A lesson to remember

A lesson to remember
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First Published: Wed, Jan 14 2009. 10 42 PM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Wed, Jan 14 2009. 10 42 PM IST
The Satyam scandal that has rocked the Indian business world and wiped out billions in shareholder value has been dubbed “India’s Enron” after the US energy company that went bust in an accounting disgrace in 2001. For the sake of Indian businesses and shareholders, let’s hope the analogy is wide off the mark.
Illustration: Jayachandran / Mint
Here’s why. The collapse of the once-revered Enron triggered a regulatory panic in Washington. One result was the Sarbanes-Oxley legislation, enacted in July 2002. Despite its good intentions, Sarbanes-Oxley has come with a host of costly and undesirable consequences that do little to protect shareholders.
The most troubling effect has been on smaller, entrepreneurial firms—the kind that are critical for sustaining growth. Mandatory paperwork and bureaucracy have hit these companies the hardest. According to Financial Executives International, the cost of complying with the law averaged at least $1.5 million per year. Those costs are down from previous years thanks to firms’ inventiveness, but that still amounts to a hefty tax for a small public company.
Perhaps unsurprisingly, the legislation has had a chilling effect on the market for initial public offerings (IPOs). Economists Leonce Bargeron, Kenneth Lehn and Chad Zutter at the University of Pittsburgh examined the effect of Sarbanes-Oxley on the IPO market in the US and found a steep drop-off in IPO activity relative to other jurisdictions immediately after the law took effect.
A 2005 survey of international firms by the London Stock Exchange found that of the almost 40% that had considered issuing securities in the US, 90% claimed that the heavy burdens imposed by Sarbanes-Oxley made London a more attractive place to list.
Washington was concerned that a too cozy relationship between managements and their auditors was part of the problem that yielded Enron. But Sarbanes-Oxley has created a new problem, one that may be worse for firms and investors down the road.
The Bill established a government board to oversee auditing firms. The result has been to make accountants more reluctant to work closely with the managements of firms and generated an antagonistic atmosphere.
It is during times of broad economic distress that Sarbanes-Oxley (or any similar kind of regulation) can be viewed as most pernicious. Peter Wallison at the American Enterprise Institute has suggested Sarbanes-Oxley acts as a “brake on growth” at a time when the broader economy is struggling. How so? One provision of the Bill required that members of important audit committees of public companies be independent directors. A firm’s independent directors know much less about the businesses they are overseeing. And this lack of intimate knowledge can breed caution. So, one unintended consequence of this rule may be to make management less willing to take the kinds of risks that might get an economy charging forward again.
Indeed, Satyam’s audit committee comprised independent directors, demonstrating that it is no panacea. And if the problems at Bear Stearns, Lehman Brothers and AIG are any indication, it’s not clear that the reforms have solved the corporate governance problems the way its authors hoped.
Another consequence of the Enron scandal was the destruction of the accounting firm Arthur Andersen. A guilty verdict in criminal proceedings emerging from Enron’s demise put the firm out of business. Three years after this verdict, however, the US Supreme Court unanimously reversed the guilty verdict citing serious flaws in the trial. But by then it was too late for Andersen which had wound down almost the entirety of its operation. As a result of Andersen’s collapse, there is significantly less competition in the accounting industry.
The Indian business and policy communities have much to do in the wake of the Satyam fraud. Satyam has its work cut out for it restoring its reputation. Ram Mynampati, the interim CEO, was wise to visit the US recently to answer questions from worried clients. This was a good first step, particularly given analyst estimates that the firm could lose half its business to competitors.
The Indian outsourcing industry is likely to come under new scrutiny at a particularly inhospitable time—anti-trade sentiment is rising in the West. It is important that Indian technology and outsourcing firms reaffirm commitments to the best corporate practices and explain the valuable role they play in the world’s globalized markets.
And the Serious Fraud Investigation Office has its work cut out for it as it determines over the next three months exactly what happened inside Satyam, particularly how the firm managed to make at least $1 billion in cash just disappear.
But as troubling as the fraud is, it is critical that policymakers act prudently and proceed cautiously. If rules and regulations are enacted in haste, the long-term consequences can create further problems down the road.
Nick Schulz is DeWitt Wallace fellow at the Washington-based American Enterprise Institute and editor of The American (www.American.com).
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First Published: Wed, Jan 14 2009. 10 42 PM IST