Home | Feedback | Contact Us
Legal Articles  


The Satyam Affair: Past, Present and Future

Rahul Satyan talks about the issue of corporate social responsibility which arose in the Satyam scam..

Backdrop

It is said that sometimes when a big tree falls, the earth shakes. When the earth shakes, squirrels fall out of the trees still standing. Those that do not fall are stunned into a state of disbelief. On the 7th of January, 2009, a similar situation was being played out across the Indian financial markets. Ramalinga Raju, founder and chairman of Satyam Computers, India's fourth-biggest software services exporter, resigned saying profits were falsely inflated for years. As the details of one of the biggest accounting frauds in India came to light, heads began to roll. Ramalinga Raju and his brother were swiftly arrested on various criminal charges and an investigation was initiated by the CID. Merrill Lynch and Credit Suisse terminated their engagements with the company.

The New York Stock Exchange halted trading in Satyam stock on the same day. India's National Stock Exchange has announced that it will remove Satyam from its S&P CNX Nifty 50-share index on January 12. The scrip fell faster than a dive-bomber on steroids and Satyam investors lost thousands of crores in the ensuing bloodbath. The credibility of Satyam’s statutory auditors, PriceWaterhouse Coopers (PWC) took a severe beating. PWC partners in charge of the Satyam account were suspended. SEBI initiated an inquiry into its audit process and threatened cancellation of its India licence. The squirrels had indeed started falling from the trees while the rest of them looked on in shocked disbelief.

The true extent of the fraud rattles investor confidence across the world. It became clear that Satyam's balance sheet of 30 September 2008 contained multiple anomalies and some outright untruths. There were inflated figures for cash and bank balances which stood at Rs 5,040 crore whereas Rs 5,361 crore was reflected in the books. There was an understated liability of Rs. 1,230 crore on account of funds which were arranged by Ramalinga Raju himself. A fictitious accrued interest of Rs. 376 crore was also shown in the books. In addition, the books also showed an overstated debtors' position of Rs. 490 crore as against Rs. 2,651 crore.

To get to the heart of the Satyam debacle, popularly called ‘India’s Enron’ one must first understand how it all came out. As said above, there was a huge gap between actual assets and what was being shown in the books. This gap according to Ramalinga Raju himself grew unmanageable over the year as Satyam’s revenues grew. As the promoters held only a small percentage of equity, the concern was that poor performance would result in a takeover, thereby exposing the gap. In order to fill the void and replace the fictitious assets with real ones, the Satyam brass decided to takeover two Maytas companies which dealt with infrastructure and real estate. The reason given was that Satyam needed to cover its risks by diversifying. Shareholder outrage at the decision forced the Satyam board to recant its decision faster that one can say “abort”. The aborted Maytas acquisition deal was the last attempt to fill the fictitious assets with real ones.

Thereafter, the increased scrutiny meant it was game over for Ramalinga Raju and his men. Ironically, if the Maytas acquisition had gone ahead as planned, Satyam’s books could probably have been balanced out and it would have emerged as a stronger company. Furthermore, Maytas, which has extensive real estate holdings and stakes in the infrastructure sector had been valued at over Rs 6523 crores by Earnst & Young. Satyam had been on the verge of acquiring Maytas for a considerably lower sum of Rs 6410 crores. All in all, it was a good deal for Satyam but unfortunately the means did not justify the end.

The Satyam debacle has striking similarities with the Enron scandal that rocked financial circles worldwide in 2001. The Enron scandal was a corporate scandal involving the American energy company Enron Corporation. In addition to being the largest bankruptcy reorganization in American history, Enron undoubtedly was the biggest audit failure. The scandal caused the dissolution of Arthur Andersen, which at the time was one of the five largest accounting firms in the world. Opaque financial reporting combined with a complex business model helped Enron conceal its true performance through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels. This was in spite of having in place a robust Corporate Governance system.

