Business Today

On the trail of fraud

Satyam’s auditors and independent directors failed to catch on to Raju’s scam. Auditors Pavan Kumar Vijay and R. Ramakrishnan, working with BT, show how dodgy numbers were ignored all along. Puja Mehra reports.

Puja Mehra        Print Edition: Feb 8, 2009

B. Ramalinga Raju would have us believe that all that he did wrong was to get caught up in the corporate rat race. Driven to desperation by a ruthless environment where the slightest slip on a quarterly earnings target would pummel Satyam’s share price, Raju began inflating both revenue and profit figures to meet market expectations. Or so he says. In a dramatic letter released on January 7, he admitted to nonexistent cash balances, fake interest proceeds and grossly overstated revenues that totalled $1.4 billion, amongst other things. In it, he also reported a ‘real’ operating margin of 3 per cent. He solemnly pledged that neither he nor his brother Rama Raju took a paisa from the company and that they did not sell “any shares in the last eight years—excepting for a small proportion declared and sold for philanthropic purposes."

Raju’s possible violations

  • Fudging Numbers Pumped up revenue, profit, bank deposits and cash reserve numbers

  • Undisclosed Pledges Procured a loan of Rs 1,230 crore without disclosure

  • Insider Trading Sold most of his 26 per cent stake while tweaking numbers to keep share price high

  • Takeover Code Probable violation if he knew when his stake fell below 5 per cent

  • Foreign Exchange Management Act Converted fictitious export income into cash
This is a surreal revelation since it means that Raju continued to lie even through one of the most earnest and startling confessions to hit corporate India. A quick examination of promoters’ shareholding patterns shows that Raju and his family decreased their holdings from 15.67 per cent in 2005-06 to 8.61 per cent in September 2008. In fact, in 2006, he had transferred these shares to his family’s company, SRSR Holdings Pvt. Ltd, from which he took out loans using the shares as collateral. Finally, early this year, the promoter stake dropped to a 2.3 per cent without anybody noticing. Obviously, Raju was benefitting from fudging his own numbers—and that too in a substantial way.

Ignoring the obvious
Another obvious red herring that should have tipped an auditor off, say BT’s auditors, was Satyam’s high amounts of debt despite easy cash positions. In September 2008, global brokerage CLSA said: “With almost $1.2 billion of cash, we find it intriguing that Satyam closed 2007-08 with $56 million of debt.” In fact, an enormous amount of cash—Rs 4,462 crore—appeared to sit in the current account unused. This is an extraordinary thing for a company since most often, excess cash is kicked back to shareholders in the shape of a dividend, or is earning valuable interest if it isn’t being utilised to pare debt or fund acquisitions. In fact, banks at the time were offering many flexi deposit schemes with attractive returns. None of the independent board members or auditors thought to question any of this.

Raju’s admitted faking of Rs 376 crore of interest income and Rs 490 crore of debtors’ positions is also mystifying. Similarly, Raju says that Satyam’s fixed deposits, which supposedly grew from a meagre Rs 3.35 crore in 1998-99 to Rs 3,320.19 crore in 2007-08, are all made up. When auditors go over a client’s numbers, they are supposed to have independent bank confirmation for things like interest income earned, in the form of a bank statement. Debtors’ confirmations are also double-checked and authenticated. Even if they didn’t cross-verify the existence of the bank balances and the fixed deposits, the auditors should have obtained certificates from the banks on the tax deducted on the interest accruing on the fixed deposits. What these imaginary numbers mean is that either the auditors were shoddy or were in collusion with the company—or Satyam was wily enough to intercept the requests for statements that auditors mail out, and forged them, something that auditors say has happened in largescale fraud cases in the past. Still, for this to happen every quarter for many years is unlikely.

In his letter, Raju says that Satyam’s operating margin for the second quarter of 2008-09 was an abysmal 3 per cent, which is what forced him to pump the numbers up. That seems absurd, considering that Infosys recently reported a 33 per cent operating margin—and the two firms compete for similar kinds of business in similar geographic locations. “Is he saying that all the work was worth just 3 per cent margins?” snarls a senior executive at one of Satyam’s development centres in Hyderabad. “Cross-checking the billings with the long-standing top ten clients like Merrill and GE will show if they were inflated.” Clearly, the effort to fudge revenue figures had less to do with corporate pressure and more to do with generating cash for all the other dubious deals that Raju could have been involved in over the years—including the funding of the two Maytas firms, paying off political dons as well as land acquisitions. How was he able to implement such a colossal fraud?

“Actual fraud Could Be bigger”
A businessman himself, minister of Company Affairs Prem Chand Gupta claims the fraud is an aberration and not a systemic failure. Excerpts of an interview with BT’s Puja Mehra:

What have the investigations revealed so far?
It’s too early to say anything... Some papers and bank statements are missing, duplicate copies of which will have to be obtained. The Registrar of Companies (RoC) and SEBI are working closely to find out how many other group companies are involved. The actual fraud could be bigger than what was confessed.

