Would the Satyam scam be discovered but for Maytas deal?

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Imagine this - what if Ramalinga Raju and his team had never suggested the Maytas transaction? What if the board had not approved it giving shareholders no reason to revolt? What if there had been no deal to cancel? What if DSP Merrill Lynch had not been hired? What if they had not noticed financial irregularities? What if the board's independents had not been questioned and what if there had not been unimaginable pressure on Ramalinga Raju? It would have been life is usual at Satyam . Raju and his team would have addressed yet another earnings conference this month and the Rs 7,000 crore frauds or even more would have stayed undiscovered.

Ironically, today if we have anyone to thank for the discovery of this fraud it's probably Ramalinga Raju himself because if he had not attempted the Maytas buyout, none of this would have come to light. How is it that despite all our rules and regulations no one detected a fraud of this mammoth size? Now, will any of these rules and regulations help us effectively prosecute this scam test? These are the questions plaguing the nation and YH Malegam, Former Chairman of Accounting Standards Committee of SEBI, Vinod Dhall, Former Secretary of MCA  and Nishith Desai, Managing Partner at Nishith Desai Associates answer them.

Here is a verbatim transcript of the show The Firm aired on CNBC TV18. Also see the accompanying video.

Q: What do you think and how big do you think this connivance is? If we were to go by Ramalinga Raju's letter and we do not have any other evidence as of now this fraud could not have been perpetrated by 1-2-5-7-8-10 people it seems that many tens of people would have had to be involved for him to pull of this kind of Rs 7,000 crore fraud. What's your opinion?

Desai: We have a system where fundamentally one would say that our laws are adequate but definitely implementation and administration. It's not an implementation by the regulatory authorities but even at the professional level we need to improve our standards and perhaps this would have gone on for little longer time. Some day definitely it would have been discovered but we do not know as at what point of time.

We have 4,900 companies listed on the Bombay Stock Exchange as on 2008 and about 1,400 on the National Stock Exchange. So we have more than Nasdaq listed companies like 3,900 there or New York Stock Exchange 3,000 so we should have the world's best standard not only best standards but perhaps this would have gone on for sometime. I do not know in how many other companies' similar situation is prevailing and we do not know when it will be discovered.

Definitely, if there is one dooms day everybody knows when you are going to die but you can prolong it as long as you want to. But this is the state of affairs in India and also there needs to be significant improvement in the law of which we can talk separately.

Q: This could have not taken placed without some assistance or negligence by the board. Would you not agree that if a fraud of this size has been perpetrated? If Rs 5,000 crore of bank balance never existed but were shown to exist on the books there has been some sense of complicity on the board and if not complicity definitely negligence and being able to answer the right kind of questions. What kind of shadow does this cast on the independence of board across the country?

Dhall: Definitely, this is a failure at various levels. There is a failure at the management level. How is it possible that a fraud of this size were being perpetrated but managers at various levels, the finance department, accounting department, internal audit department were not in the know of it or did nothing about it.

Second, it's a failure of corporate governance; there is the board of directors and there is an audit committee. Under the company's act plus Clause 49 of the listing agreement the audit committee has enormous powers to the extent that it is virtually the final word in accounting matters. They have the power to summon the internal auditors, the finance people, the external statutory auditor and to ask questions and their report cannot be brushed aside by the board easily without giving very concrete reasons for it. So what was the audit committee doing which was suppose to consist of independent directors.

The third level of failure is the audit. If this thing was going on for one-two-three years whatever and it related to cash that cash which was set to be available was not actually there then how is it that it was not detected in the external audit because the auditors are suppose to cross check with the banks with the fix deposit receipts and so on.

Q: Everyone asking this question - how could the auditors have missed a fraud of this size bank balances, cash balances that did not exist and all kinds of other fudging of accounts?

Malegam: At this state we do not really what has happened. As I can see the situation what is happened is Mr. Raju had borrowed money from certain institutions, had pledged his shares. He probably felt that if the value of the shares had dropped he would be required to provide additional margin money and therefore he had to maintain the value of the shares. So this is a case of a fraud not where any funds have been taken out but where fictitious income has been reflected and when you reflect fictitious income you automatically create a fictitious asset.

Normally, one would have expected that when you create fictitious income it would get reflected as a fictitious recoverable. But it is quite possible that if you have a fictitious recoverable and remains outstanding for any length of time it would draw attention. So maybe he has shown that as if that has been recovered and reflected as a bank balance.

Q: One equity research report or researcher rather pointed out that is almost Rs 5,000 crore of Satyam's balances were in current accounts not earning any interest. Would this kind of detail not have struck the auditors and would they have not felt the need to investigate further over a period of time. Why is it that this kind of money is lying in a current account?

Malegam: Quite frankly, I do not know because the only evidence we have is the audited balance sheet as on 31st March 2008. According to that balance sheet there was Rs 3,300 crore in fixed deposit account. There wasn't a very large amount in current account. Subsequent to 31st March there have been two statements which have been filed that are the statements of financial results on June 30 and September 30 and financial results are confined to the revenue account. They do not show any balances of the bank account so I do not know what is the source of this report. But even assuming that this was in current account it's not very clear whether this has been certified or reported upon by the auditors.     
    
