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Allow the market to punish malpractices

Allow the market to punish malpractices

India is still a poor country. But it has recently made a fortune on trust: it has become the country where Fortune 500 companies entrust sensitive data, banks their back-office operations, and patients their health.

The Satyam Computer Services Ltd scandal raises disturbing questions about the risks of doing this kind of business with India. So it’s important to get to the bottom of Satyam’s accounting shenanigans if we want this economic model dependent on trust to continue. For that, India needs its market forces to perform at their best without hurdles.

Reputable men on Satyam’s board—from corporate governance guru and Harvard Business School professor, Krishna G. Palepu, to the then-dean of Hyderabad-based Indian School of Business, M.R. Rao—saw nothing. Highly-regulated exchanges in Mumbai, New York and Amsterdam—where Satyam is listed—found nothing. A well-known auditor, Price Waterhouse, discovered nothing. Satyam had all the essential checks and balances. So how did no one detect the fraud?

At times, one needs to read or hear between the lines to detect potential fraud. One realizes that an interview with the Financial Timesnewspaper B. Ramalinga Raju gave in 2000 gave a hint of his way of thinking. A great fan of Albert Einstein, Raju said: “The theory of relativity teaches you so much about decision-making: about not choosing between black and white, but shades of grey." If he proudly claims to choose the grey, why did no one person find him operating in it?

To start with, the auditors could surely have done more to get to the bottom of the balance sheet. In the second quarter of 2008, Satyam made an operating profit of Rs61 crore. For a firm that employs 53,000, this implies each would have earned an operating profit of only $3.75 per day, a very low figure indeed. Such easy back-of-the-envelope number-crunching should have set off alarm bells at the office of any intelligent auditor.

It’s also the auditor’s responsibility to make sure the numbers they are dealing with are correct. It’s easy for Price Waterhouse to now deflect the blame on to Satyam, saying it was fed erroneous bank documentation. These auditors could have, and should have, got statements directly from the concerned bank to verify authenticity. This practice is not just normal in international accounting standards, but also essential.

In fact, the revelation of the fraud cannot be attributed to any one person. It was the result of the vicissitudes in market capitalism. My own research, collected from data available at www.bigcharts.com, has shown that most accounting frauds come to light closer to the bursting of a bubble. During the bubble, the accounting irregularity keeps bloating itself and suddenly appears when things start getting tough and the bubble is about to deflate or has already deflated. After the revelation, the market begins to bottom out.

In fact, wherever in the world there is extraordinary growth and then a slowdown, fraud emerges. It’s no accident that Enron and Worldcom took place when the Internet bubble in the US burst.

India is no exception. At the end of the last boom, Indian firms were highly leveraged, thanks to big capital investments made by promoters. As the flab in accounting begins to appear, there will be temptation on the part of promoters to indulge in financial engineering. That’s what Satyam did when it tried to buy the two Maytas firms in December. But the market didn’t let it, as investors revolted.

This same market also ruled last week after the full disclosure of the fraud. At the end of the day, the impersonal market did more to regulate Satyam than any private sector auditor or government regulator. The market has brutally responded to Satyam, hammering its stock, which fell 72% in a single hour the day the fraud came to light.

That’s why it’s important to keep these market forces alive and kicking. There may be a temptation by regulators to needlessly hamstring the private sector. India can ill-afford burdensome, complex and largely ineffective regulations such as the 2002 US Sarbanes-Oxley Act, which imposed huge costs on US business and drove investments overseas in the wake of the Enron fiasco.

When one man can’t do justice, it’s the collective wisdom of many that delivers precisely that. We need the market to punish malpractices when no one else does.

Sunil Kewalramani is CEO, Global Capital Advisors, a firm based in Mumbai. Disclaimer: The author may have advised some clients in accordance with the opinions expressed above and he and his clients would have invested accordingly in stocks.

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