Improving Corporate Governance: A Blueprint to Prevent Scams Like Satyam's

Why are we so surprised that Satyam Computer (SAY) blew up?

Probably not because there were accounting shenanigans, not because Raju placed himself before shareholders, not the fact that auditors were probably hand in glove with the management and conveniently turning a blind eye to the fraud being perpetrated at the company, certainly not the fact that the so called independents were dwarfed by Raju, his charm, his wealth, his connections or were just plain incompetent and beholden to Raju for inducting them as independent directors in the first place. We are surprised by the sheer scale of the fraudulent activities which went on unchecked by reputed auditors and the numerous corporate governance awards which multiple organizations vied to bestow on Satyam. Well, it speaks volumes for these organizations but that is a matter for another debate.

I wonder whether we are more shocked at the events that unfolded at Satyam or by the fact that Raju had to own up to the goings-on at Satyam. That such a wealthy and well connected man had to own up to mischief and scams gives rise to innumerable conspiracy theories ranging from blackmail to jail in India being preferred over jails in the USA by Raju.

I have had the opportunity to discuss this issue in detail with many fund managers based in India as well as overseas and I am attempting to detail a few steps which might help in preventing such scams in the future.

I acknowledge that greed and hubris are an integral part of human nature. History of mankind and the scams perpetrated by humans on unsuspecting fellow humans make for an interesting read. I believe that no amount of regulation can eliminate completely the possibility of recurrence of such scams. However, we certainly can make efforts towards minimizing the probability of scams and their size by utilizing the twin tools of enhanced scrutiny and deterrent punishment.

It is critical to work towards increasing the probability of discovering nascent scams early enough if we were to minimize damage to trust and transparency which, combined together, form the underpinnings of any financial system. The interesting part is that most of these suggestions are already being partly applied in India with quite positive results. So we are not reinventing the wheel but just suggesting an extension of the existing format for wider coverage. While I do believe in self regulation, I also believe in strong industry regulators who can ‘police the police’. Without further ado, here is a prescription sheet which, if implemented, can probably control the spread of the disease.

Make the watchdogs accountable for the theft: Punishment should be substantial

We hope that the truth about the role played by Satyam’s auditors will come out after an extensive investigation. When questioned about the investment decision, the common refrain is that the investors relied on certifications by Price Waterhouse, the reputed auditors of Satyam. If these so called savvy and professional watchdogs could not detect the fraud at Satyam, then how can we expect the due diligence done by investors to reveal the mischief? I am not in a position to conclude conclusively whether the auditors were misled and were negligent in the conduct of their duties or they willfully colluded with the management at Satyam in perpetrating the fraudulent events. In any event, the impact of their role cannot be underestimated.

In both scenarios, they failed their duties miserably. I would not be alone in calling for an exemplary punishment to be meted out to these auditors, a punishment which would raise the stakes for others who may have been knowingly or unknowingly aiding or turning a blind eye to similar events at other firms.

The Securities and Exchange Board of India (SEBI) had passed strictures against some prominent foreign banks some time back due to their role in activities considered undesirable. I am told that this action by SEBI had indeed led to a greater due diligence by their risk management and compliance departments and certainly has led to a salutatory effect on these and other foreign banks in respecting the laws of the land.

Do not get me wrong. Deterrent punishment is not the panacea for all ills. However, it does serve its purpose in raising the stakes for players abusing the system. I must mention here that while the SEC in the USA prosecuted more than 600 companies for wrongdoing in 2008, it still was unable to prevent Madoff from ripping off more than $50bn from investors.

Rotate the watchdogs: Fixed, finite and rotating tenure

Auditors and independent directors are the first line of defense against abuse for ordinary investors. The best strategy would be to have one watchdog watch the other. I suggest a fixed tenure for auditors for a finite period of three years. At the end of his tenure, the auditor will have to hand over his assignment to a new auditor. The new auditor will take a sign off from the previous auditor and it would be reasonably difficult for any auditor to assist in perpetuating wrongdoings if there is a more than reasonable chance of being discovered by the new incoming auditors. This could be a simple and effective deterrent against wrongdoing.

