CORPORATE FRAUDS AND INDIAN STOCK MARKET

Corporate frauds have exploded in India and have become a phenomenon. From Harshad Mehta to Ketan Parekh, to Madhavapura Co-operatives in 2002 to the CRB scam involving Roop Bhansal and further down to the initial public offering scam — popularly known as the Rupalben scam in late 2005 to the latest one Satyam’s fraud, it is a familiar story of a few corporate heads indulging in creative accounting with the sole object of enriching themselves at the cost of the lower middle-class investors.

Frauds are not new for the corporate world. This is because by it very definition, even bribery or supplier kickbacks comprise fraud. Other type of frauds includes accounting frauds (includes financial misconduct by top management), theft of intellectual property, data or information, counterfeiting etc. What is unfortunate is the fact that not many organizations seem to have a complete understanding of frauds that botch their balance sheets and cause financial injury even as they stand helpless in the wake of poor mechanisms to plug loopholes.

According to estimates, India is losing a whopping $40 bn per year because of corporate frauds, which is more than 4% of the country’s gross domestic product.

There is a crisis of confidence arising from the failure of the pillars of the capitalist system such as the stock market, financial analyst and accountants and the investment banks. It is unbelievable that the hundreds and thousands of “whistle-blowers” from board directors to corporate insiders and the accounting firms and the credit-rating agencies were kept in the dark about the goings-on in the Indian financial world.

LIST OF FRAUDS IN INDIA

The Flying Companies: In the last decade of nineteenth century IPO was the buzzword of the stock markets. Investors were lured due to the hefty returns on the listings. It was the IPO boom. There were however no stringent norms for the companies to come out with an IPO. The flying company scam or the IPO bubble in the mid nineties exposed the half baked nature of reforms of Indian Economy.

Plantation boom in 1990’s: Somebody promise that growing plants is the shortest way to create the wealth. Investors are taken for the ride in Plantation Fraud.

Market manipulations: Twice in the history of the stock markets in India single person succeeded in manipulating the share prices on large scale. Ketan Parekh and Harshad Mehta get the dubious distinction of being the Stock Market Fraudsters.

CRB Capital Markets (1996): Chairman Chain Roop Bhansali was accused of using CRB’s accounts in SBI to siphon off Rs 1,200 crore bank funds, claiming the firm was encashing interest warrants and refund warrants. He used very innovative products to attract the depositors to his non-banking finance company.

ITC-Chitalia’s Fera Violation (1996): It was an $ 80 million fraud into exports transactions between ITC and EST Fibres of the Chitalia group during 1990- 1995 revealed Fera violations.

Western Paques:Nandan Gadgil who gave his investor the dream of making his company bigger than HDFC suddenly disappeared from the Indian Bourses. All his companies defaulted to a great extent.

Home Trade (2002): A Rs 6,000 crore fraud when eight co-operative banks, including Valsad People’s Co-operative Bank and Navsari Co-operative Bank among others collectively lost over Rs 80 crore.

SSI Technologies Inc: An arm of SSI Technologies Ltd, which figured in the K-10 stocks of broker Ketan Parekh, who led the 2002 market collapse and was arrested later for alleged share price manipulation. Kalpathi Suresh, the chief executive of SSI, eventually sold the software services and software education businesses to PVP group.

DSQ Software (2003): Dinesh Dalmia’s DSQ Software was accused of dubious acquisitions and biased allotments made in 2000 and 2001. It was an Rs 595 crore fraud. In March 2006, Indian authorities arrested Dinesh Dalmia, chief executive of DSQ Software, for fraud and inducing US investors to part with $100 million for investment in substandard equipment for operating a back-office firm out of India.

Along with DSQ Software Ltd, companies like Pentasoft Technologies Ltd and Pentamedia Graphics Ltd also recorded scandals over insider trading and other corporate malpractices and collapsed after their promoters in 1999 diversified from the software and animation services business into new ventures such as resorts and multiplexes.

Rising instances of corporate fraud have set the alarm bells ringing within India Inc. Below is the fact file of Fraud Survey Report 2008, conducted by KPMG: · 70 percent companies believe fraud will increase over the next 2 years.

· 75 percent respondents identified fraud as a matter of highest concern.
· 80 percent said fraud poses a big problem.
· 60 percent acknowledged fraud occuring in their own companies.
· 11 percent lost between Rs. 1 to 100 millions due to fraud.
· 5 percent companies lost more than Rs. 100 millions due to fraud.
· 53 percent reported loss less than Rs. 1 million.
· Unethical behavior of employees and inadequate anti-fraud measure main worrying factors.
· 60 percent respondents do not have adequate knowledge of anti-corruption law.
· Financial sector hit worst – followed by real estate & infrastructure – pushing IT & ITeS to third place.

Profile of a fraudster
People who have longstanding relationships with the victim company perpetrate a majority of frauds.

How companies treat fraudsters
More than a third of Indian companies do nothing about frauds.

The most vulnerable sectors
The Indian financial servcies, real estate and IT/ITES sectors are most susceptible to frauds.

SAYTAM’S FARUD

The purpose of the scam

The purpose was aimed to make the company more attractive for investors. Raju pointed out that given the low promoter holding in the company (8.6% as of September 2008), poor performance could result in a take-over. It was important, therefore, to make it seem as if both the top and bottom lines were growing at a healthy rate, even if that was not actually true.

