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India's Satyam Accounting Scandal By David Winkler February 1, 2010 This Briefing Paper will provide an analysis of the

Indian accounting scandal that analysts have called "India's Enron." Section I of the paper will provide a corporate history of Satyam. Section II will provide insight into how the $2.7 billion scandal evaded regulators, investors, and the board of directors. This Section will also provide a discussion of who was responsible for the fraud along with corporate structural issues in India that create unique obstacles to Indian corporate governance. Section III explains the scandal's effect in India and the implications for dealing with future obstacles. Finally, Section IV discusses regulatory reform following Satyam and the current status of Indian securities markets. The Satyam scandal highlights the importance of securities laws and corporate governance in emerging markets. Mounting evidence suggests that weak corporate governance slows economic development. The Satyam scandal provides insight into the problems that emerging markets face when they transition from locally controlled corporations to globally traded corporations. There is a broad consensus that emerging market countries must strive to create a regulatory environment in their securities markets that fosters effective corporate governance. India has managed its transition into a global economy well, and although it suffers from corporate governance issues, it is not alone as both developed countries and emerging countries experience accounting and corporate governance scandals. A. History of Satyam In 1987, B. Ramalinga Raju ("Mr. Raju") formed Satyam in Hyderabad, India with fewer than 20 employees. Ironically, Satyam means "truth" in the ancient Indian language Sanskrit. The company specializes in information technology, business services, computer software, and is a leading outsourcing company in India. Satyam immediately experienced success after it issued an initial public offering on the Bombay Stock Exchange in 1991. The company grew quickly during the 1990s and 2000s as more and more companies around the world looked to India for outsourcing solutions. It eventually became the fourth largest outsourcing company in India. Satyam provides solutions to approximately 185 Fortune 500 companies throughout the world. The business community recognized Satyam as a global leader in information technology outsourcing. At the peak of its business, Satyam employed nearly 50,000 employees and operated in 67 countries. Satyam was as an example of India's growing success. Satyam won numerous awards for innovation, governance, and corporate accountability. In 2007, Ernst & Young awarded Mr. Raju with the Entrepreneur of the Year award. On April 14, 2008, Satyam won awards from MZ

Consult's for being a leader in India in corporate governance and accountability. Satyam's CFO issued a press release noting the award and stating, "These awards recognize this commitment to keeping the market and our investors informed, having our financial information be clearly and easily understood by stakeholders, and complying with increasingly strict regulatory environments." "Additionally, our high rankings show that we are committed to being a responsible corporate citizen that leverages best practices wherever possible." In September 2008, the World Council for Corporate Governance awarded Satyam with the "Global Peacock Award" for global excellence in corporate accountability. Unfortunately, less than five months after winning the Global Peacock Award, Satyam became the centerpiece of a massive accounting fraud. B. Fraud Is Uncovered The discussion below will first show how problems started to appear and how the CEO eventually disclosed the fraud. The discussion will also identify the roles that various parties had in the fraud. 1. First Cracks Appear As stock markets around the world collapsed during 2008, the Indian Stock Exchange, the Sensex, fell from a high of over 21,000 to below 8,000 between January 2008 and October 2008. The enormous losses caused investors to withdraw large amounts of cash from their investments. These cash withdrawals in turn triggered the discovery of several cases of financial fraud in America, as perpetrators could no longer hide the results. The discovery of high-profile financial scandals increased scrutiny on governance practices and companies' financial statements. To quote Warren Buffet, "It's only when the tide goes out that you realize who has been swimming naked." Satyam continued to report positive results during 2008 and claimed success in navigating the economic crisis. In October 2008, Satyam reported net income of $132.3 million, an increase of 28 percent from the same quarter the previous year. Saytam asserted that, despite the challenging environment, it continued to find opportunities for growth. The first crack in the company's reputation occurred during October, when the World Bank fired Satyam and issued an eight-year ban against the company. The World Bank accused Satyam of installing spy systems on its computers and stealing assets from the World Bank. In addition, during an October conference call reporting earnings, one stock analyst drew attention to large cash balances in non-interest bearing bank accounts. The analyst expressed concern about the large balances and expressed reservations about the accuracy of the numbers. Investors ignored the analyst's comment and the stock price rose with the reports of positive earnings and revenue growth. In December 2008, Satyam's Board of Directors unanimously approved the purchase of Maytas Properties and Maytas Infrastructure, two companies unrelated to the information technology

