Corporate Governance Failure @

SATY M

Circumstances Under Which The Satyam Scam Was Exposed

• 16 December 2008: The board approved a 51% stake acquisition of MAYTAS INFRA and 100% stake in MAYTAS PROPERTIES. Both firms were in construction & real estate business.

• The deal required borrowing of US$300 million in addition to US$ 1.2 billion of cash that Satyam claimed to possess.

• There was stiff resistance from the Investors.

• Even though Satyam called off this deal, it raised questions about its corporate governance practices.

• 23 December 2008: World Bank suspended Satyam for 8 years from doing any business with itself.

• On December 26- Mangalam Srinivasan, an independent director resigned.

• IL&FS sold 4.41 million shares of Satyam in open market and hence Raju’s and his family’s stake diluted to 5.13%.

• According to ‘Investors Protection and Redressal’ Forum, “Investment bank DSP Merrill Lynch, which was appointed by Satyam to look for a partner or buyer for the company, ultimately blew the whistle and terminated its engagement with the company soon after it found financial irregularities”

• A former senior executive in Satyam wrote an anonymous email about the financial irregularities & fraud to one of the board members.

• On January 7,2009 B. Ramalinga Raju wrote a resignation letter to the SEBI where he admitted that he falsified the financial statements.

Reasons For The Fraud1. Weak corporate governance:– The mechanism for monitoring the actions, policies and decisions

made in Satyam was proved to be weak.

2. Dubious role of independent directors:– It is hard to believe the independent directors could not discover

the well-planned massive fraud and manipulations.– They should have questioned how and why the company was sitting

on such a huge pile of cash.

3. Failure at all 3 levels of auditing: Financial irregularities were ignored by the internal & external auditors.

– Internal audit headed by the CFO– External audit by PwC– Board’s audit committee headed by independent directors

•If a company claims it has huge cash on its hand, then auditors should check whether that cash in hand is available or not.

•There needs to be a physical verification of assets owned by the company.

•But PwC did not perform this for even a large sum of Rs. 5040 crore.

External audit by PwC

•Board had to ensure that transparency in the company, that financial disclosures and financial statements provided a true picture

•That no kind of fraud existed in the company.

•But the audit committee of Satyam failed to detect any manipulation in the accounts.

Board’s audit committee headed by

independent directors:

Reasons Of The Fraud (Contd.)

4. Greed

5. Ambitious corporate growth

6. Stock market expectations

7. Whistle blower policy not being effective

Prevention of Fraud

Board1. Must monitor the ethical practices and the way they are implemented in the company2. Accountable for the financial information being projected3. No to inactive board members4. Authority to independent board of directors5. Clear understanding of responsibility between the board and the next level of employees6. Qualified board members

Government Regulation, Policies and Intervention1. Play an active role in company affairs because company runs with public money2. Frequently check the company’s performance in the market and take necessary steps in curtailing any malpractices or falsifications3. Government intervention must be increased in the auditor’s work to have a foolproof mechanism in the company policy matters

Accounting Standards1. To check the fairness and trueness of the financial statements by involving proper audit tools2. Freedom for auditors3. Reputation of auditing firm/individual can’t avoid scandals4. Most of the companies involved in mega scandals were audited by reputed auditing firms

Ethics of individual/company, defining and implementing code of conduct1. Search or Nominations Committee2. Proper code of conduct updated on a regular basis should be implemented3. Every company should have fraud detection mechanism4. Good corporate governance5. Good educational practices doesn’t always mean individual has good ethics6. Whistle-blowing practices

Corporate Governance at Satyam

• Composition of the board & committees was in total compliance with rules & regulations (It had 5 independent and 4 Internal members.)

• Satyam followed governance standards beyond what was prescribed by law.

• The board of directors was elected by shareholders to set objectives & to ensure the long term interests of all stakeholders are served by enforcing the principles.

• The management was responsible to establish & implement policies, procedures to enhance long term value of the company & delight all its stakeholders.

