Over the years this column has reported on its fair share of scandals in the financial world, often in the biggest this and biggest that. Today we report on two such biggest – one from, you would have guessed, New York and the other India. The ingredients that make up these frauds are the usual suspects – persons too clever for their own good; greed; an unsuspecting public; poor oversight and accountants sleeping on the job. The historical economist and author Charles Kindleberger expressed it in slightly more elegant language, writing that “swindling is demand-determined, following Keynes’s law that demand determines its own supply, rather than Say’s law that supply creates its own demand. In a boom, fortunes are made, individuals wax greedy, and swindlers come forward to exploit that greed.”
Whatever it is, the vehicle used in the Madoff scandal is one that came to be known as a Ponzi scheme, a swindle offering unusually high returns, with early investors paid off with money from later investors. The scheme got its name from the Italian-born American resident who promised clients a 50% profit within 45 days, or 100% profit within 90 days.
While Ponzi was a known itinerant crook who served time on more than one occasion, Bernard Madoff, was a star of Wall Street, former chairman of the Nasdaq Stock Market and founder of Bernard L Madoff Investment Securities LLC, which had operated successfully for over four decades. And to support Kindleberger’s theory, the victims of what may turn out to be a US$50 billion swindle were not the small-town residents buying postal coupons, but top names in banking, show business, the intellectual class and many on the list of the wealthy. HSBC said its losses were about one billion US dollars while the Royal Bank of Scotland estimates its losses at US$600 million.
Investigators estimate that it will take more than two years to complete their work, but it is unlikely that they will ever come up with even reasonably precise figures. It is the nature of a Ponzi scheme that early investors do benefit, quickly receiving their initial capital from subsequent investors.
What must surely annoy is that once again there is failure of regulatory oversight. Last month, SEC Chairman Christopher Cox expressed grave concern at the “multiple failures over at least a decade to thoroughly investigate these allegations [at Madoff] or at any point to seek formal authority to pursue them,” ordering belatedly an internal review into the agency’s failure. And it is the same SEC that facilitated a three-employee accounting firm to audit Madoff on an annual basis. Brokerage firms like Madoff Securities are required to be audited by firms that were registered with the Public Company Accounting Oversight Board created after Enron to help prevent frauds.
Amazingly, the SEC allowed a waiver, which it extended on numerous occasions, to the audit requirement in respect of privately held brokerage firms. It is not surprising therefore that the auditors Friehling & Horowitz failed to detect the large Ponzi scheme run by Mr Madoff. Ironically, in its latest extension of the rule, issued December 12, 2006, the SEC said it had determined that allowing such firms not to register was “consistent with the public interest and the protection of investors.” Well, well, well.
Now to India
India was not too long ago held up as the country where the Beatles would go to seek spiritual renewal. The country lost its innocence with the Indira Gandhi emergency of 1975, but still the myth of innocence prevails with former Australian cricket captain writing in the aftermath of the Mumbai bombing in November that India had been “robbed of its innocence.”
Now in a twist of irony, one of its top information technology companies that have led the way in the in-sourcing credited with the country’s economic boom, Satyam Computer Services Ltd, has found itself embroiled in a scandal dubbed by commentators as “India’s Enron.” The word ‘Satyam’ in Sanskrit means ‘truth.’ Last week the company’s founder and chairman, B. Ramalinga Raju, resigned amid revelations of widespread accounting fraud in the company.
Mera Naam Raju
The resignation came in a five-page letter to the company’s board in which Mr Raju apologised to the shareholders, taking personal and sole responsibility for the fraud involving bogus accounting over several years, including inflating profits by more than tenfold between July and September of last year. As if making a concession the soft-spoken Raju with trademark paternal charisma, said he was prepared to face the law.
Raju was like a corporate deity in India, not only for having built a $2 billion IT empire bringing in foreign currency, but also for launching the Emergency Management and Research Institute, a national, not-for-profit 911-like emergency-response service funded by $50 million of his and his family’s money. Three months ago his company received the Golden Peacock award from a group of Indian directors for excellence in corporate governance.
Juxtaposed against Satyam or Mr Raju’s personal accounting misdeeds, such benevolence raises doubts about human nature and the philanthropy with which we associate businesspersons. In his letter Mr Raju disclosed that Satyam had inflated its operating profit for the three months ended September 30, 2008 to 6.49 billion rupees ($136 million) from 610 million rupees reported previously, while revenue was inflated to $565 million from $443 million. It had reported an operating margin of 24 per cent which was actually 3 per cent. On the asset side, Satyam’s balance sheet as of September 30 had a non-existent cash balance of over $1 billion (remember Parmalat?); nonexistent accrued interest of $79 million; an understated liability of $258 million and an overstated debtor position of $103 million.
Several investors in Satyam were considering suing PricewaterhouseCoopers LLC, the company’s auditors, which like all the top auditing firms benefited from the fall of Enron’s auditors, Arthur Andersen. The investors say the auditors are supposed to check on the accounts and that they rely on the auditor’s report. In a careful meaningless statement PWC said that they had worked “in accordance with applicable auditing standards and were supported by appropriate audit evidence.” That statement really says nothing since it is no more than a repetition of the standard words used in any audit report.
While the firm was right to explain that their obligations for client confidentiality precluded the possibility of commenting on the alleged irregularities, how do they expect the public to have any confidence in a profession where top auditing firms repeatedly fail to detect massive frauds year after year? Like Raju, Pricewaterhouse’s assurance that it “will fully meet its obligations to cooperate with the regulators and others,” seems neither a concession nor an option.
Raju’s explanation was a bit more interesting and philosophical, even if far too defensive. His letter which will go down as one of history’s most creative and longest resignations states in part that what had begun as a small gap between real and reported profits continued to grow over the years, like “riding a tiger, not knowing how to get off without being eaten.”
It is probably too early to assess the impact of the scandal described by PC Gupta, the federal minister for company affairs as a “shameful act” while Jagdish Malkani, country head at TAIB Capital Corp described it as “a monumental scandal [that] is terrible for the Indian IT industry.”
Some things, however, are fairly certain. There will be calls for more oversight and regulation of public companies, which happened in the aftermath of Enron and the other Dotcom failures. Indeed Mr Gupta has already said that government would take coordinated action with the Securities and Exchange Board of India. Meanwhile and more immediately, there are two major risks making India very uncomfortable – the likelihood that the Satyam is not unique in creative accounting and the same thing is happening in other public companies. That would scare away foreign investors. Equally serious is the potential disruption of services to the lucrative US outsourcing market. The timing could not be worse. As the Obama administration responds to the highest unemployment rate in the US for decades, tempted by protectionist instincts, outsourcing must be high on the agenda.
Satyam was already facing a World Bank ban for improper financial dealings with a top bank official. Along with the World Bank, Satyam’s clients include General Electric Co, General Motors Corp, Nissan Motor Co, Applied Materials Inc, Caterpillar Inc, Cisco Systems Inc. and Sony Corp. Will the other Indian IT firms be chosen to take up any slack or will these customers go elsewhere?
The almost co-incidental revelations of Madoff and Satyam have no doubt come about because a bear market drives the chickens home to roost while no one cares about corporate governance in a bull market. In Guyana here in the nether world – neither bull nor bear – we never seem to care. The scandals show that those who appear as good guys may be putting on a front. Madoff is described on his company’s website as having “a personal interest in maintaining the unblemished record of value, fair-dealing, and high ethical standards that has always been the firm’s hallmark.” Raju was the personification of piety and generosity.