field. At the time, Mr. Raju stated that he and the Board anticipated that the market would "be delighted" by the two transactions as it would provide Satyam with greater diversification. However, investors were outraged over the transactions because Mr. Raju's family held a larger stake in Maytas Properties and Maytas Infrastructure than it did in Satyam. Shareholders viewed the transactions as an attempt to siphon money out of Satyam into the hands of the Raju family. Satyam quickly aborted the transactions, but the incident still caused significant damage to Satyam's reputation as a well-managed company. After the incident, chaos ensued. Analysts immediately soured on the company and put sell recommendations on its stock. Satyam's shares dropped nearly 10 percent and four of the five independent directors resigned. On December 30, analysts with Forrester Research advised clients to stop doing business with Satyam because of the fear of widespread fraud. Satyam hired Merrill Lynch to advise it on ways to increase shareholder value. By January 5, 2009, rumors circulated about several potential mergers between Satyam and competitors. On January 7, just hours before Mr. Raju disclosed the fraud, Merrill Lynch sent a letter to the stock exchange indicating that it was withdrawing from its engagement with Satyam because during the course of its representation it learned of material accounting irregularities. The Board called an emergency meeting for January 10 to address the company's rapidly deteriorating reputation. 2. How the Fraud was Uncovered On January 7, 2009, Mr. Raju disclosed in a letter to Satyam's Board of Directors that he had been manipulating the company's accounting numbers for years. Mr. Raju said the manipulation started out small, and grew larger by the year. In the letter he stated, "It was like riding a tiger, not knowing how to get off without being eaten." Mr. Raju stated that eventually, the stress of hiding the fraud grew too much for him to bear. 3. Responsible Parties Mr. Raju was the primary individual responsible for the fraud. Indian authorities accused Mr. Raju, and subsidiary players such as the CFO, a managing director, the company's global head of internal audit, and Mr. Raju's brother, with responsibility for the fraud and filed charges against them. Additionally, Satyam's auditors and Board of Directors bear some responsibility for the fraud because of their failure to detect it. Finally, the ownership structure of Indian businesses contributed to the Satyam scandal. a. Mr. Raju and Company Insiders' Role Mr. Raju claimed that he overstated assets on Satyam's balance sheet by $1.47 billion. Nearly $1.04 billion in bank loans and cash that the company claimed to own was nonexistent. Satyam also underreported liabilities on its balance sheet. Satyam overstated income nearly every quarter over the course of several years in order to meet analyst expectations. For example, the results