What shocked financial regulators even further was the fact that Enron’s high-risk accounting practices were not hidden from the Board of directors. In fact, the Board not only knew of them but also made possible such activities by Board resolutions. As a direct result, the US Congress passed the Sarbanes – Oxley Act which tightened regulations relating to corporate governance and financial reporting.

The Satyam affair as one can call it must therefore be analyzed under the twin sets of accounting/audit failure and failure of the Board of Directors. However one must first keep in mind the Corporate Governance situation in India as well as regulations which mandate financial reporting. In 1998, the Confederation of Indian Industries ( CII ), came out with a ‘Code of Corporate Governance’ for listed companies which acted as a guide for corporates to voluntarily adopt principles of good governance. Acknowledging the fact that in a globalized world where flows of goods, services and capital are worldwide, a company which does not promote a culture of strong independent oversight risks its very stability and future health, the Securities and Exchange Board of India (SE I) constituted a committee under the Chairmanship of Kumar Mangalam Birla in 1999 to suggest and lay down certain norms of Corporate Governance.

Many of its recommendations dealing with composition of the Board of Directors, constitution of Audit Committees, more comprehensive disclosure etc were incorporated into the Standard Listing Agreement in the form of a new Clause 49 in 2000. Furthermore, the Companies Act was amended in 2000 incorporating many provisions dealing with Corporate Governance like additional grounds of disqualifications for Directors, formation of the Audit Committees etc.

In 2002, following the passing of the Sarbanes-Oxley Act by the US Congress after the collapse of global giants like Enron in 2001, the Government of India appointed a committee under the Chairmanship of Naresh Chandra, former Cabinet Secretary, to suggest changes in the law with respect to certain fundamental aspects of Corporate Governance like auditor-client relationships, auditor independence, role of independent directors etc. At around the same time in 2002, SEBI constituted a Committee under the Chairmanship of N.R Narayana Murthy to review Corporate Governance in India and make recommendations to further the same. Observing that “Corporate Governance is beyond the realm of law; it stems from the culture and mindset and cannot be regulated by legislation alone”, the Committee fine tuned the recommendations of the Naresh Chandra Committee in addition to presenting its own recommendations. In August 2003, SEBI revised Clause 49 of the Listing Agreement by incorporating many of the recommendations made by the aforesaid committees.

In addition to Clause 49, the Indian Companies Act contains various provisions dealing with the concept of Corporate Governance. Sec 299 of the Act requires every director of a company to make disclosure, at the Board meeting, of the nature of his concern or interest in a contract or arrangement (present or proposed) entered by or on behalf of the company. Sec 292A of the Act requires every public having paid up capital of Rs 5 crores or more to constitute a committee of the board called the Audit Committee. Sec 309(1) of the Act requires that the remuneration payable both to the executive as well as non-executive directors is required to be determined by the board in accordance with and subject to the provisions of Sec 198 either by the articles of the company or by resolution or if the articles so require, by a special resolution, passed by the company in a general meeting.

Further, Schedule VI of the Act requires disclosure of Director’s remuneration and computation of net profits for that purpose. To pave way for introduction of real corporate democracy, Sec 192A of the Act and the Companies (Passing of Resolution by Postal Ballot), Rules provides for certain resolutions to be approved and passed by the shareholders through postal ballots. Clause 49 has often been called the cornerstone of Corporate Governance in India. The recommendations made by the Kumar Mangalam Birla Committee in 1999 were incorporated in 2000 by SEBI into the Standard Listing Agreement as Clause 49 dealing with ‘Corporate Governance’ for implementation by all Stock Exchanges for all listed companies within 3 years. This clause mandates all listed companies to implement and comply with its requirements relating to good Corporate Governance practices.

Clause 49 lays down various requirements to be implemented by a company. The mandatory requirements leave the company with no choice but the implementation of the non mandatory ones is at their discretion. The mandatory requirements are laid out under 6 heads, namely Board of Directors, Audit Committees, Disclosures, CEO/CFO certification and Compliance Certificate from Auditors or PCS ( practicing company secretaries).The non-mandatory requirements deal with a variety of topics such as remuneration for directors, the company’s whistleblower’s policy, shareholder’s rights, audit qualifications, training of board members etc. Thus it can be said that at least on paper, that India has one of the most comprehensive codes of corporate governance in the world.

