregulated in the United States. In fact, Madoff was extremely secretive about everything and was "audited" by a 3-person accounting firm that apparently wasn't even certified to do audits. This would have sent off a red flag immediately if he ran a publicly-traded company. Publicly-traded companies are very high scrutinized in the US and some would even argue "overregulated".
In essence, what I'm suggesting is that the really scary thing about the Satyam scandal is that it appears that even publicly traded companies theoretically scrutinized under US GAAP and required to comply with Sarbanes-Oxley can get away with this stuff in India and possibly other emerging markets --- that an auditor report saying that these standards have been met might be worth nothing more than toilet paper in some places. That's simply not true in the United States.
People can convince themselves this happens all the time in the US, but it does not. There are scandals here, there are crooks here, and there will be more fraud in the future here --- but at least, it is difficult for publicly-traded companies here to get away with this sort of stuff for long due to our financial reporting standards.
There is a reason that stocks overseas look like better discounts than stocks over here and the reason is more risk.
So why did no one catch that gaping $1.3 billion missing cash balance? I don't think that happens all the time in the United States. In fact, this could be a warning sign that auditing in some of the emerging markets is effectively useless.
There are probably more Satyams out there in the emerging world. There are more fraudsters out there here in the US. But I don't think you'll see a Satyam here in the US.
continue invrsting,
most fabulous returns would be there in indian equities in next 10 to 20 years
Check this article: www.thehindubusinessli.... Quote "The idea of separation of ownership and management that is an essential feature of the corporate form of organisation has never seriously appealed to Indian businessmen. The Indian listed company has been, for the most part, a glorified family enterprise that tolerated outside investors at best and looted them in the worst case. Companies such as Infosys are rare exceptions to this rule.".
One another thing that I don't like about Indian companies is congolomerate model - many large companies want to be in all businesses.
You are being naive - accounting scandals happened at Enron, Worldcom and other US companies also. So I don't think there is anything unusual.
However, India does have huge problem of corporate governance. Check this: www.thehindubusinessli...
Moreover, at the rate we are globalizing, all smart American doctors, lawyers, auditors and other professionals will be outsourcing significant parts of their business processing to developing countries and will have to accept their skills, lower pricing and cultural differences for better or for worse.
In any case, HJ cannot afford to pontificate for long to American investors. With a gaping hole in BoP and China, Japan, Korea and other trade surplus nations plugging Americans leaks as fast as they arise, it may be worth his while to address non-American investors of the pitfalls of investing in a system he seems to be so familiar with.
I kind of echo the sentiment of your comments; however, I note one possible typo as follows: "...I think Indians and Chinese can be as...". Would you mean: "...I think Indians and Chinese cannot be as..."?
If so I would concur with you. Summa Cum Laude grads in business and finance in such Ivy League schools COULD make superstars in fraud and scandals as in many instances.
On Jan 09 12:48 PM tilut wrote:
> I understand the differences between the cultures and so on , but
> let me remember you that the greatest expert crooks are here in AMERICA
> and they are those banksters gangsters who have destroyed the US
> economy and exported their virus around the world . Moreover, we
> still do not know one tenth of what is in banks offbooks and even
> the FED refuses to say where the monies they printed is going and
> so on.GREAT TRANSPARENCY by our own government ! I think Indians
> and Chineses can be as crooks as our own people unless they studied
> at Harvard.
More importantly here is a list of accounting scandals grabbed from wikipedia.. how many of them are from emerging countries ? Who is the daddy?
The neutrality and factual accuracy of this section are disputed.
Please see the relevant discussion on the talk page. (March 2008)
AOL
Adelphia
Bristol-Myers Squibb
CMS Energy
Computer Associates
Duke Energy
Dynegy
El Paso Corporation
Enron
Freddie Mac
Global Crossing
Halliburton
Harken Energy
Homestore.com
ImClone Systems
Kmart
Liberate Technologies
Lucent Technologies
Merck & Co.
Merrill Lynch
Mirant
Nicor Energy, LLC
Peregrine Systems
Qwest Communications
Reliant Energy
Sunbeam
Tyco International
Waste Management, Inc.
WorldCom
[edit] Later scandals
Royal Ahold (2003)
Parmalat (2003)
Calisto Tanzi (2003)
HealthSouth Corporation (2003)
Chiquita Brands International (2004)
AIG (2005)
CF Foods
Satyam Computer Services (2009) (India)
In fact, it really should be among the richest countries in the world, not one of the poorer ones.
I hope to invest there sooner than later, nonetheless
On Jan 10 12:58 PM Teutonic Knight wrote:
> tilut,
>
> I kind of echo the sentiment of your comments; however, I note one
> possible typo as follows: "...I think Indians and Chinese can be
> as...". Would you mean: "...I think Indians and Chinese cannot be
> as..."?
>
> If so I would concur with you. Summa Cum Laude grads in business
> and finance in such Ivy League schools COULD make superstars in fraud
> and scandals as in many instances.
But watch out for the red alert - - the more they self-promote and self-glorify themselves, the more you would watch out for their tricks.
The Christian Bible tells us that "whenever you do charity, do it with your right hand as if your left hand would know what the right hand just did."
Corruption knows no bounds and would not distinguish between cultures and races, let alone the color of the skin. Remmeber the South Sea Bubble in 1720? It was then fully sanctioned by the highest rung of Royalty.