announced on October 17, 2009 overstated quarterly revenues by 75 percent and profits by 97 percent. Mr. Raju and the company's global head of internal audit used a number of different techniques to perpetrate the fraud. Using his personal computer, Mr. Raju created numerous bank statements to advance the fraud. Mr. Raju falsified the bank accounts to inflate the balance sheet with balances that did not exist. He inflated the income statement by claiming interest income from the fake bank accounts. Mr. Raju also revealed that he created 6,000 fake salary accounts over the past few years and appropriated the money after the company deposited it. The company's global head of internal audit created fake customer identities and generated fake invoices against their names to inflate revenue. The global head of internal audit also forged board resolutions and illegally obtained loans for the company. It also appeared that the cash that the company raised through American Depository Receipts ("ADRs") [1] in the United States never made it to the balance sheets. Mr. Raju initially asserted that he did not divert any of the money to his personal accounts and that the company was not as profitable as it had reported; however, during later interrogations, Mr. Raju revealed that he had diverted a large amount of cash to other firms that he owned and that he had been doing this since 2004. Mr. Raju also initially asserted that he acted alone in perpetrating the fraud. However, as noted above, Indian authorities also charged Mr. Raju's brother, the company's CFO, the company's global head of internal audit and one of the company's managing directors. b. Auditors Role Global auditing firm Price Waterhouse Coopers ("PWC") audited Satyam's books from June 2000 until the discovery of the fraud. Several commentators criticized PWC harshly for failing to detect the fraud. PWC signed Satyam's financial statements and was responsible for the numbers under Indian law. One particularly troubling item concerned the $1.04 billion that Satyam claimed to have on its balance sheet in non-interest bearing deposits. According to accounting professionals, a reasonable company would have either invested the money into an interest bearing account or returned the excess cash to the shareholders. The large amount of cash thus should have been a red flag for the auditors that further verification and testing was necessary. Furthermore, it appears that the auditors did not independently verify with the banks in which Satyam claimed to have deposits. Additionally, the fraud went on for a number of years and involved both the manipulation of balance sheets and income statements. Whenever Satyam needed more income to meet analyst estimates, it simply created fictitious sources and it did so numerous times without the auditors ever discovering the fraud. Suspiciously, Satyam also paid PWC twice what other firms would charge for the audit, which raises questions about whether PWC was complicit in the fraud. Furthermore, PWC audited the company for nearly 9 years and did not uncover the fraud,

whereas Merrill Lynch discovered the fraud as part of its due diligence in merely 10 days. Missing these red flags implied either that the auditors were grossly inept or in collusion with the company in committing the fraud. PWC initially asserted that it performed all of the company's audits in accordance with applicable auditing standards. c. Board of Directors Role Satyam's Board of Directors consisted of nine members. Five members of the Board were independent as required by Indian listing standards. In its regulatory filings with the SEC, Saytam revealed that it did not have a financial expert on the board during 2008. Further concerns later developed surrounding the Board of Directors lack of independence. The Board contained several prominent figures in the business world, a fact that likely contributed to the lack of scrutiny that Satyam received. Members of the Board included Krishna Palepu who is a Harvard Professor and corporate governance expert, Rommohan Rao, the Dean of the Indian School of Business, and Vinod Dham, co-inventor of the Pentium Processor. The Board first came under fire on December 16, 2008 when it approved Satyam's purchase of real estate companies in which Mr. Raju owned a large stake. The Board rescinded the approval after shareholders led a revolt of the deal. Krishna Palepu, Rommohan Rao, and Vinod Dham all resigned from the Board within two days of the rescission of the transaction. The botched transaction provided the investors with the impression that the Board was not actively monitoring Satyam. Furthermore, the Board should have caught some of the same red flags that the auditor, PWC, missed. Additionally, the Board of Directors should have been concerned with the knowledge that Mr. Raju decreased his holdings of Satyam significantly over the three years leading up the disclosure of the fraud. Mr. Raju's holdings fell from 15.67 percent in 2005-2006 to 2.3 percent in 2009. 4. Indian Businesses and Board Structure The ownership structure of Indian businesses contributed to the Satyam scandal. Family business groups dominate the ownership of Indian corporations. As of 2006, family ownership structures, and to a lesser extent state-owned structures, comprised 60 percent of the 500 largest companies. Concentrated corporate control is the norm in most emerging markets. India's ownership structure is a legacy from its historical weak corporate governance. In addition to the pervasiveness of family-owned businesses, business promoters have often structured businesses within a pyramid structure. The pyramid structure involves owning several different business lines and treating the different businesses as one entity, transferring funds from one entity to another as needed. The following example shows how the pyramid structure works. A control group will own 51 percent of the company at the top of the structure. This top firm then will hold similar 51 percent stakes in a second tier of companies. The second tier of companies will then hold 51 percent stakes in a third tier of companies. In this structure, the control group has effective control of the entire pyramid from top to bottom, even though its financial commitment