The question then arises that how did the Satyam incident take place? How could such a huge accounting fraud spanning years in time and over thousands of crores in monetary value remain hidden from its auditors? The answers lies in the nature of the failures themselves as well as the nature of the law that governs various aspects of corporate Governance like auditing & accounting practices as well as the responsibilities and liabilities of Directors. One can analyse the aforesaid independently.

Anatomy of an audit and accounting failure

Ramalinga Raju’s confessional statement on the 7th of January, 2009 uncovered the one of the biggest accounting scandals till date in India. Thousands of crores of fake assets had been reported in the books. What was even more disconcerting that Satyam’s statutory auditors PriceWaterhouse Coopers had no clue the books were being fudged. Together with allegations of negligence and collusion on part of PWC, the episode also raised questions about the role of the auditor. Before one gets into the endoskeleton of what exactly caused the audit failure in the Satyam case, it would be prudent to examine what exactly is the role of the Auditor.

The complete scope of who an auditor is and what he does is laid down by many sections of the Companies Act. Sec 209 of the Act lays down that not should a company maintain “proper” books of accounts; such books should also give a true and fair view of the state of affairs of the company. Sec 211 of the Act, inter alia, requires that every balance sheet of the company should give a true and fair view of the state of affairs of the company at the end of the financial year and that every profit and loss account should give a true and fair view of the of the profit and loss of the company and they should comply with accounting standards.

Therefore, to ensure that all aspects of the Act in this regard are complied with, the books represent the true and fair state of affairs and that the financial statements are in agreement with the books of accounts, an auditor is appointed. The powers and duties of the auditor are laid down in Sec 227 of the Act. He has the right to call for information and explanations as well as have access to the books of account. The auditor owes the shareholders a duty to safeguard their rights. The examination by an independent agency such as the Auditor is practically the only safeguard the shareholders have against the enterprise being carried on in an unbusinesslike way or their money being misapplied ( Deputy Secretary to the Government of India, Ministry of Finance v. S.N Das Gupta, (1955) 25 Com Cases 423 )

An audit,as defined in the landmark case of Frankston and Hastings Corpn. v. Cohen, (1960)102 CLR 607, comprises of three main objects –
  • To certify to the correctness of the financial position as shown in the balance sheet, and the accompanying financial statements.

  • The detection of errors.

  • The detection of fraud. The detection of fraud is of primary importance.
Having said that, it is also paramount to state that the auditor is a watch-dog, not a bloodhound, as said by LOPES LJ. This means that his job is verification and not detection. When suspicion is aroused, it is his duty to probe the issue to the bottom but in case there is no material to arouse suspicion, he is not bound to go sniffing around with the intention of uncovering financial anomalies. He is not concerned with the policy of the company and does not sit in judgment on management decisions. The word Auditor has its roots in the word ‘audiere’ which means ‘to hear’. An auditor is supposed to check the company’s financial records to see if they are consistent with the prevalent laws and accounting standards and that they give a true and fair view of the financial position of the company. He is not supposed to go hunting for a financial fraud and its perpetrators.

If one takes the specific case of the Satyam audit failure, it shows that though there is evidence of negligence at many levels, there is none with respect to collusion or criminal conspiracy on part of the auditors. PWC relied on the documents provided by the company to do the audit. The charges of negligence have been heaped on them because they did not go to every bank to independently verify that the cash deposits as shown in the books really existed. Though ideally, an auditor is supposed to do this, it is a fact that very few actually do. In fact when a firm like PWC is dealing with a company like Satyam (which won the prestigious Golden Peacock Award for Corporate Governance in 2008) it generally takes the company at its word that the statements provided are true and represent the true state of affairs.

