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CHAPTER I

SATYAM SCAM - AN EYE OPENER FOR INDIAN

CORPORATE WORLD

Satyam Computer Services was among the top four information technology (IT) majors in the

country. It played a crucial role in the stock market as one of the 30 largest and most actively

traded stocks that determined the Bombay Stock Exchange’s (BSE) value-weighted index,

Sensex. Industry analysts say Satyam promoter B. Ramalinga Raju’s biggest crime was perhaps

in misleading investors completely.

The scam at Satyam Computer Services, the fourth largest company in India’s much showcased

and fiscally pampered information technology (IT) industry, has had an unusual trajectory. It

began with a successful effort on the part of investors to thwart an attempt by the minority-

shareholding promoters to use the firm’s cash reserves to buy out two companies owned by them

— Maytas Properties and Maytas Infra.

That aborted attempt at expansion precipitated a collapse in the price of the company’s stock and

a shocking confession of financial manipulation and fraud from its chairman, B. Ramalinga Raju.

The whole story is now of facts and figures which have been analysed by corporate experts as

well as various economists in India. The certain parties/issues which need to be analysed to

understand the nature of the fraud and its related problems have been highlighted which shall be

elaborated later.

Satyam Company and The Board: The event came to the light when B, Ramalinga Raju,

Chairman of Satyam Computer Services made a confession that took the nation as well as the

world at large1 by surprise and everybody listened with an awed expression as to what one was

1 The company offers information technology (IT) services spanning various sectors, and is listed on the New York Stock Exchange and Euronext.Satyam's network covers 67 countries across six continents. The company employs 40,000 IT professionals across development centers in India, the United States, the United Kingdom, the United Arab Emirates, Canada, Hungary, Singapore, Malaysia, China, Japan, Egypt and Australia. It serves over 654 global companies, 185 of which are Fortune 500 corporations. Satyam has strategic technology and marketing alliances

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hearing. It is believed that Raju diverted Satyam funds to the companies headed by his sons, B.

Teja Raju (Maytas Infra) and B. Rama Raju Jr. (Maytas Properties), to buy large tracts of land

and win projects. He had chalked out a game plan to acquire the companies and in the process

also reduce the alarming gap in Satyam’s accounts, between actual profit and the figure stated in

the books, and keep the wealth within the family. Much like Satyam, Raju nurtured the two

companies well and had ambitious plans for them, using his clout with the Andhra Pradesh

government, which bent over backwards to patronise Maytas. During the past three years,

Maytas Infra bagged projects worth Rs.30, 074 crore on its own or in joint ventures and became

the “fastest growing infrastructure company” in the State. The projects covered areas such as

irrigation, railways, roads and ports. The “superfast growth” of the company, which recorded a

turnover of Rs.1,600 crore in 2008 as against Rs.100 crore in 2003; the speed and ease with

which it got projects, and the questionable role played by the top political leadership, are all

under the scanner now.

The ‘honest’ confession2 brought many issues to the lime light along with the truth that the fraud

committed by The Chairman was not single-handed and also included other perpetrators. This

with over 50 companies. Apart from Hyderabad, it has development centers in India at Bangalore, Chennai, Pune, Mumbai, Nagpur, Delhi, Kolkata, Bhubaneswar, and Visakhapatnam.2 The letter written by B, Ramalinga Raju, Chairman of Satyam Computer Services to the Satyam Board:

“It is with deep regret and tremendous burden that I am carrying on my conscience, that I would like to bring the

following facts to your notice:

1. The Balance Sheet carries as of September 30, 2008,

a. Inflated (non-existent) cash and bank balances of Rs 5,040 crore (as against Rs 5,361 crore reflected in

the books);

b. An accrued interest of Rs 376 crore, which is non-existent

c. An understated liability of Rs 1,230 crore on account of funds arranged by me;

d. An overstated debtors' position of Rs 490 crore (as against Rs 2,651 reflected in the books);

2. For the September quarter(Q2) we reported a revenue of Rs 2,700 crore and an operating margin of Rs 649

crore(24 per cent of revenue) as against the actual revenues of Rs 2,112 crore and an actual operating

margin of Rs 61 crore (3 per cent of revenues). This has resulted in artificial cash and bank balances going

up by Rs 588 crore in Q2 alone.