A similar system is already in place for the Indian banking sector where auditors are appointed in rotation for a fixed tenure of three years.

Make independent directors truly independent with a finite tenure

A lot of hopes have been pinned on the role of independent director on the board of directors in recent times. However, its impact has been hollowed by giving management the prerogative of choosing the independent director. This in itself is a contradiction with directors being called independent. More often than not, the independent director chosen by management is chosen because of his proximity to the controlling management and is beholden to management for selecting him to the board of the company. This raises serious conflicts of interest in impartial discharge of duties. Many independent directors are not technically and professionally qualified to head the committees they chair in the companies.

I recommend that the independent directors be chosen from a pool of qualified professionals who are known for their expertise and integrity. Further, like the auditors, they should be chosen for a fixed tenure of three years, after which they should be replaced by another set of independent directors from the identified pool of independent directors.

A small note on identifying this pool of watchdogs (auditors and independent directors) would be appropriate at this juncture. SEBI is quite suitable for implementing this scheme.

• There should be clear guidelines for eligibility for admission to the proposed pool of auditors and independent directors.
• A thorough and open vetting process at the selection stage itself is critical for this initiative to succeed. The internet can be used effectively for this. The list of eligible candidates and their resumes and qualifications should be posted on the internet and public feedback invited. The feedback received should be considered on due merit. My guess is that the rotten apples amongst the eligible candidates would be exposed by empowering the masses in this manner.
• The watchdogs should be divided into various categories depending on their size and experience in the case of auditors, and experience and qualifications in the case of independent directors. An appropriate match between experience, size and qualifications of these watchdogs and the size of the companies where they are to be appointed should be made.
• The companies should be given a slate of eligible independent directors from which they can choose the directors.
• A 360 degree feedback system could be used to monitor the performance of the watchdogs and keep the pool fresh with movement between the various categories dependent on skill sets and feedback.
• A market-driven compensation guideline for the watchdogs should be disclosed. The compensation should be reviewed every three years to keep it in line with market requirements.

Subsidiaries over a certain size should have different auditors than the parent company

Business conducted in subsidiary companies is normally not scrutinized in the same detail as the parent company and is open to abuse. Subsidiary companies which are over a certain size relative to the size of the parent company should not be audited by the same set of auditors auditing the parent company. This, combined with a rotating tenure for auditors, would ensure transparency and further minimize the possibility of conflicts of interest.

Institutional nominees on the board

Pension Funds, Mutual Funds and FIIs today own a bigger chunk of equity than the promoters in many of our large companies. They owe it to their own shareholders and stake holders to work towards protecting their business interests and underlying investments. The same pool of independent directors which I spoke about earlier could be utilized to have them nominate their directors on the boards of various companies.

Finally, there is another significant player in the curious cast of characters who has been the first one to cry foul but this play of events could not have been as intriguing and melodramatic as it has been now without them. We would be erring if, to the cast of the Raju brothers, their ‘independent directors’, the infamous auditors, and the bestowers of corporate governance awards, we forget to add the collective conscience of the ‘fund managers and brokers’ who, in my opinion, had a fair inkling that not all was well at Satyam.

Any broker or fund manager worth his salt would have heard not only of the huge real estate parcels said to be owned by the Rajus, but also of their extremely close political connections. These managers would have known of the phoenix-like rise of Maytas and the lucrative contracts housed in these ‘Satyam Group Companies’. They would have had an understanding of the nature of real estate transactions in India and the significant cash component which accompanies these transactions. Yet, they chose to turn a blind eye to the shenanigan, invested and traded in Satyam Computers, contributed to the enhancement of its market capitalization and ironically now profess shock at the lack of corporate governance at Satyam.

While the financial community needs to inspect its own doings and the propensity to turn a blind eye to the goings-on in corporate India, I believe that, collectively, the financial community can be one of the most significant agents of change. However, I worry that by the time change is implemented and percolates down the system, the same Satyam story might have been repeated in many companies in India, and Satyam most certainly would not be the last one to hit the can due to accounting fraud.