In the case of Satyam, the company allegedly went a step further and even submitted forged documents from banks confirming the presence of the said deposits. In such a scenario, where none of the documents show even the slightest hint of a financial anomaly, the auditor would generally not go behind the scenes with the motive of uncovering any dirt. Though this is not how an audit is supposed to be done ideally, time and convenience coupled with the name & reputation of the company generally means that the auditor does not bother. However, since the Satyam scandal came to light, auditors have begun to ask for independent verifications from banks with respects to deposits etc.

Another aspect of auditing that was questioned after the Satyam scandal was that of the internal auditor. Internal auditing activity is primarily directed at improving internal control. The internal auditor forms the company’s own level of checks and balances. Under Indian law, a company must have an adequate internal control procedure commensurate with the size of the company and the nature of its business. The internal auditors are the constituent entities of this control. The external auditor is supposed to provide over-watch over the functions of the internal auditor. The reporting requirement under Section 227(4A) of the Companies Act, 1956 mandates the statutory auditor to make an affirmation on the quality of internal audit of the company if it is of certain size.

However, if one looks closely at the internal audit scenario in Indian companies, one is liable to open a large can of worms. There are instances where the statutory auditors have been the de facto internal auditors as well, though professional ethics prohibits this. This is brought into effect by the simple ruse of floating another company where a sizable number of partners are not from the firm doing the statutory audit. While this complies with the law in letter, it’s highly questionable if it does the same in spirit. Then, to compound it all, the statutory auditor goes on to attest to what the internal auditor has been doing saying that that the internal audit system is indeed commensurate with the size and nature of business of the company. It would be obvious that nothing could be farther from the truth.

In the case of Satyam, the internal auditors have been alleged to have been actively colluding with the management to perpetuate the fraud. In such a situation, one may argue that even the statutory auditor may find no material to arouse any suspicions. Keeping in mind the fact that an auditor is only a verifier, not an investigator, it would thus be erroneous to say that in PWC should have definitely come to know that Mr Raju was perpetrating. That there has been negligence in not independently verifying the bank accounts is obvious, whether PWC was an active partner in the conspiracy is highly suspect.

Anatomy of the independence as a director

Another vital issue of Corporate Governance the Satyam scandal brought to light was the role of the independent director. Their role was highlighted in the wake of Satyam’s aborted takeover of the two Maytas infrastructure companies. When Satyam attempted to takeover the two companies, the official explanation was that Satyam wanted to diversify to cover its risks. Several questions went unanswered. Why was it trying to take over an infrastructure company when its peers in the IT market were acquiring companies with similar profiles as themselves? If it was seeking to diversify, why did it choose infrastructure which typically has long term gains and requires heavy capital investment?

It is had decided on infrastructure, why did it not choose to go after Unitech, which was available for a similar price and whose portfolio was more balanced? These unanswered questions created such shareholder outrage that the Satyam board completely recanted its decision within a matter of days. This had two repercussions. The first one was that the credibility of the board was lost. Questions were raised as to the speed at which a unanimous decision of the Board was overturned by itself. The second question raised was that given the state of affairs, how ‘independent’ were the independent directors.

To seek answers to the above questions, one must necessarily look into that facts of the case as well as the law that mandates independent directors in India. The list of independent directors on the Satyam board is an extremely impressive one and comprised of distinguished academics like Prof Ramamohan Rao, Dean of the Indian school of Business who was also incidentally the head of Satyam’s Audit Committee, Professor Krishna Palepu ( professor at the Harvard Business School ),Prof. V.S Raju ( former Director of two IITs), Mr Vinod Dham ( father of the Pentium Chip) as well as eminent persons like Mr T.R Prasad ( a former Union Cabinet Secretary ) .