The gap in the balance sheet has arisen purely on account of inflated profits over several years (limited only to

Satyam standalone, books of subsidiaries reflecting true performance).

What started as a marginal gap between actual operating profit and the one reflected in the books of accounts

continued to grow over the years.

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issue of corporate fraud as most like to name it as the biggest corporate fraud in Indian Corporate

history contains such players as The Auditors, The Bankers, The Promoters and also the

investors.3

Auditors- Price Waterhouse Coopers: The incident also raised some serious question about well-

named bodies and organisations who were involved in the business of managing the ‘fraudulent’

affairs of the Company. In this context it is also necessary to note the role of the auditors as the

It has attained unmanageable proportions as the size of the company operations grew significantly (annualised

revenue run rate of Rs 11,276 crore in the September quarter, 2008, and official reserves of Rs 8,392 crore).

The differential in the real profits and the one reflected in the books was further accentuated by the fact that the

company had to carry additional resources and assets to justify a higher level of operations thereby significantly

increasing the costs. Every attempt made to eliminate the gap failed. As the promoters held a small percentage of

equity, the concern was tha poor performance would result in the takeover, thereby exposing the gap. It was like

riding a tiger, not knowing how to get off without being eaten.

The aborted Maytas acquisition deal was the last attempt to fill the fictitious assets with real ones. Maytas' investors

were convinced that this is a good divestment opportunity and a strategic fit. 3 One Satyam's problem was solved, it was hoped that Maytas' payments can be delayed. But that was not to be.

What followed in the last several days is common knowledge.

1. I would like the board to know:

2. That neither myself, nor the Managing Director (including our spouses) sold any shares in the last eight

years - excepting for a small proportion declared and sold for philanthropic purposes.

3. That in the last two years a net amount of Rs 1,230 crore was arranged to Satyam (not reflected in the

books of Satyam) to keep the operations going by resorting to pledging all the promoter shares and raising

funds from known sources by giving all kinds of assurances (statement enclosed only to the members of the

board).

4. Significant dividend payments, acquisitions, capital expenditure to provide for growth did not help matters.

Every attempt was made to keep the wheel moving and to ensure prompt payment of salaries to the

associates. The last straw was the selling of most of the pledged shares by the lenders on account of margin

triggers.

5. That neither me nor the managing director took even one rupee/dollar from the company and have not

benefited in financial terms on account of the inflated results.

6. None of the board members, past or present, had any knowledge of the situation in which the company is

placed.

7. Even business leaders and senior executives in the company, such as, Ram Mynampati, Subu D, T R

Anand, Keshab Panda, Virender Agarwal, A S Murthy, Hari T, S V Krishnan, Vijay Prasad, Manish Mehta,

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whole affair was managed by one of the biggest names in the auditing business- Price

Waterhouse Coopers.

According to audited balance sheet figures (if they are to be trusted) available from the CMIE’s

database, the paid-up equity in Satyam Computer Services rose from Rs. 56.24 crore in March

2000 to just Rs. 64.89 crore by March 2006 and further to Rs. 133.44 crore in March 2007.

Overall, the number of shares held by the promoter group fell from 7.16 crore (22.8 per cent) to

Murli V, Shriram Papani, Kiran Kavale, Joe Lagioia, Ravindra Penumetsa, Jayaraman and Prabhakar Gupta

are unaware of the real situation as against the books of accounts. None of my or managing directors'

immediate or extended family members has any idea about these issues.

Having put these facts before you, I leave it to the wisdom of the board to take the matters forward. However, I am

also taking the liberty to recommend the following steps:

1. A task force has been formed in the last few days to address the situation arising out of the failed Maytas

acquisition attempt.