Doesn’t the fraud put a question mark over the regulation of auditors?
The government will not interfere in the working of the ICAI. We want them to work independently.

If Ramalinga Raju hadn’t confessed, the fraud would have remained undetected. Why didn’t the system generate an alert?
What we learn from Satyam can be used to further improve the companies Bill. The Indian Companies Act is dependent on certification by auditors. If that is faulty, not much can be done. e-governance is in place, which requires companies to file their annual statements with the RoCs electronically. It is a system of early alerts. You must realise that the balance sheet for the year ending March 31, 2008 was filed with the RoC only six months later. Analyses take time. Even if Raju hadn’t confessed, there is a possibility that our early alert system, MCA 21, would have caught him.

When was MCA 21 launched and how many companies has it generated such alerts for?
It was launched three years ago. We’re taking action against several companies on the basis of the alerts it has generated. Legal experts say that absence of a Chapter 11 like provision (protection in case of bankruptcy) is a big hindrance in salvaging Satyam-like cases. The National Company Law Tribunal is pending before the Supreme Court. Once it is resolved, the bankruptcy provisions will be streamlined.


How to catch a thief

Six signals to detect a possible financial fraud.

  • Pricey acquisitions: These are often used to funnel back cash to the promoter, partly or fully

  • Large idle cash reserves: These should be returned back to shareholders as dividend or bonus shares if not earning interest

  • Capitalised expenses: Enable a firm to illegally stagger them over years

  • Rise in cash and bank balances: These should match growth in cash flow

  • Large revenue jumps: Especially ones that don’t follow a proportionate increase in the number of employees could be fake

  • Change in promoter shareholdings: These should be monitored to detect management confidence in company

Pulling it off
Many industry observers suspect that Raju just removed all the cash that he now says never existed from the bank accounts, over the last three months. Several bank statements crucial for investigating the fraud are missing, Union Minister for Company Affairs P. C. Gupta told BT. “We have asked the banks to give us duplicates,” he said.

Raju could also have entered fake sales and expenditure, or engineered asset billings, such as overinvoiced capital expenditures to drain out money—another commonly-used technique. The Rs 400-crore capital expenditure Satyam had reported for the April-September quarter of 2008-09 could have been cooked up since the employee count hadn’t changed. IT companies have little need for capital expenditure other than rent for office buildings and equipment for employees.

In fact, the income tax department had searched several offices of Satyam in Hyderabad in 2002 and found that Raju had opened multiple benami accounts containing fixed deposits of Rs 29.5 crore through relatives and friends. He could have channelled the money into these and other yet-to-be detected benami fixed deposits.

Another possible money generating trick: company acquisitions. In 2005, Satyam spent $160.4 million on the acquisition of six companies that many on Dalal Street questioned. CLSA said in August 2008: “There has been little articulation of any follow-on wins, thanks to these assets, and the scale of acquisitions continues to raise doubts on whether they can truly move the needle for a $2-billion top-line company.” Accounting experts say that it is common for Indian promoters to overpay for acquisitions in order to siphon out money from their companies and then pay a commission to the sellers of the acquired companies. It is quite likely that Raju was using this technique.

Finally, Satyam’s international sprawl must have been an enormous asset in churning out illegal funds. It had operations in 66 countries and 65 different banks. Over 90 per cent of the revenues were from export services, the income from which is exempt from regular income tax. It would have been supremely easy for Raju to receive a payment of say, $50 million, for a subsidiary’s services and then take it off the books—funnelling it back to India through a hawala route.

Where were the watchdogs?
It wasn’t as if no one was ever suspicious of Satyam’s dodgy numbers. CLSA had originally put out a report way back in 2001 on Satyam’s “dubious accounting practices”. Then, RPI MP Ramdas Athawale accused Raju and gang of tax fraud and insider trading in 2003. But clearly, the company police—the independent directors on the board, the external auditors, the banks, the stock exchanges and NSDL and CSDL—were either napping or in collusion. The Satyam fraud has exposed the weakness of the regulatory framework in India as well as the failure of auditors, in one fell swoop.

Clearly, Satyam’s indifferent board is one big reason Raju was able to get away with his fraud. He chose them well. No one would even think of questioning such illustrious members of the business community as Harvard Professor and corporate governance expert Krishna Palepu, co-father of the Pentium processor Vinod Dham and Dean of the Indian School of Business, Rammohan Rao. None of these board members ever thought of finding out why Satyam had so much underutilised cash reserves or why Raju and Co.’s share in the company was falling so precipitously, even after meeting seven times in last year. SEBI, too, should have had a built-in trigger, alerting them to any kind of unusual selling activity from promoters.

As corporate India absorbs the implications of Raju’s actions, business leaders need to push for stricter—yet sensible—accounting practices and other regulation that keeps a functioning checks and balances on companies. Raju in his letter confessed that doctoring the books over the years was akin to “riding a tiger, not knowing how to get off without being eaten”. If effective prescriptions are not found, it is more than just Raju and Satyam who will be consumed in the following year.