When the Satyam management proposed the acquisition of the two Maytas companies, concerns were raised by the Board on several issues. There was concern about the unrelated diversification and whether there would be synergy between the companies especially since infrastructure involves long term growth. There was also the concern of needless diversification from the company’s core competency. However the fact that due diligence of the companies had been completed coupled with the fact that Satyam was going to pay significantly less that the firms’ valuation by Earnst & Young led to the board giving the go-ahead. Even the fact that the target companies — Maytas Properties and Maytas Infra were led by the two sons of Mr Ramalinga Raju did not seem very relevant. Shortly thereafter, the reaction from the markets forced the Satyam board to recant the decision completely.

The concept of independent directors first took shape in 2004, when SEBI revised its corporate governance norms on the recommendations of the Narayana Murthy Committee. A key suggestion of this panel was to increase the number of independent directors on the board of a company. Currently it is mandatory that at least one-third of a company’s board of directors are independent, if the chairman of the board is a non-executive member. In other cases, independent directors should constitute a minimum of 50 per cent of the board. In addition, Clause 49 of Listing Agreement framed by SEBI incorporates many key features of the Sarbanes-Oxley Act, enacted after a series of accounting scandals in the US like the one that forced Enron into bankruptcy. The question then arises as to what the problem with independence of directors in India is. The answer to this question reveals an interesting scenario in India where one part of the law undoes the effect of the other. This is explained as under.

The role of an independent director is not day-to-day management of the company. That is the job of the Executive Directors. The role of the independent directors in administration is therefore limited. In the context of their independence, three very interesting points come out. Firstly, independent directors are mandated under law i.e. Clause 49 of the Listing Agreement to have no pecuniary relationship with the company. They must have no ‘material association’ with the company. They should not be related to the promoters or anyone in senior management position from one level below the board. They should not have been an executive of the company or of its audit, consulting or legal firms in the past three financial years.

Besides, owning 2 per cent or more of the block of voting shares or being a service provider to the company, would disqualify one from taking up an Independent Directorship in a listed company. Their decisions should be independent of those who have controlling stake in the company and in the overall interest of the company and its stakeholders. However, these Directors still have to be nominated to the Board. This is done de jure by the shareholders but de facto by the other Directors. The shareholders merely confirm the nomination. This makes it possible for people who are known to the Directors to get elected. Their ‘independence’ thus becomes suspect at the very beginning.

Secondly, there is the remuneration factor. By law, the independent directors in a public company are prohibited from getting a salary. An independent director is supposed be compensated by sitting fees and commissions. However, it is argued that where the commission is linked to the company’s performance, the very objective of prohibiting such directors from accepting a salary is defeated. Also, the law mandates that directors have to hold a minimum number of shares in the company. Once compensation is linked to a company’s profit or share price performance, it is arguable whether this creates a vested interest in ensuring that the company’s reported numbers are good since even a hint of financial troubles may cause a fall in the share price resulting in the fall in value of a Director’s holdings.

Therefore, even as the law on one hand wants to keep up the independent nature of the director, other provisions weaken this very stand.

The road ahead: moving beyond Satyam

In my view, however, all is not bleak. The Satyam episode has forced a rethink of the accounting and audit policies that Indian companies now follow. Many solutions have come up to plug the loopholes which were exposed by the Satyam scandal and if implemented, some of the solutions could be highly effective. With respect to accounting and audit, knee-jerk reactions like taking confirmations from banks with respect to amount of funds have already begun. Most of the big auditors have started to implement the aforesaid. However, these are procedural changes and not policy ones. It’s the latter which can hope to accomplish anything. One very viable solution put forward by the IASC Foundation is a call for all major Indian companies to move towards full convergence with the International Financial Reporting Standards (IFRS).

The IASC Foundation governs the International Accounting Standards Board (IASB), which is standard-setter and the body behind International Financial Reporting Standards (IFRS), which is emerging as a gold standard for accounting. The argument given forth in this regard is that full IFRS adoption will enable Indian companies to access capital globally at lower cost. It will increase credibility of foreign investors in balance sheets of Indian companies, which is very essential in a time of global recession. It will also make sure over a period of time that companies in India can tap into the global pool of capital.