2. This consists of some of the most accomplished leaders of Satyam: Subu D, T.R. Anand, Keshab Panda and

Virendra Agarwal, representing business functions, and A S Murthy, Hari T and Murali V representing

support functions.

3. I suggest that Ram Mynampati be made the chairman of this Task Force to immediately address some of

the operational matters on hand. Ram can also act as an interim CEO reporting to the board.

4. Merrill Lynch can be entrusted with the task of quickly exploring some merger opportunities.

5. You may have a 'restatement of accounts' prepared by the auditors in light of the facts that I have placed

before you.

I have promoted and have been associated with Satyam for well over 20 years now. I have seen it grow from few

people to 53,000 people, with 185 Fortune 500 companies as customers and operations in 66 countries. Satyam has

established an excellent leadership and competency base at all levels.

I sincerely apologise to all Satyamites and stakeholders, who have made Satyam a special organisation, for the

current situation. I am confident they will stand by the company in this hour of crisis.

In light of the above, I fervently appeal to the board to hold together to take some important steps. TR Prasad is well

placed to mobilise a support from the government at this crucial time.

With the hope that members of the Task Force and the financial advisor, Merrill Lynch (now Bank of America), will

stand by the company at this crucial hour, I am marking copies of the statement to them as well.

Under the circumstances, I am tendering the resignation as the chairman of Satyam and shall continue in this

position only till such time the current board is expanded. My continuance is just to ensure enhancement of the

board over the next several days or as early as possible.

I am now prepared to subject myself to the laws of the land and face the consequences thereof.

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5.8 crore (8.6 per cent) between September 2001 and September 2008. This points to a conscious

decision by the promoters to sell shares, which may have been used to acquire assets elsewhere.

The more inflated the share values, the more of such assets could be acquired. It is quite possible

that the assets built up by the eight other Raju family companies under scrutiny, including

Maytas Properties and Maytas Infra, partly came from the resources generated through these

sales. If true, this makes Raju’s confession suspect, since he stated that “neither myself, nor the

Managing Director (including our spouses) sold any shares in the last eight years — excepting

for a small proportion declared and sold for philanthropic purposes.” Price Waterhouse Coopers

has been the statutory auditor for Satyam Computer services for last six years. Auditor‘s

involvement is crystal clear. Satyam had paid twice the amount of what was charged by other

Audit Firms. There was no cash within the company's banks and yet the auditors went ahead and

signed on the balance sheets saying that the money was there. Not just the cash, even they even

signed off on the non-existent interest that accrued on the non-existent cash balance! Auditors do

bank reconciliation to check whether the money has indeed come or not. They check bank

statements and certificates. So was this a total lapse in supervision or were the bank statements

forged? No one knows yet as everyone still awaits the investigation report regarding this issue.

The company officials said they relied on data from the reputed auditors. But

PricewaterhouseCoopers, stung by this insinuation hit back at Satyam.4

Satyam and Corporate Governance: Just three months ago, India's fourth-largest software

services exporter, Satyam Computer Services received a Golden Peacock Global Award from a

group of Indian directors for excellence in corporate governance. Now that Satyam is in turmoil

and its shares have plunged after a botched attempt to buy two infrastructure firms in which

management held stakes, concerns over the conflict of interest and a lack of transparency are

(B Ramalinga Raju)

Copies marked to:

1. Chairman SEBI

2. Stock Exchanges4 Price Waterhouse Coopers to the media: “The audits were conducted by Price Waterhouse in accordance with

applicable auditing standards and were supported by appropriate audit evidence. Given our obligations for client

confidentiality, it is not possible for us to comment upon the alleged irregularities. Price Waterhouse will fully meet

its obligations to cooperate with the regulators and others."

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being raised. Ramalinga Raju himself was the recipient of many an award for corporate

governance and transparency, but the fraud has brought to light the fact that in India the

distinction between owners and management is still not very clear. Where the owners are also the

managers, such frauds are always a possibility. In the Satyam case, of course, none is guiltier

than the Rajus. This shows the status of Indian Corporate Governance and how it can easily fall

prey to people like Rajus’.