to the second tier is only 26 percent (51 percent of 51 percent) and its financial stake in the third tier is only 13 percent. The pyramid structure permits groups to control more of the operations than their equity claims represent. In the 1990's, approximately 30 percent of Indian businesses operated within this type of structure. Family owned businesses and pyramid ownership structures present unique challenges to effective corporate governance. Consolidated control also makes it more difficult for board members to be independent from the controlling shareholder. One problem with family-owned businesses is that independent directors often succumb to serve the interests of the family group instead of the interests of the corporation as a whole, thus harming the minority shareholders. When a small group controls a firm, the control group's interests often diverge from the minority shareholders. Without the proper oversight and governance, the control group can take actions that benefit the control group and harm the minority shareholders. One such tactic involves the "tunneling" of corporate gains or funds to other entities within the group. Tunneling is the process whereby a control group transfers profits from one firm to another firm in which it owns a larger share. An additional problem with the pyramid structure is that it becomes difficult for outside shareholders to monitor how well each business unit within the structure is performing. The pyramid structure causes minority shareholders to value the minority shares significantly less than if the entity were not within a pyramid structure. This creates a higher cost of capital for the firm and ultimately creates a net drag on the economy in which the company operates because of the inefficient allocation of resources. Finally, the Satyam scandal revealed some flaws in the way that many Indian companies structure their boards. Indian listing standards require a company to have an independent board of directors pursuant to Clause 49 of the India 1956 Companies Act. Company management appoints the independent board of directors. The Indian Companies Act defines who qualifies and who does not qualify as an independent director. For example, an individual is not independent if he owns 2 percent or more of the company. An individual is also not independent if a family member appointed him or her to the board. The consolidated control of Indian businesses by families and the pyramid structure increases the difficulty for board members to act independently from the controlling shareholder. These limitations do address this problem by imposing some restrictions on the types of people Indian companies can appoint as independent board members; however, as Satyam revealed, the regulators could strengthen the regulations to provide more assurance of an independent board. C. Aftermath The Indian stock market fell dramatically upon the disclosure of the Satyam scandal. Indian authorities quickly started an investigation and pursued criminal actions that ensnarled Satyam's executives, auditors, and Indian politicians. Satyam successfully emerged from the crisis through an asset sale during the spring of 2009. The authorities' swift actions also restored confidence in

the Indian securities markets. 1. Stock Market Consequences The news of the scandal rocked the Indian stock exchanges. On the day that the scandal broke Satyam's stock lost 82 percent and the Sensex index closed down 7.3 percent. Uncertainty pervaded the market during January as investors lost confidence in India's markets. The Sensex fell 13 percent between the time that problems first emerged at Satyam on December 17, 2008 and January 23, 2009. Politicians feared that the loss of trust in the market would take years to regain. 2. Investigation, Criminal, and Civil Charges The investigation that followed the revelation of the fraud has led to charges against several different groups of people involved with Satyam. Indian authorities arrested Mr. Raju, Mr. Raju's brother, B. Ramu Raju, its former managing director, Srinivas Vdlamani, the company's head of internal audit, and its CFO on criminal charges of fraud. Indian authorities also arrested and charged several of the company's auditors, Price Waterhouse Coopers, with fraud. The Institute of Chartered Accountants of India ruled that the CFO and the auditor were guilty of professional misconduct. The CBI is also in the course of investigating the CEO's overseas assets. There were also several civil charges filed in the United States against Satyam by the holders of its ADRs. The investigation also implicated several Indian politicians. As of the date of this article's posting, both civil and criminal litigation continue in India and civil litigation continues in the United States. 3. Satyam Post-Crisis Immediately after Mr. Raju's revelation of the fraud, new board members were appointed and started working towards a solution that would prevent the total collapse of the firm. Indian officials acted quickly to try to save Satyam from the same fate that met Enron and WorldCom when they experienced large accounting scandals. Both Enron and WorldCom filed for bankruptcycreating a large upheaval in the capital markets, as well as an increase in unemployment as the employees working at those firms lost their jobs. The Indian government immediately started an investigation while at the same time limiting its direct participation with Satyam because it did not want to appear like it was responsible for the fraud or attempting to cover up the fraud. The government appointed a new board of directors for Satyam to try to save the company. The Board's goal was to sell the company within 100 days. To devise a plan of sale, the board met with bankers, accountants, lawyers, and government officials immediately. It worked diligently to bring stability and confidence back to the company to ensure the sale of the company within