Driving forces of Corporate Governance at Satyam: Associate Delight Investor Delight Customer Delight The pursuit of Excellence

Goal: “ The company’s goal was to find creative & productive ways of

delighting its stakeholders, (i.e. Investors, customers Associates & society) ”

Accounting Practices: U.S. GAAP (Generally Accepted Accounting Principles) IFRS Complied with Indian Accounting Standards

Financial Fraud Prediction Models And Ratios

1. Z-Score Fraud Prediction Model (Beneish 1999; updated by Basilico and Grove 2008)

2. F-Score Fraud Prediction Model (Dechow et al. 2007) 3. Sloan Accrual Measure (Sloan 1996; updated by

Robinson 2007) 4. Quality of Earnings Ratio (Schilit 2003) 5. Quality of Revenues Ratio (Schilit 2003)

• Satyam won the Golden Peacock Award for Excellence in Corporate Governance from the Institute of Directors in New Delhi in 2002.

• Investor Relations Global Rankings (IRGR) rated Satyam as the company with Best Corporate Governance Practices & risk management for 2006 and 2007

Responsibility of the Auditors

• One lesson from the failure of the watchdogs at Satyam is that continuing with procedures that depend heavily on trust and good faith rather than putting matters beyond any doubt by verification will leave the door open to frauds.

• Did the watchdogs at Satyam fail to alert the outside world because the perpetrator of the scam was a familiar figure they trusted?

•In accounting scams like Satyam, coming from the top, internal controls are easily overridden

•Only the external checks in the form of independent directors and external auditors can provide real assurance to shareholders and investors if they work as envisaged.

•The external checks failed to work as they should have to prevent a fraud of such major proportions that continued for at least seven years in a seemingly well run and well regulated company meeting the standards of both (SEBI) and SEC.

•In Satyam’s case auditors failed at all 3 levels of audit

Where they failed?

•The directors, especially the independent directors should have no hesitation in asking tough questions and should not be satisfied with evasive or vague replies.

•Independent directors are supposed to keep a watch on the management and safeguard the interests of the shareholders.

•While the board including the independent directors approved the Maytas deal as making sound business sense, investors revolted, sending share prices plunging

•They can look for inconsistencies in the information and for trends and operations that do not make business sense and raise the red flag.

What should have done?

The critical role of Internal Auditors

The critical role of Price Waterhouse

• PwC affiliates had been accused of repeatedly conducting deficient audits of Satyam's financial statements for several years.

• Satyam paid them a huge fee and it was suspected that PwC allowed irregularities.

• PW India violated its most fundamental duty as a public watchdog by failing to comply with some of the most elementary auditing standards and procedures in conducting the Satyam audits.

• The result of this failure was very harmful to Satyam shareholders, employees and vendors

• Fake bank balances and cash — of Rs. 5,040 crore in this case should be easy to detect.

• The auditors are required to verify the company’s bank balances but Indian practice allows them to accept certificates from the bank handed to them by the company.

• It is questionable if an auditor should place such trust in the management when he is supposed to watch over its handling of finances on behalf of the shareholders, the regulator and the general public.

• It becomes easy to forge bank certificates and hand them to the auditor.

What Should be Done?

• Auditors brought in by the top management develop a cozy relationship which has led them to get comfortable with even fraudulent accounting practices found time and again in a company

• Requiring confirmation of bank balances and the rotation of auditors for listed companies.

• For very large companies auditors could even be appointed by SEBI.

• Good auditing practice requires the auditor to confirm the balances directly with the bank or by confirming with the banks the statements provided by the management.

Evaluation of the Letter

• Ramalinga Raju stated most of the facts about the financial fraud including the amount to which certain components of the balance sheet were inflated

• Never mentioned the role of the financial auditors' in the scam

• The letter shows that the intent of the entire fraud was to just stay ahead in the competition but not for personal gains

Came out with a confession letter so as to minimise the effect of damage that could have been even more had it been discovered in a later time

The attempts that were made by him to cover the inflated cash balances.

He also recommended three steps to minimise the loss in view of the well being of the employees as well as the investors.