SEBI and its take on Satyam: The Securities and Exchange Board of India, which says it is

‘horrified at the magnitude of the fraud’ had in December given a clean chit to Satyam saying

that it had not found any violation of norms relating to takeover and corporate governance in its

preliminary surveillance of the deal involving the acquisition of Maytas Infra by Satyam

Computer Services. Analysts say the “market watchdog” lacks the teeth for ensuring compliance

on governance. Now, after so much water has flown under the bridge, Sebi has moved to ‘take

action’ against the company.5

The Satyam episode has brought out the failure of the present corporate governance structure.

The present corporate governance structure hinges on the independent directors, who are

supposed to bring objectivity to the oversight function of the board and improve its effectiveness.

Stakeholders place high expectation on them. But is the expectation misplaced? Perhaps, yes. An

individual independent director cannot play an effective role in isolation. Even if a particular

independent director is highly committed, he can only watch‘ wrong doing and at best initiate a

discussion, but alone she cannot stop a decision even if it is detrimental to the interest of

shareholders or other stakeholders. Neither can she blow the whistle outside the board room (e.g.

to regulators) because board proceedings are considered confidential.6

CHAPTER II

SATYAM SCAM: ROLE OF AUDITORS AND

BANKERS AS TO THEIR INVOLVEMENT5 Infra Chapter III “Satyam Scam and SEBI: Who is to be blamed?”6 www.ndtv.com/convergence/ndtv/story.aspx?id=NEWEN20090079469 - 101k

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Once the picture becomes clear as how the manipulation of funds were done and as to how the

scam could be caused in spite of so many regulations and statutory restrictions7 present to curb

and check any deviation from the established duties and obligations that are essential and

compulsory on nature.

If one is to blame the Satyam for instigating the corporate down-fall and rise of the questions as

to corporate governance and similar concerns then there are others also involved who may be

said to have played a pivotal role in ‘aiding’ Mr. Raju in pulling off such a fraud and hood

winked even the best in the business to prevent such mishaps.8 Hence, it is bemusing as to how

Satyam could have indulged in accounts fudging without getting detected by the auditors.

Firstly, one needs to speak about Price Waterhouse Coopers the auditors of Satyam Computer

Services who should have caught it as because:

Book sales belonging to the subsequent year in the current year by pre-dating the

invoice. This is like catching the tiger by the tail.  Unless the sales improve, the Company

will have to follow the same thing in the subsequent years as well to ensure that the profit

trend is maintained. (The auditors can detect this by matching the dates of invoices,

shipment advises, gate passes, delivery receipts, physical stock verification reports,

debtors’ confirmation etc.)

7 Infra Chapter V, “Satyam Scam & Legal Provisions Under Companies Act, 1956”; Chapter III, “Satyam Scam and

SEBI: Who is to be blamed?”8 www.expressindia.com/latest-news/Satyam-fraud-Not-a-one-man-show/408664/ reports “KPMG, which audits the

accounts of IT majors like Infosys and Wipro, doubted the veracity of the confessional letter written by B Ramalinga

Raju, the founder-chairman of Satyam Computer, saying the financial bungling cannot be done only by the head of

the Hyderabad-based firm. “It defies logic, one is not sure whether there is much more to it than is written in the

letter and whether the letter contains all the facts,” KPMG Chief Operating Officer Richard Rekhy said here on the

sidelines of a CII function. It is too simplistic at the moment to believe that the kind of thing that has happened in

the company is done by Raju alone, he said. “It requires a whole battery of people to advance those accounting

entries and credit those because you have to involve other people as well like bankers to get those certificates,” he

said. When asked whether Raju might have siphoned off funds and he is now admitting to lesser crime, he said it is

quite possible but it could be known only after investigation of group companies”

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Book bogus sales to inflate profits in one year and show return sales in the subsequent

year. This is again like catching the tiger by the tail as the quantum will have to be

increased each year to compensate for the additional charge coming in the subsequent

year due to return sales.  (The auditors can detect this by checking the invoices,

subsequent year sales returns, debtor confirmations, stock tally etc.)