Comments

[Tradememe:]

Unfortunately, Satyam is not the first or the last company to blow up like that. No matter how good the corporate governance of a company is, if the CEO or executives want to commit fraud, there is not much the investor can do. As you said, the auditors did a lousy job. It reminds me of Arthur Andersen.

Jan 27 01:02 PM

[Bill Herbert:]

Atim,

Good article. We definitely need to get much tougher scrutiny of the companies and banks that employ our capital and ask for our trust.

Everybody knows that auditing is sort of a joke, a smokescreen to assure investors that the 'books have been scrubbed' and that they can sleep at night, knowing their investment is safe.

Unfortunately, there are many crooks about, and often the investor is not kept abreast of what is really happening at the company.

I agree with rotating auditors, having them assigned and paid by an independent audit board, and making them more accountable for good performance rather than the song and dance that "auditing" has become in the U.S. at least. I can't imagine it's any better in India, but if it is, good. But auditing is not enough, unfortunately.

It is not that hard to have good, sharp investigators go into a public company unannounced at random times during the year, to spot-check such things as bank transfers, suspicious transactions, insider self-dealing, options abuses, and the like.

But above all, we should have very tough and vigorous prosecution of corporate wrongdoers. The Bernie Ebbers types, the Andy Fastows and Jeff Skillings, Dennis K, etc. - these are all terrible crooks and they deserve very tough sentences when caught and convicted. We get some, and some deplorable skanks like Scrushy get away with it - but prison time gets these jokers rattled like nothing else.

Most high-level execs I know think audits are pretty much of a joke, and we have proven to them time and again that they are right!

Jan 27 09:19 PM

[Atim Kabra:]

I agree copperbaron. I have been on Boards of both US and Indian companies and what i have seen is not much different in either of these places.

I think we have to break the nexus between who appoints the watchdogs and who gets watched over...

As long as the auditor, independent director, the investment bank or the rating agency knows that their fees from current assignment, other assignments from the same client and their future renewal of the contract depends on their ability to 'please' the management while doing their job supposedly, we are walking very treacherous grounds.

Let us see what changes the collective outcry produces or whether it is back to regular business.


On Jan 27 09:19 PM copperbaron wrote:

> Atim,
>
> Good article. We definitely need to get much tougher scrutiny of
> the companies and banks that employ our capital and ask for our trust.
>
>
> Everybody knows that auditing is sort of a joke, a smokescreen to
> assure investors that the 'books have been scrubbed' and that they
> can sleep at night, knowing their investment is safe.
>
> Unfortunately, there are many crooks about, and often the investor
> is not kept abreast of what is really happening at the company.
>
>
> I agree with rotating auditors, having them assigned and paid by
> an independent audit board, and making them more accountable for
> good performance rather than the song and dance that "auditing" has
> become in the U.S. at least. I can't imagine it's any better in India,
> but if it is, good. But auditing is not enough, unfortunately.<br/&...
>
> It is not that hard to have good, sharp investigators go into a public
> company unannounced at random times during the year, to spot-check
> such things as bank transfers, suspicious transactions, insider self-dealing,
> options abuses, and the like.
>
> But above all, we should have very tough and vigorous prosecution
> of corporate wrongdoers. The Bernie Ebbers types, the Andy Fastows
> and Jeff Skillings, Dennis K, etc. - these are all terrible crooks
> and they deserve very tough sentences when caught and convicted.
> We get some, and some deplorable skanks like Scrushy get away with
> it - but prison time gets these jokers rattled like nothing else.
>
>
> Most high-level execs I know think audits are pretty much of a joke,
> and we have proven to them time and again that they are right!

Jan 28 02:35 AM

[Neelakantan:]

The Satyam case is classic case of conflict of interest between majority / founder shareholders and the minority shareholders. Such situations exist in atleast 75% of the companies regulated by SEBI and scams of similar nature exist rampantly in many of these listed companies. It is indeed going to be mammoth exercise to scrutinize and monitor every company. This, therefore, increases the role of auditors in minimizing, if not completely stopping, the occurence of such scams.

It is true, that, unless auditors are punished with exceptional punishments for their role in such scams, things really cannot improve.

Feb 01 01:03 AM