A major point to be noted here is that Infosys has already adopted the IFRS system from this financial year. The Indian reporting system does not lag far behind the IFRS. Where the IFRS does score over Indian law in this regard is the level of transparency. The IFRS is inspired from the stringent Sarbanes Oxley Act which is perhaps the strictest code of Corporate Governance anywhere in the world. Another interesting solution being heard in financial circles is that of dual statutory audit — two sets of auditors simultaneously bestowing their attention and energy on the annual accounts of a company to be placed before the annual general meeting (AGM) in a spirit of healthy competition that is admittedly an antidote to laxity.

However, this does lead to escalating costs for the company and may not even be fool proof. Other solutions include things like rotation of auditors. Given the Indian penchant for solving issues by regulation and more regulation, also doing the rounds is the proposal for appointment of auditors by a dispassionate agency with no axe to grind, much like the Comptroller &Auditor General in the context of audit of public sector companies. But some say this will eventually go back to the Licence-Raj era.

With respect to independence of directors, there have been many ‘suggestion’ and a few steps taken by the government which should help in ensuring good Corporate Governance. The Companies Bill of 2008 sought to increase the levels of transparency and corporate governance to ensure greater accountability to stakeholders. To this end, the Bill brings in a more stringent definition of an independent director. The new Bill introduces the requirement that independent directors must not receive any remuneration, other than a sitting fee or reimbursement of expenses. However, they may receive profit-related commission or stock options if approved by the members.

In addition, an independent director must, in the opinion of the board, be a person of integrity and possess relevant expertise and experience. The Bill also lays down that if the chairman of a company is a non-executive director, at least one-third of the Board should comprise of independent directors and if the chairman is executive chairman, then the Board should comprise of 50% independent directors. These directors are expected to professionalize corporate management and assist the Board in taking corporate decisions in an objective manner for the benefit of the company and its shareholders.

The Bill by clause 132 provides that every listed public company having such paid up capital as may be prescribed should have at least one-third of the total number of directors as Independent Directors. The Central Govt may prescribe the minimum number of independent directors in the case of other public companies and their subsidiaries. Such a director is a non-executive director of integrity and should possess relevant expertise and he or any of his relative should not have any pecuniary relationship with the company more fully described in the aforesaid clause.

It is considered that a section of non-executive directors need to be independent in a stricter sense, to counterbalance the natural potential for conflict between the interests of executive directors and shareholders and in view of this very point, the new Bill requires that at least a third of the board is independent, within the definitions set in the Bill; independent directors make up the majority of the audit committee. In addition, the chair of the audit committee must be independent and at least one member of the remuneration committee is independent. This brings the membership of the board of directors in India in line with regulations required by other international markets. To cite an example, to list on the London Stock Exchange there is a requirement that at least a third of the board is made up of independent directors. However, a very interesting point is that the new Bill does not go as far as to eliminate independent directors from benefiting from profit-related commission, something that is forbidden under the UK guidance laws and the Sarbanes Oxley law in the United States.

Conclusion

The Satyam incident, though unfortunate, exposed some big loopholes in the system. Just as the United States needed the Enrol Scandal to clean up its act, perhaps India needed the Satyam fiasco to introduce sweeping changes in its own financial reporting system. It cannot be denied that the Satyam episode was a stark failure of the code of Corporate Governance in India. Corporate Governance is not something which can be enforced by mere legislation; it is a way of life and has to imbibe itself into the very business culture the company operates in. Ultimately, following practices of good governance leads to all round benefits for all the parties concerned. The company’s reputation is boosted, the shareholders and creditors are empowered due to the transparency Corporate Governance brings in, the employees enjoy the improved systems of management and the community at large enjoys the fruits of better economic growth in a responsible way.

RAHUL SATYAN is a 3rd year student pursuing LL.B (Hons) from Campus Law Centre, Faculty of Law, University of Delhi.
 
© 2007 India Law Journal   Permission and Rights | Disclaimer