Book bogus other income.  This is done to inflate the profits and mostly to as a money

laundering exercise: Unaccounted money is laundered into the books by showing

income for no actual service rendered.   (Auditors can detect this by seeing the actual

documents supporting the other income and by comparing with the expertise available in

the company to provide such services)

By not booking purchases or overheads.  Companies try to inflate profits by not

booking purchase of material or overheads: This again has to be covered up in the

subsequent year when the creditors are to be paid.  (Some of the ways in which the

Auditor can find these include, comparison of the purchases with physical stock,

quantitative tally of stocks and consumption, trend analysis of overheads between two

periods, obtaining creditor’s confirmation, bank reconciliation statements to check for

amounts paid but not accounted in books which will be hanging as a difference between

bank balance as per books and as per the bank statements for a given cut-off date)

In all the cases of inflation of sales in the books, the company will credit the sales account to

increase the sales and pass the debit to a debtor account to show receivables.  The problem here

is that the receivables has to be squared off either by reversing the sale or by writing off as most

fraudulent companies do not introduce cash to square of the receivables for bogus sales.

However, Mr. Ramalinga Raju has introduced a new gambit in this fraud committed by him and

his ‘allies’. He booked bogus income, most likely with fictitious companies and cleared off the

debtor balances by showing collections and there by increasing the cash and bank balances. In

order to get actual collections from fictitious companies, he didn’t make any actual collections. 

He just got some more book entries made to clear the debtors and transferred the debits to bank

balances. If something remains in debtors, it will raise questions from many quarters, starting

from the auditors to the Board of Directors to the analysts to institutional investors to (at least)

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some of the intelligent retail investors. If the debtor balance is converted into Bank balances? No

one is going to doubt.  In fact, people will become happier to see the swell of cash.  The

Company will be valued higher it is sitting on a huge pile of cash.

The problem starts here. Normally, auditors will ask for confirmation balances for the bank

balances shown by the company.  But then how did he get away for so many years without

having actual bank balances?  Or how did he produce the needed confirmation to the auditors for

these balances?  Did the auditors (one of Big Four, mind you) overlook seeking confirmation of

balances? This presumption seems to be impossible. Auditors though by definition are not

“bloodhounds” but are “watchdogs”, they minimum become a nagging wife if confirmation for

significant balances are not received.  They will qualify such things in their audit report and also

will draw the attention of lack of confirmations to the Board of Directors and Audit Committee.

So the big question that arises here is “How could Mr. Raju convince the auditors?” 9  There can

9 One has to note that the Auditors Report required under the Indian Companies Act, 1956 is very different from the

Auditors’ certificate as per USA and other country laws.

Under those laws, much of the responsibility on the accounts is shifted to the management.  Interestingly, this report

doesn’t specify any such minute details to be followed but simply asks auditors to look at all things that may require

a scrutiny, which is lucid and ‘flexible’.

227. Powers and duties of auditors: (1) Every auditor of a company shall have a right of access at all times to the

books and accounts and vouchers of the company, whether kept at the head office of the company or elsewhere, and

shall be entitled to require from the officers of the company such information and explanations as the auditor may

think necessary for the performance of his duties as auditor.1[(lA) Without prejudice to the provisions of sub-section (1), the auditor shall inquire-

(a) whether loans and advances made by the company on the basis of security have been properly secured and

whether the terms on which they have been made are not prejudicial to the interest of the company or its members;

(b) whether transactions of the company which are represented merely by book entries are not prejudicial to the

interests of the company;

(c) where the company is not an investment company within the meaning of section 372 or a banking company,

whether so much of the assets of the company as consist of shares, debentures and other securities have been sold at

a price less than that at which they were purchased by the company;

(d) whether loans and advances made by the company have been shown as deposits;

(e) whether personal expenses have been charged to revenue account;