Similarities with US frauds
When it comes to accounting scams, the US wins hands down. We examined the two biggest in recent years—Enron and WorldCom— for their similarities (and the lack of them) with the Satyam episode, and the lessons we can learn. Rajiv Rao

The companies
Audacious and aggressive, Enron defined the new breed of American companies in the nineties. Steered by founder Kenneth Lay, the company first made a fortune, transmitting and distributing electricity and gas, but soon started building and operating power plants and selling broadband Internet services as a wholesale commodity. Its then-President and COO Jeff Skilling launched EnronOnline, and the firm quickly became the biggest wholesaler of gas and electricity. Under Skilling, Enron adopted mark-to- market accounting, in which anticipated future profits from deals were registered as if real today.

Worldcom CEO Bernie Ebbers was a cowboy capitalist— he habitually wore boots as he spurred WorldCom onto a dizzying spate of acquisitions, including the jewel in his crown—the $37-billion merger with MCI. A former milkman, basketball coach and Best Western hotel owner who dropped out of high-school twice, Ebbers built his company over the years by personally overseeing more than 70 acquisitions. His personal fortune in 1999, according to Forbes magazine, was $1.4 billion. Ebbers’ trailblazing telecom days came to a halt when merger mania in the U.S. abated and the telecom industry began to implode. In 2000, the long distance business in voice shrank faster than expected. Almost overnight, the acquisition of MCI seemed more of an albatross than a savvy deal.

The fraud
On March 5, 2001, Fortune writer Bethany McLean published a piece questioning some of the ways in which Enron made money. It turned out that Enron—thanks to its online trading business and its broadband outfit—had lost a ton of cash and borrowed heavily for new businesses. So, a resourceful CFO Andrew Fastow, under new CEO Jeff Skilling’s aegis, began structuring off-shore partnerships to hide both debt and losses. Meanwhile, senior managers were desperately selling in their shares while urging employees to buy more. The house of cards eventually came tumbling down in October 2001, when Enron was forced to announce a loss of $638 million. On November 8, 2001, Enron revealed that it had overstated earnings for the past four years by $586 million and that it owed over $6 billion in debt. For WorldCom, things came to a head when Internet data traffic also began to slow down. With no more acquisitions to boost numbers, top management at WorldCom became desperate. CFO Scott Sullivan, under the guidance of Ebbers, began to use increasingly aggressive accounting to pump up revenues. The two then began slashing expenses by illegally capitalising line costs— monies WorldCom paid to other telephone companies to rent their lines—drawing out expenses over 10 years instead of taking a one-time hit. Meanwhile, Ebbers had borrowed nearly $400 million from the company with his personal shares as collateral. Ultimately, WorldCom overstated its results by more than $5 billion over seven quarters. By other measures, the fraud totalled $11 billion. WorldCom finally went bankrupt in July 2002.

Punishment
• Ken Lay was convicted of fraud and was about to be sentenced, when he died of a heart attack while on vacation.
• Skilling had a nervous breakdown in 2004 and is now serving 24 years in jail. In return for spilling the beans, CFO Fastow got a relatively cushy six years.
• Enron became bankrupt in November 2001. All 22,000 employees lost their jobs and many saw their life savings in Enron stock go up in smoke.
• Bernie Ebbers is serving a 25-year sentence and will be 85 by the time he is released. During his trial, he argued that his CFO Scott Sullivan was responsible.
• Sullivan made a deal with prosecutors and squealed on Ebbers. He will serve out a 5-year sentence, despite being described as the fraud’s architect.
• All 80,000 employees of Worldcom lost their jobs and a company that was once worth a formidable $180 billion at its peak share price simply evaporated.
• Satyam, like Enron & Worldcom, fudged numbers and committed other frauds. What happened to these U.S. companies could inform Raju’s and Satyam’s fates.

Regulatory changes
Soon after these scandals, the Sarbanes-Oxley Act of 2002 (SOX) was passed. The legislation established new standards for all U.S. public company boards, management, and public accounting firms. Now, the CEO and CFO of a company are required to take ownership for their financial statements under Section 302. Additionally, auditor conflicts of interest have also been addressed—they are now banned from having consulting contracts with the firms they audit. These seem like sensible measures that would effectively keep management in check. Still, Satyam did file its ADR in the U.S. after SOX was passed and met all of the law’s compliance requirements so its efficacy in preventing Satyam-like scams is unproven. While a number of critics of SOX say that it has only succeeded in driving business out of the U.S. due to its stricter norms, a host of industry experts has reported improved investor confidence and more accurate financial reporting. Ultimately, a law such as this would go a long way in boosting institutional investor’s sagging faith in Indian companies.

Youtube
  • Print

  • COMMENT
BT-Story-Page-B.gif
A    A   A
close