the 100-day time frame. To accomplish the sale, the board hired Goldman Sachs and Avendus Capital and charged them with selling the company in the shortest time possible. By mid-March, several major players in the IT field had gained enough confidence in Satyam's operations to participate in an auction process for Satyam. The Securities and Exchange Board of India ("SEBI") appointed a retired Supreme Court Justice, Justice Bharucha, to oversee the process and instill confidence in the transaction. Several companies bid on Satyam on April 13, 2009. The winning bidder, Tech Mahindra, bought Satyam for $1.13 per shareless than a third of its stock market value before Mr. Raju revealed the fraudand salvaged its operations. The acquisition has experienced a few problems. On November 26, 2009, shares tumbled 10 percent amid further revelations that the fraud was almost $1 billion larger than initially thought. Furthermore, the Indian courts brought criminal charges against one of the investigators for accepting a bribe related to the investigation, calling into question whether further investigations were necessary. Both Tech Mahindra and the SEBI are now fully aware of the full extent of the fraud and India will not pursue further investigations. The stock has again stabilized from its fall on November 26, 2009 and, as part of Tech Mahindra, Saytam is once again on its way toward a bright future. 4. India's Stock Market Post-Crisis During 2009, investors gained confidence as both the credit crisis and the uncertainty surrounding the Indian markets caused by the Satyam revelation abated. India's stock market has recovered since the beginning of 2009, rising from just above 9,000 in January 2009 to over 17,000 by December 1, 2009. Investors are confident that India will continue to liberalize its economy and create more opportunities for investment and growth in the future. D. Regulatory Reform and the Importance of Corporate Governance Corporate governance is important for economic development. Research shows that the ratio of stock market capitalization to GDP in countries that rank in the highest quartile for corporate governance is four times higher than stock markets that rank in the lowest quartile for corporate governance. Poor corporate governance significantly hampers the ability of businesses to raise capital and impedes economic growth. Effective corporate governance provides for more efficient allocation of resources, as the return on assets in countries with the highest levels of corporate governance is double that of the return on assets in countries with the lowest levels of corporate governance. India has been proactive throughout its past 20 years of economic liberalization in bringing regulations to help foster effective corporate governance that contributed to its economic growth. India immediately portrayed the Satyam scandal as an aberration to try to salvage the remaining confidence in its capital markets. Several commentators, however, claimed that the scandal was