(f) where it is stated in the books and papers of the company that any shares have been allotted for cash, whether

cash has actually been received in respect of such allotment, and if no cash has actually been so received, whether

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be only speculations as to how he could have hoodwinked his auditors but unless the SEBI or the

administrators frame and deduce something definite in this regard speculations cannot be the

correct answer as to whether there was any involvement between the auditors and the perpetrator

of the fraud, Mr. Raju. Under S. 227 read with S. 233 of the Companies Act, 1956 the auditors are

required to accurately, fairly and diligently review and audit the accounts of the company before

issuing the signed auditors’ report.10 Failure to do so would result in a penalty under S.233 of Rs.

10,000. Under Sections 62 and 63 of the Act, any person issuing a prospectus that contains a false

statement may be punished with up to 2 years imprisonment and fine up to Rs.50, 000.11 This

includes directors, promoters and experts such auditors and investment bankers. Satyam also had an

ADS listing in the US and filed a prospectus with the US SEC. Under Rule 10b-5 issued under

Section 10 of the Securities Act of 1933, it is unlawful for any person to make any untrue statement

the position as stated in the account books and the balance-sheet is correct, regular and not misleading.]

Looking at the provisions of Section 227 (1A) (b) can it be said that the auditors ensured as to whether it is not

the same case with Satyam before certifying their accounts? If yes, how did they ensure?

Difficult questions as the whole baloon of Satyam was blown up only with “book entries”.  Instead of acting as

book keepers, the Satyam finance department under instructions and intrusions of Mr. Raju, probably “book

cooked”.

In addition to the above, subsection 3 of the same section 227 warrants the auditor to report this:

(3) The auditor’s report shall also state-

(a) whether he has obtained all the information and explanations which to the best of his knowledge and belief were

necessary for the purposes of his audit;

(b) whether, in his opinion, proper books of account as required by law have been kept by the company so far as

appears from his examination of those books, and proper returns adequate for the purposes of his audit have been

received from branches not visited by him;2[(bb) whether the report on the accounts of any branch office audited under section 228 by a person other than the

company's auditor has been awarded to him as enquired by clause (c) of sub-section (3) of that section and how he

has dealt with the same in preparing the auditor's report;]

(c) whether the company’s balance-sheet and profit and loss account dealt with by the report are in agreement with

the books of account and returns;3[(d) whether, in his opinion, the profit and loss account and balance-sheet comply with the accounting standards

referred to in sub-section (3C) of section 211;]

Then the obvious question arises in the mind of people that whether compliance was done by Satyam? And, if so

done then to what respect?10 See Sec. 233, Companies Act, 195611 See Sec. 63, Companies Act, 1956

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of a material fact or to omit to state a material fact in connection with the sale of a security. Under

Section 11 of the Securities Act, the persons who signed the registration statement (directors and

officers) are liable in addition to the underwriters, auditors and other experts.

In addition, disciplinary proceedings/enquiries could be initiated by the Institute of Chartered

Accountants of India12 against the audit firm, which would be a very serious implication for the audit

firm, as it could have the immediate effect of disqualifying their eligibility to act as statutory auditors

for several banks and other institutions. Such an event could also result in suspension or debarment

of the audit firm if the ICAI13 concludes that there were serious lapses on the audit firm‘s part.

Secondly and most importantly comes, the issue of independent directors14 and the

shareholders. The role of the company's directors, including independent directors, in the entire

episode too has been exposed after the Satyam episode. Most of them essentially remain

‘nodders’ in the boardroom and agree to whatever the management or the promoters want to

push through.

