Satyam and Balance Sheet Manipulation

Today’s “honest” disclosure by “Satyam” Mr. R. Raju in his resignation letter submitted to the Board of Directors of Satyam and filed with SEBI and the stock exchanges is at the outset the outpouring of the frustration of managing an organization which has “grown” bigger than it’s boots to keep its investors happy, is how I would look at it. The holes which the disclosure has put in the audited financials, corporate governance and regulatory oversight are too big and far too many to be ignored. The issues raised by the disclosure have a wider import and impact on industry as a whole and on the software business in particular.

Valmiki – a dacoit by profession was struck by remorse and was advised by Narad muni to meditate on the word “Rama” - as Valmiki could not say “Rama”, Narad advised him to say “Mara” which is what he had been doing – but in a continuous chant it sounded “Rama”, thereby achieving the objective. Similarly Mr. Raju after the “Mara” phase is trying to enter the “Rama” phase! But at what cost? He has completely betrayed the trust of 50000 plus employees putting their career at stake in one fell stroke, wool pulled – willy nilly – over the auditors eyes, investors conned and the Government and others taken on a “runaway, uncontrollable tiger ride and getting of the tiger would mean being eaten up”!

We are talking about a sum in excess of Rs 5000 crore, that is in excess of US$ one billion which is non existent! That is an amount which is too huge to digest – can’t just disappear right? How can this happen? Investors and ordinary shareholders will be asking this question. One of the top four in the software industry in India, and probably one of the top 25 globally! The company is listed in the US, it is subject to US laws, so why this obfuscation of numbers? Why take this huge risk at all? When decisions are taken in the Board, I am sure a cost benefit analysis is carried out, the pros and cons are weighed. If the pros far exceed the cons then only crucial decisions are taken. So what is it that convinced the Board to do what it has done?

As per SEBI Corporate Governance norms all listed companies are to have non-executive and executive directors on the Board. Most companies appoint big names as their non-executive directors for marketing purposes. The question is, do these people understand the business? Do they understand the industry? Do they understand numbers? Why then do they lend their names as independent directors? Is it just the sitting fees which they get along with undisclosed perks? Do these people not have a responsibility to ask tough questions of the executive board? Has SEBI looked into this? Has it thought through the basic requirements for oversight? There are far too many questions and very few answers. In fact I would say, the answers would be unpalatable and would not be easy to swallow.

We come to the question of the role of auditors. Auditors are an easy target. 20-20 vision is always perfect in hindsight. Let me tell you, if the management is hell bent on manipulation of records, there is no way an auditor can smell a rat in the ordinary course of audit. But not figuring out that Rs. 5000 crore in cash is non-existent is either sheer negligence or complete complicity – which the auditors would need to clarify. Take the case of the big four. Why are they just the big four today? A few years ago they were the big six. Scandals and legal suits have reduced them to the big four. In 2006 the big four reportedly have cumulatively paid fines in excess of US$ 1.2 billion to the SEC. Do you know why? Just imagine if they were reduced to the big three – what would happen? The attest function would then become a non starter. Who would want to certify the accounts of listed companies. Definitely not the small audit firms, they do not have the financial clout to manage malpractice suits. Hence to protect investor confidence, the SEC let the big four off realizing full well that having one more firm falling by the way side would affect industry as well as investor confidence to such a degree that it would not be possible to recover.

Let us look at the issue from Mr. Raju’s perspective for a moment. Why would a person who has built a company over more than twenty years to the size and reputation it enjoyed do what he has done. For one, there is investor pressure. Big money is involved. When billions of dollars come in as investment, then the management feels it is morally bound to show impressive figures to the investors to keep them happy! How do you do this? Mr. Raju has managed to show you how it is done. If Rs. 5000 crore cash is not there, that means either the debtors are inflated or the liabilities are grossly understated thus overstating the profits which are not backed by cash inflows. Which brings us back to the basic question? Were the auditors doing their duty? Or were they just like the President of India – attesting whatever was presented to them by the Board. Interesting isn’t it? It suddenly becomes a vicious circle. You can only get money if you show impressive figures. So you end up window dressing the balance sheet, initially in small measures, and as pressure builds up you find that the window is too small and you end up dressing up the entire building. Who gains? Who loses? At the end of the day what has happened – the investors have lost big time, the auditors have been shot in the head, the Indian business environment has taken a hit, there is a big question mark on issues of corporate governance in India, foreign investors and business partners will be taking a re-look at the India story and a whole host of other issues!!

What should be the approach of the Government and ICAI? The Companies Act which is being rewritten should take a look at corporate governance issues. The CEO / CFO certification, auditors and company secretary certification on corporate governance should have greater emphasis on the nitty gritty of compliance processes. There should be a whistleblower protection program for grant of immunity for senior management who would like to expose corporate fraud. Rotation of auditors should be made mandatory. Joint audit for large cap companies should also be made mandatory to bring some semblance of control and sanity in the credibility of financial statements. The ICAI should look at bringing out specific guidelines for audit of software companies. Investors and analysts should look at operating cash flows instead of the traditional profit and loss account and balance sheet.

What happens to Satyam and it’s stakeholders? In my views the regulatory authorities, like Enforcement Directorate, Income Tax, Customs, Excise etc will come down on them like a ton of bricks. What worth will the scrip be? 50000 plus employees lives just cannot be ignored – can it. The Government will probably try to bring in a stake holder to take control of the company. But which stake holder will come in with legal and compliance issues hanging over the company like Damocles’ Sword? The path to follow would be for the Government to give immunity to the new stakeholders to clean up the Company books with the consent of the regulatory authorities and with guarantees that the neither the new management nor the new stake holders will be penalized financially or otherwise for doing what is right. As far as the old management is concerned let the law take it’s course meting out exemplary punishment for all acts of commission and omission. An example should be made out of this disclosure, so that if there are other companies out there which indulge in such mal practice, are scared out of their pants and end up cleaning their books. If that happens – then one can say that some good did come out of this disclosure after all.

What happens if investors in the US decide to sue the Company – already there is hatred for Indian BPO and KPO companies as these are perceived to take local jobs! The damages which the company will end up paying will push the company into bankruptcy and liquidation. So many losers – I don’t see any winners.

As far as the investors are concerned I would like to point out what Warren Buffet says as regards investing in software companies. He does not invest in software at all because he does not understand the business! He says he can understand something which is tangible but not something intangible. Software under no circumstances is measurable. Steel production is – the input output ratio will tell you how much of iron ore and the other product mix is required to give a certain grade of steel. The bill of material tells you exactly how many units of various raw material need to be input to give you a finished product – but in software everything is ethereal – ghostly. You just go by what management tells you – as you yourself do not have the knowledge or competence to contradict the management! So basically it boils down to TRUST!! Apart from the house of TATAS how many business houses can you really trust in the public domain? If you know the answer please let me know.