How did the bubble build?

The problem with overstating performance is that if you want to keep growth rate looking good, the absolute extent of the exaggeration has to keep getting bigger. To take this particular example, in 2003-04 Satyam reported net sales of Rs 2,542 crore. In the four years since then, that figure was reported to have grown by 36%, 34%, 40% and 31% respectively to reach Rs 8,473 crore in 2007-08.

Now, if an Rs 2,500-crore company wants to show 35% growth when it has actually grown by only say 25%, the extent of overstatement would be only Rs 250 crore (10% of Rs 2,500 crore).

But if an Rs 8,500-crore company wants to do the same thing, it will have to fudge the figures by Rs 850 crore. It is also important to realise that overstating revenues by 10% can overstate profit by a lot more.

For instance, if actual revenues were Rs 2,000 crore and actual net profits Rs 200 crore, an addition of Rs 500 crore to revenues without changing anything else would also add Rs 500 crore to net profit. While this would mean exaggerating revenues by only 25%, the profit figure would get overstated by 250% (500 cr is two-and-a-half times 200 crore).

Aftermath

The incident has resulted in immeasurable and unjustifiable damage to Brand India and Brand IT in particular. No doubt, India Inc has reacted with shock and dismay to the scam and it is likely to dent the public credibility about the concepts of corporate governance that the Indian industry has been so persistently trying to cultivate for the last decade.

An accounting fraud was the last thing investors in India would have imagined as a trigger for a reversal in investor sentiment. The Satyam accounting fiasco has come at a time when the sentiment is already brittle and is likely to affect the image of Indian companies among foreign portfolio investors.

Impact on Satyam as a company

1. Satyam stock is being removed from its S&P CNX Nifty 50-share index from Jan 12 and the Bombay Stock Exchange is expected to follow suit. Satyam will also be excluded from the CNX 100 index, CNX 500 index and the CNX IT index. Reliance Capital Ltd will replace Satyam in the main index. Satyam has lost more than 10000 Crore rupee in a single day trading (on Thrusday).

2. Satyam’s American Depository Receipts is halted for the time being (suspended) and replaced it by Axis Bank.

3. Satyam’s largest shareholder, Aberdeen AMC, dumped the tainted software entity’s shares on Wednesday, was also a seller in other index stocks like Reliance Communications and JP Associates.

4. Several domestic and foreign brokerage firms, including Credit Suisse, Religare and Angel Broking, suspended their coverage of Satyam shares.

5. The selling after Raju’s 7 pages letter to the board:
(a) Swiss Finance Corp Mauritius Ltd: Sold 7786759 shares at Rs.74.61
(b) Aberdeen International India Opportunities Mauritius Ltd:Sold 9830811 shares of the company at Rs.43.41
(c) Aberdeen Asset Managers Ltd Aberdeen Global Asia Pacific fund: Sold 4179064 shares at Rs.43.41

Impact on Investor

Normally the common man did not really look at balance sheets and only went by media reports, stock market performance and word of mouth to make his investment decisions. Now, he will be careful.

Impact on FII’s

The fraud at Satyam, wherein the books were cooked to show inflated topline and bottomline, will most definitely make foreign institutional investors (FIIs), the biggest believers in the Indian IT story, look at this counter closely.

FIIs had walked the talk and are currently large shareholders of most publicly traded Indian IT companies. In Satyam Computer, the FII holding is about 47%. At Infosys Technologies, it is 41%. At Wipro they hold a third (7%) of the non-promoter stake. At HCL Technologies, of the 33% held by non-promoters, FII holding is 18%. At TCS, their stake is 11% (promoters own 76%). All figures are for September 30,2008.

FIIs will be cautious about investing in the IT services counter. Naturally there will be higher level of due diligence.

Foreign investor confidence is basically dependent on how the regulators act. In Satyam’s case, uniquely two regulators are involved, SEC in the US and SEBI in India, as Satyam is also listed in the US. A lot depends on how they behave. How our government behaves. Business will take cues from that.

Satyam’s fraud disclosure, the industry believes, has come at a bad time, when recession is likely to hurt the earnings of the IT industry.

Impact on employees

Co. will not pay 2 months salary to the 53,000 employees and strong chances to lay-off of people are there who were sitting on the bench or were close to completing their assigned projects.

For a company, which is indulged in service sector, employees contribute to almost 52% of the co. expense, so lay off is the strong tool to cut the cost.

The other Big IT giants like Infosys has refused to hire any Sataymite.

The India Inc. image

The whole of the Indian industry should not be tarred with the same brush as most of the companies uphold the highest standards of corporate governance and this will help in mitigating the damage done to India’s image.

However, the revival of India’s position as a preferred investment destination would depend on the speed of regulatory action to salvage the situation. The regulators would have to take drastic measures to regain the confidence of foreign investors in Indian companies as frauds like these will have greater implications on emerging markets than developed markets.

Now, All Indian companies listed in the US have to go through a lot of procedures and filings, which talks about risk factors and financial position of the company.

FIIs will be difficult to convince and it will take time before FIIs line up in India and India loss will be the gain of China.

The need of the hour

Tighter rules for accounting and corporate governance, including appointment of independent directors by selection committees, and greater oversight from regulatory and government authorities.

Noble Group also suggests separation of audit and consultancy functions at companies, and quicker publication of annual reports.

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