On Jan 10 02:34 PM Teutonic Knight wrote:
> I would concur with dspg's remarks. Often, the swindlers would come
> with respectable star credentials, clothed in sparkling starched
> white shirts and pin-stripped suits, plaques of awards, honors of
> this and that...So that you guards are down. Recall that Raju was
> named "Something of Year 2007"!
>
> But watch out for the red alert - - the more they self-promote and
> self-glorify themselves, the more you would watch out for their tricks.
>
>
> The Christian Bible tells us that "whenever you do charity, do it
> with your right hand as if your left hand would know what the right
> hand just did."
>
> Corruption knows no bounds and would not distinguish between cultures
> and races, let alone the color of the skin. Remmeber the South
> Sea Bubble in 1720? It was then fully sanctioned by the highest
> rung of Royalty.
Dr S.N Pandey
sheonandan@hotmail.com
In case of Sataym every Mutual Funds had invested in a big way and they also lost money.All Mutual Funds heads are experts in Finance Audit Accounts but still they made mistake in identifying true colour of the company and Mr Raju.
We all invest based on trust and whatever figures which are made available to the company. In this Satayam case government must check all transactions of all people involved at PWC Hydrabad office.
It will be very good if we get good information for any Chartered Accountant about fact that what are the responsibility of Auditing company towards shareholders . SEBI must publish all do and do not for all AUDITING Companies in India. There is association of CA in india and they can also publish this kind of information for all investors in India as well as world wide.
Tyco's scandal was probably the closest. Mangement pilfered cash, and they overstated cash flow.
Satyam's hiding of the cash flow through "creative" measures is probably going to turn out to be complex as well, later. And this kind of fraud, it will be found, is likely to happen in the US as well.
Having said that the disclosure norms in India are not exhaustive or specific enough, and companies still need not disclose balance sheets and cash flow statements at the end of each quarter. While the US SOX is nowhere close to successful, but we definitely need more rigorous norms, peer audits, and verification procedures in India.
But the thing is: Such frauds will happen all over the world. After this bank rescue moral hazard, it will only get worse; we've seen excesses already in AIG, and we're likely to see more conventional filching by the newly crowned "bank holding companies", which by definition includes everyone except you and me.
I wouldn't adopt a holier-than-thou attitude on regulation; definitely nt after the recent past. That there is a problem is accepted, that there won't be a similar one in the US is just laughable. Though if anything I must admire the massive amount of reliable data available in the US on everything not in corp balance sheets - CDS prices, real estate, construction, jobs, and even architectural billing! At least that gives you a way to assess an industry.
Tyco's scandal was probably the closest. Mangement pilfered cash, and they overstated cash flow.
Satyam's hiding of the cash flow through "creative" measures is probably going to turn out to be complex as well, later. And this kind of fraud, it will be found, is likely to happen in the US as well.
Having said that the disclosure norms in India are not exhaustive or specific enough, and companies still need not disclose balance sheets and cash flow statements at the end of each quarter. While the US SOX is nowhere close to successful, but we definitely need more rigorous norms, peer audits, and verification procedures in India.
But the thing is: Such frauds will happen all over the world. After this bank rescue moral hazard, it will only get worse; we've seen excesses already in AIG, and we're likely to see more conventional filching by the newly crowned "bank holding companies", which by definition includes everyone except you and me.
I wouldn't adopt a holier-than-thou attitude on regulation; definitely nt after the recent past. That there is a problem is accepted, that there won't be a similar one in the US is just laughable. Though if anything I must admire the massive amount of reliable data available in the US on everything not in corp balance sheets - CDS prices, real estate, construction, jobs, and even architectural billing! At least that gives you a way to assess an industry.
by "attenuation31"
My take away from your article is:
Do not invest in emerging market companies because they are wet-behind-the-year freshmen committing easily detectable frauds. But do invest in US companies because they are seniors who have fully mastered the art of fraud.
Tell me I'm wrong.;-)
Just as Indians can get swindled due to their lack of understanding on certain things in American society, American can likewise get swinded based on lack of understanding on business practices in India. The important thing is to realize what you don't know and make informed risk calculations based on that. I'm sure many Indians got duped by investing in American banks over the past few years.
If you called into question American accounting standards based on that --- you'd be absolutely correct. However, just because ugly things can sometimes happen in America does not mean that India is somehow immune from problems and the fact that Satyam slipped by for so many years is very troubling. I would not dismiss concerns about it simply because 'America has had scandals before.'
This is really not about American investors knowing India or not - even if they did, like many Indians do, Satyam would be a dramatic surprise.
But in general, yes, one needs to know about Indian laws, that we allow our companies to defer tax reporting till the last quarter, that we let companies take non-hedged forex losses on a balance sheet (and then not report balance sheets), that our insider trading laws have very lax enforcement etc. And I learn about American laws everyday - how companies can buy back shares when they continue to throw out options or share sales, how mark-to-market can be thrown out the door for a while, how naked short selling continues to be unregulated etc.
Even enforcement is different: Madoff does away with $50 bn and is out on bail, while Raju does $1.2 bn and is in jail (bail was refused). In other cases, it might be the exact opposite (heck, Raju might never get convicted!)
Having said that we all get the frauds, some blatant and some subtle.