The point I wanted to make is this is a possibly a fraud which has been going on for some length of time but it gets increased progressively as you want to maintain a level of profits and for e.g. as I said there was Rs 3,300 crore in the fixed deposit as of March 31 if that has grown to Rs 5,000 crore odd it means that during this period between March and September a major portion of the funds have been or fictitious funds have been created and that seems to coincide with the period when there was a downturn in the IT industry. So if you wanted to maintain or show a same profitability or an increased profitability he has to show more and more of fictitious income.

Q: I think the question this has raised on account of auditor accountability and few I will get your brief response to each one of them. Is it time we finally called for rotation - if not audit firms at least audit members mandatory rotation of audit members to ensure there is some sort of independence, there is no negligence and more oversight within audit firms of audit members of certain companies. That's one question and second - do we need a super regulator of auditors like the PCAOB (Public Company Accounting Oversight Board) in the United States of America?

Malegam: As I said we do not know what has happened but let us look at the institutional arrangements which already exist. Satyam is a company which is listed on the New York Stock Exchange because of the listing agreement with the New York Stock Exchange it is subject to Sarbanes-Oxley therefore it has to comply with all the requirements of the internal controls which are applicable to Sarbanes-Oxley and these are verified by the auditors.

There is a system whereby the public oversight board in the US inspects audit firms which are outside the US and to the best of my knowledge they came here and they inspected the big four firms so presumably they also inspected Pricewaterhouse.

Pricewaterhouse, like any other international firm has its own internal peer review system which means that the international company reviews the working of the local PwC.

The institute has a peer review system. So the institute must have reviewed there workings and with all these existing situations which exists to create more institutional arrangements is not the answer.

Even today there is a requirement with both international firms that after four years the audit partner is rotated. So it's not the same man who does the audit for any periods of time and I believe in Pricewaterhouse, in the Satyam case there was a rotation. The audit accounts were signed by different person compared to what was there earlier.

So if there has been a failure it's a failure of performance and not a failure of institutional arrangements.

Q: One question on Independent Directors on board because those are the other big questions being raised in this country. Do we need rotation of Independent Directors? Is there a period of time after which an Independent director can no longer be called independent because of his familiarity with the management? We also suffer from a lot of family owned companies in this country and therefore his familiarity with the promoters also compensation for Directors has increased substantially over the last few years which is a good thing because if you want Directors to be involved you should pay them well. But a lot of the compensation nowadays comes in the form of stock which means the fortunes of these Directors linked to the market performance of the company. So where do you draw the line between the Director being independent and not being independent. Do we need to put in rotation and do we need more accountability measures for Independent Directors?

Dhall: I will add one more thing to what Mr. Malegam had rightly said about Independent Directors. You would recall that when the Enron and other scams took place in the US we also had setup a high level committee called the Naresh Chandra Committee. They came out with an excellent report and one of the things which they recommended was which we tried to put into the company commandment bill which got shelved at that time. One of the things we tried to put in was to prescribe the parameters for an Independent Directors. If the same Director is on board for more than nine years he can no longer be classified as an Independent Director. He may continue as a Director but not as an Independent Director. If he has any kind of pecuniary relationship with the company by way of shareholdings or delinks with the company or a supplier or a customer he cannot be called an Independent Director and similarly there were so many other recommendations which were made at that time and some of those were incorporated into the amendment bill which got shelved as I said.

Now we have to revisit these provisions. There are many provisions in the companies' act which allows the government for e.g. to carryout a special audit of a company or to carryout investigation of a company or even seize the documents of a company as indeed the MCA (Ministry of Corporate Affairs) has done yesterday, I am told or even to seek the appointment of government directors on a company without taking over a company. But there are so many procedural hurdles in the implementation of these provisions that the action becomes very slow rather ineffective and that is why we had setup one consolidated agency and that was the other problem. Too many agencies working in a different aspect of same transaction we had setup the serious fraud office in order that there is an integrated investigation, quick investigation into a scam of this kind. The SFIO (Serious Fraud Investigation Office) was meant for very selected few cases so that they can concentrate all its energy and resources which cannot be unlimited on to these few selected cases so that there is a deteriorate effect.

I think our corporate sector does have a good record of corporate governance; our software companies have a good records therefore it's a sad thing which has happened. But we need not taint the entire corporate sector with this. What is required now is to show to the world that whatever provisions there are we are capable of speedy and effective action. If that does not happen then the whole world would say that in India such things can go unpunished or unpursued and one of the important things is to where the SFIO with statutory powers so that they have to look to the police for prosecution or to the police for supplementing the investigation. They are able to carry out the entire investigation on their own; they do not have to wait for a registrar of companies to go and carry on a seizure of documents or an inspection.