The Satyam board, including its five independent directors15 had approved the founder's proposal

to buy 51 per cent stake in Maytas Infrastructure and all of Maytas Properties, owned by the

family members of Satyam chairman B Ramalinga Raju. Despite the shareholders not being

taken into confidence, the directors went ahead with the management's decision. The decision of

acquisition was, however, reversed 12 hours later after investors dumped Satyam's stock and

threatened action against the management. By any yardstick, the directors were men of eminence

and learning who should be independent. Clause 49, of the Indian listing agreement deals with

12 ICAI, 194913 ibid14 see Chapter III: “Satyam Scam And Sebi: Is Somebody To Be Blamed.”15 Satyams’ independent directors includes—

Mangalam Srinivasan,

Vinod Dham (Entrepreneur)

Krishna Palepu (Harvard professor)

M. Rammohan Rao (Indian School of Business dean) from CNN-IBN Published on Thu, Jan 08, 2009 at

13:10 , Updated at Thu, Jan 08, 2009 at 17:42

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the role of independent directors and assumes, that not being related to a promoter or having a

direct economic benefit from a company, makes a director independent.16

In Satyam‘s case, directors may have voted differently if they knew perhaps through such meetings

the views of shareholders on the issue of unrelated diversification of the kind proposed by the

promoters. Shareholders on their part, have a right to know how their directors represent them.

Details of dissenting views, in a board can convey useful information about the various options

considered at a meeting. While detailed views cannot usually be disclosed in the short term, it is

possible to have minutes publicized after two-three years. This will not serve the immediate purpose

of protecting present shareholders, but would impose pressure on independent directors to be seen to

be fulfilling their duty of loyalty. If diligence was exercised at the board then it is to be known as to

how independent directors voted on such issues, perhaps through a statement in the annual report. It

would call in to question, the real independence in a board, if persons of widely varying backgrounds

were to always seem to agree, on every issue. By resigning instead of coming up with an explanation

for what transpired at the board, some of the directors of Satyam, beg the question whether any

meaningful debate took place at all, on this issue. It is not difficult for the regulators to bring the

sunlight of transparency to board discussions, through a few changes in their disclosure guidelines.

Under the SEBI and Companies Act 1956, all directors cannot be held responsible because

institutional directors and independent directors are nominated directors of various financial

institutions or the government nominees. They cannot be held responsible as nominated directors

cannot be held legally liable.

CHAPTER III

SATYAM SCAM AND SEBI: IS SOMEBODY TO

BE BLAMED?

16 Supra note 14

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The scam or fraud whatever one may term the incident as it caught the Regulatory bodies’ off-

guard and also pointed out the gaping holes existing in the legal framework to prevent such fraud

from happening. The Satyam scam represents a lowering of guard and the throwing of

established practices to the wind by those who were expected to safeguard the interests of small

investors. The auditors imagined the fixed deposit receipts were genuine, the company’s

directors overly trusted Raju, SEBI mistakenly thought it could easily get at Raju with its wide-

ranging powers, while the CID was too protective about sharing information.17

THE Securities and Exchange Board of India (SEBI) may not have foreseen, as experts claim,

the fraud committed in Satyam Computer Services, but there is plenty the market regulator can

do to ensure that another one like this does not occur in the country.

The SEBI wears several hats: it regulates the market; facilitates information flow between the

stock exchange, the listed companies and the investors; and keeps tabs on the operations of listed

companies. Its responsibility towards investors is to ensure that any information regarding listed

companies is placed in the public domain. If fraud exists in a listed company, SEBI’s job is to

probe the matter to protect the investors.

SFIO and SEBI

As soon as Ramalinga Raju admitted to the fraud on January 7, the regulator, empowered by the

provisions of the SEBI Act, 1992, ordered an investigation and sent its officials to Hyderabad to

inspect the books and records. The officials were, however, not allowed access to Raju as he had

already surrendered before the Hyderabad police. It is essential for SEBI to interrogate Raju as

he has insisted that only he was involved in the scam.