not an aberration, but a sign of governance issues in India. After the Satyam scandal, investors and regulators called for strengthening the regulatory environment in the securities markets. In response to the scandal, the SEBI revised corporate governance requirements as well as financial reporting requirements for publicly traded corporations listed in the country. The SEBI also strengthened its commitment to the adoption of International Financial Accounting Reporting Standards. In addition, the Ministry of Corporate Affairs is devising a new Corporate Code and is considering changing the securities laws to make it easier for shareholders to bring class action lawsuits. 1. Governance Reform Independent Directors The Satyam scandal reinforced the Indian regulators' commitment to continue the process of corporate governance reform. Even before the Satyam scandal broke, India was in the process of updating its 1956 Companies Act, which sets out key Indian corporate governance rules. The SEBI is considering several proposals ranging from mandating increased due diligence on transactions to increasing personal liability of board members. If reform continues on its current course, reform within the 1956 Companies Act will make it easier for shareholders to sue officers and directors of corporations. The SEBI is also considering making publicly listed companies carry director and officer liability insurance to protect shareholders from damages. Additionally, the SEBI proposed creating a law that provides whistleblowers with protection for reporting fraudulent activity. Finally, the SEBI revised takeover regulations to increase disclosure in takeovers. 2. Disclosure of Pledged Securities After Satyam, the SEBI increased disclosure obligations of promoters and controlling shareholders. Before the Satyam scandal, promoters[2] and controlling shareholders were not required to disclose to investors if they had pledged their stock. Pledging stock is the process whereby a person offers his or her stock to a bank or other institution as collateral for a loan. The problem with a controlling shareholder pledging stock is that once the stock drops below a certain level, the drop will trigger a margin call. After receiving a margin call, the person who pledged the stock must provide additional collateral. If the person cannot provide additional collateral, the lender will liquidate the stock that the person posted as collateral, potentially causing a significant decline in a company's stock price. This hurts minority shareholders who are unaware that the controlling shareholder had pledged his or her stock. Two weeks after Satyam's collapse, the SEBI made it mandatory for controlling shareholders to disclose any share pledges. 3. Increased Financial Accounting Disclosures The SEBI also recently proposed requiring companies to disclose their balance sheet positions twice a year. Pre-Satyam, the regulations only required disclosure of balance sheet positions

once a year. The increased reporting of companies' balance sheets will provide investors with more information on the stability of a company's financial position. The increased reporting requirements of balance sheets will probably eventually lead to the requirement that companies provide a statement of cash flow in its biannual reports as well. Increasing both the frequency and detail of disclosure will help provide for a more robust market checke.g. investors will be able to police companies better and pay more attention to accounting irregularities. For example, increased frequency of disclosure of Satyam's balance sheet could have led to an investor discovering, and pressing the board to investigate, the claimed large cash deposits in non-interest bearing accounts more quickly. 4. IFRS (Adoption of International Standards) Satyam strengthened India's commitment to adopting International Financial Reporting Standards ("IFRS") by 2011. Currently, Indian Generally Accepted Accounting Practices and the IFRS differ significantly. Globally, more and more countries are moving towards IFRS, as currently more than 100 countries require, permit, or are converting to IFRS. Adopting IFRS will facilitate investor comparisons of financial performance across country lines and will increase confidence in the accounting numbers. 5. Creation of New Corporate Code - Ministry of Corporate Affairs In addition to the new SEBI regulatory requirements, the Indian Ministry of Corporate Affairs is drafting a new corporate code for Indian publicly listed companies. The Ministry of Corporate Affairs expects to complete the new code by December 2009. The new code will apply along with the regulatory obligations imposed by the SEBI. Adherence to the Code will be voluntary; however, every company that deviates from the code's requirements must disclose the deviations to the ministry. The Ministry of Corporate Affairs anticipates that the new code will impose more stringent disclosure obligations than the SEBI currently requires. The Ministry of Corporate Affairs recently proposed a new law that would make it easier for Indian investors to form class action lawsuits against fraudulent actors in the company. Indian Corporate Affairs Minister, Salman Khushid, stated that he envisioned drafting the law to provide investors with a claim similar to the shareholder derivative suit [3] that U.S. law permits. Indian law currently creates obstacles to investors filing class action lawsuits. The Ministry of Corporate Affairs hopes that this new law will provide Indian citizens with the confidence to invest in the financial markets. E. Conclusion In the aftermath of Satyam, India's markets recovered and Satyam now lives on. India's stock market is currently trading near record highs, as it appears that a global economic recovery is taking place. Civil litigation and criminal charges continue against Satyam. Tech Mahindra

purchased 51 percent of Satyam on April 16, 2009, successfully saving the firm from a complete collapse. With the right changes, India can minimize the rate and size of accounting fraud in the Indian capital markets.