His gain from the fraud that he was indulged in.

Responsibilities of Board of Directors

Towards Investors

• Act in good faith in order to promote the objects of the company for the benefit of its stakeholders.

• Ensuring that there is no conflict of interest

• To keep a check on the financial reporting system

Towards Company

• Maintaining appropriate relationship with the company’s auditors.

• Independent Directors should have challenging, skilled who have time to devote to the business.

• Setting up of sound internal control system

• Exercise independent judgment in the company

Rules & Regulations

• Declare his interest in acquiring or selling of any new company or subsidiaries.

• Proper reporting and communication after detecting any fraud and taking necessary actions as soon as possible.

• Act in accordance with the articles of the company

Can Regulatory Changes Prevent Frauds

Har

shad

Meh

ta S

cam

(199

2) SEBI(Securities & Exchange Board Of India) was formed on 1988,but powers were confined to C.C.I.After Harshad Mehta scam Government passed SEBI act in 1992.Now SEBI is the regulator of stock markets in India.Rolling settlement was made compulsory.Suspended brokers acting as directors and other office bearers of BSE for alleged insider trading

Enro

n Sc

am (2

002) Sarbanes-Oxley act came

into existence in July 30,2002 after Enron scam.The provisions in the law are exactly the Enron’s corporate governance failings.The provisions of the act includes Public Company Accounting oversight Board(PCAOB) to develop standards for the preparation of audit reports.On February 13,2002 due to instances of accounting violations and corporate irregularities SEC recommended changes of the stock exchange’s regulations.

Keta

n Pa

rekh

Sca

m (2

001) Withdrew broker control

over stock exchangeTrading cycle was cut short from week to dayCarry forward system in stock trading called BADLA was bannedIntroduced forward trading through exchange traded derivatives

Laws Enacted After Different Scams

Repetition Of History• There appears to be some similarity between Harshad Mehta

scam and current scam involving NSEL(National Spot exchange Ltd).

• In Harshad Mehta scam fake BR8(Bank receipts) were issued in NSEL case fake WR(Warehousing Receipts) were issued.

• Still FMC has limited powers as compared to SEBI.• The matter appears as a combination of Harshad Mehta &

Ketan Parekh scam.• From Harshad Mehta scam to current NSEL scam, it is seen

that culprits have taken the benefits of the loopholes in the system.

• By designing stringent laws government can prevent scam. It can pluck loopholes in the current system.

• This is not the only remedy. Avoiding unethical things is related to the conscience of individuals.

• There have been laws against bribery but, we have not been able to exterminate it completely.

• In Satyam’s case it is implied that it bribed PWC (Price WaterHouse Cooper) to neglect the fraud.

• It derailed from the path of ethics to stay in the market and gain an edge over individuals .

• “Ethics is nothing but finding the difference between what you have right to do and what is right to do.”

An institution of mechanism for whistle blowers with an effective‘whistle blower policy’ in place.

Central Government’s power to direct special audit in certain cases

To re-appoint independent directors after expiry of a term offive consecutive years

Blacklisting of Chartered Accountants by ICAI for indulgingin fraudulent accounting practices

Suggestions

Use of investigative audit techniques & Forensic auditors

New Auditing regulations must be cost effective for the companies

Setting up of a separate risk management team by Governmentto detect, respond and prevent frauds and their after effects

Lesser Government control over internal corporate processes

Promotion of shareholders’ democracy with protection of rights of minority shareholders

Lessons Learned

Compelled Govt. to rewrite Corporate Governance rules, and tighten the norms for Chartered Accountants

Responsible self-regulation with adequate disclosure and accountability

Criteria for remuneration to key personnel and strengthening quality review should be there in place

Voluntary corporate governance code should be adopted

Promoters should be prohibited from interfering in the recruitment of independent directors.

Company should build sustainable competitive advantage through ethics, values, excellence, quality, social responsibility and human development.

Whistleblowers play an important role in letting others know about the fraud.

Proper training on ethical values

Thank You