So what we need is: Firstly, strengthening the institutional machinery. Secondly, the deterrent provision in companies act is very weak for e.g. for falsification of accounts which is one of the confessed allegations over here the punishment in our act is only two years of imprisonment. For a similar malfeasance or fabrication of accounts the punishment under Sarbanes-Oxley is 20 years of imprisonment. We need more effective. For some of the offences under the companies act, the penalty is as little as Rs 5,000. If it is repeated day after day the recurring penalty is only Rs 500 a day. That is a laughable amount in today's circumstances. We need to hike up the deterrent penalties for selected cases of malfeasance so that there is a deterrent kind of effect.

We need to strengthen the machinery as I said whether it is the SFIO or the powers of the government to appoint Directors so that these actions can be taken effectively and speedily.

Today Satyam needs - I think what government needs also to do apart from whatever action they maybe taken is to appoint a set of directors who have some credibility without actually taking over the firm a set of directors who have credibility, who would enjoy the confidence of the shareholders and the general public and can oversee the management of the company.     

Q: We've managed to identify some of the gaps whether it is in the audit space, in the independent director's space or in the Serious Frauds Office space. What are the remaining gaps that you think that we need to quickly identify and how do we plug them? 

Desai: My view is that these cosmetic corrections will not really work. Independence is a state of the mind. Even today it is difficult to find independent directors. For example, I don't take up directorship in any company. We have worked on at least five of the ADRs that have happened out of India in the US. So, independence is a state of mind. It will be difficult for you to rotate the directors who are truly independent. That is my answer to your question whether it is worthwhile rotating them. You may do it as a matter of formality.

 

Let me add to what Vinod just said about some of the gaps. Correct me if I am wrong, Section 209 of the Companies Act requires that proper books of accounts be kept by the company. What is the penalty? Failure to maintain proper books of accounts leads only to imprisonment up to six months and a fine of Rs 10,000 or with both. A Rs 10,000 fine for not maintaining proper books of accounts. It is funny.

 

Look at Section 233, penalty for non-compliance by auditor, with duties of the auditor. What is the penalty? Failure to exercise duties of auditors as prescribed under the Companies Act (if the defaultee is willful) will be punishable with fine, which may extend to Rs 10,000.

 

Now these are the kinds of penalties we have. What is the penalty or accountability on independent directors? All that independent directors have, which is Clause 49, it results in - if there is no compliance with listing guidelines, you delist the company and that is the end of the matter. So, there is no accountability on independent directors as such at all.

 

Q: Where do you think this case is going to be six months from now?

 

Desai: We not need only this implementation and increased penalties but we also need to bring some amount of behavioural changes in our institutions. For example, today, everybody is so much after greed, speed and scale, and in trying to do all that you miss out on the fundamentals. For example, I would suggest that the Institute of Chartered Accountants of India - today most chartered accountants do not want to practice accounts. They do not want to do audit. Therefore best of the brains go on to doing other things, whether it is tax practice, consulting et cetera. It is very important that the main role of the accountant is to have the best of the standards, and the best brains have moved somewhere else. We should bring some pride in auditing.

 

Secondly, we need to change the entire mindset and the behavioural pattern once again and change the laws very quickly so that we not only go to the best practices but also to the next practices I would say. If we have 4,900 companies more than anywhere else in the world, what else do we do? We need to export standards from India. We need to bring a lot more other reforms including bringing about changes in the system so that we can have Class Action suits so that people can take up the issues.

Q: Where do you think this case will be six months from now?

Dhall: Its very hard to say but going by past experience one can say that it's not very encouraging if the powers for prosecution under the different provisions of different laws are split in this manner and if the penal provisions are to be prosecuted by the State police we generally does not have the equipment or the training to pursue, to successfully investigate and prosecute cases of this nature then it is quite possible that those who are guilty might escape.

I want to add one more point and that is about the auditor independence if you do not mind - one of the provisions which we had stipulated at that time is to ensure auditor independence; there are certain kinds of activities and services which an auditor should not be allowed to perform and the auditor should not have a certain kind of dependence on the company for e.g. no auditor should derive more than 25% of his income from that particular company. That auditor should not provide consultancy services in respect of management information service or the accounting.

Q: Where do you think this case is going to be six months from now?

Malegam: I think there are two things which are there; first, this is a case which has implications not merely for what has happened in this country but it has serious implications for the confidence level of Indian companies so far as foreign investors are concerned. So therefore Sebi has to anvil act very fast on this matter. They should act on two areas; (1) they should act on punishing those who have been guilty and (2) they should act on restoring confidence by measures to show that this is an isolated case, this is no representative of the general level of financial statements which India has produced and in taking actions against individual - its not just taking action against the managing directors. I refuse to believe that the fraud of this type could have taken place without the involvement of a large number of persons and therefore Sebi has to take action against that.

Final point, I think someone mentioned or you mentioned that the institute take action only against the person and not the firm. But I might mention that regulators do the other way for e.g. the RBI with which I am connected when there is a failure the RBI in fact debars the whole firm; it doesn't talk of an individual.

Q: So you are saying there needs to be both - individual liability as well as firm liability to set a proceeding?

Malegam: Exactly.