A senior official said that perhaps Raju was advised well to get himself arrested in order to stall a

probe by SEBI. A lawyer said the police would not be able to deny SEBI access to Raju as the

regulator is armed with the provisions of the 1992 Act. SEBI moved a Hyderabad court seeking

permission to interrogate Raju and his brother Rama Raju. However, on January 23, the court

rejected the plea and refused to entertain another petition by the Serious Fraud Investigation

17 “Far from the truth” by S. Nagesh Kumar published in ‘the Frontline’ [Volume 26 - Issue 04 :: Feb. 14-27,

2009]

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Office. It was not until February 4, 2009 that the Supreme Court came to rescue SEBI by giving

it permission to examine them in jail. While the lower court had rejected its petition, while the

Andhra Pradesh High Court asked it to wait for some more time. The interim report of the

Registrar of Companies (RoC) has, according to reports, confirmed falsification of books of

accounts and inflation of the company’s financial position to the extent of over Rs.5,000-6,000

crore by Satyam Computer Services Ltd. The RoC report is the basis for the probe by the Serious

Fraud Investigation Office (SFIO), set up under the Ministry of Corporate Affairs in 2003. As

the probe by the SFIO is the main limb of the multi-pronged investigation into the fraud, a close

look at what the SFIO can achieve under the present legal and regulatory framework needs to be

examined.

The SFIO is a non-statutory body and was set up on the basis of the recommendations of the

Naresh Chandra Committee18 on corporate governance in the backdrop of stock market scams,

failure of non-financial banking companies and the phenomena of vanishing companies and

plantation companies. It is a multi-disciplinary organisation with experts on finance, capital

market, accountancy, forensic audit, taxation, law, information technology, company law,

customs and investigation. These experts are drawn from banks, the Securities and Exchange

Board of India (SEBI), the Comptroller and Auditor General’s office and the organisations and

departments concerned of the government.

The SFIO’s mandate is extremely focussed and, to some extent, limited by Sections 235 to 247

of the Companies Act, 1956. Although the Naresh Chandra Committee envisaged a separate

statute to enable the SFIO (along the lines of the SFO in United Kingdom) to investigate all

aspects of fraud and direct the prosecution in appropriate courts, the Central government,

inexplicably, did not find it necessary to simultaneously create a separate legislative framework

for the SFIO to function under. This has, according to observers, seriously compromised the

SFIO’s efficiency and effectiveness.

18 The Naresh Chandra Report (2003) seeks to enforce the guidelines laid down in Kumarmangalam Report (1998)

and also lays stress on “Independent Directors” which are to be characterised in line with:

Independence of judgment.

No material relationship.

No pecuniary relationship

15

SFIO takes up investigations only into those cases of alleged fraud when:

referred to it by the Central government under Section 235/237 of the Companies Act,

1956;19

cases that substantially involve public interest, to be judged by size, either in terms of

monetary misappropriation or in terms of persons affected, or those cases that may lead to a

clear improvement in systems, laws or procedures;

the SFIO may also take up cases on its own without them being referred to it by the

Department of Company Affairs.20

After completing all the formalities for listing its securities, including of entering into listing

agreement, the securities of the company are listed and traded at the concerned stock exchanges.

Before listing, the company enters into a listing agreement with the concerned stock exchanges.

Almost all the stock exchanges have a standard listing agreement (which is amended from time

to time by issuing circulars by each of the stock exchanges). Companies listed on stock

exchanges have many obligations to discharge. These obligations are elaborated in all the

relevant clauses of the Listing Agreement which the company has entered into with the Stock

Exchange(s).

Clause 49 and SEBI

Clause 49 Background: SEBI had constituted a Committee on Corporate Governance under the

chairmanship of N R Narayana Murthy to improve standards of corporate governance in India.

SEBI introduced some major amendments based on the report on this committee on 26th August,

2003, in clause 49 of its listing agreement.

19 These provisions enable the Central government to appoint one or more competent persons as inspectors to

investigate and submit a report on the affairs of a company if, in its opinion, or in the opinion of the RoC or the

Company Law Board, there are circumstances suggesting that the business of a company is being conducted with

the intention to defraud its creditors or members, or for a fraudulent or unlawful purpose.20 In these cases, the SFIO Director has to record the reasons in writing, and the decision will be subject to review by

a coordination committee set up for the purpose. It is to be seen whether these aspects of its functioning have

restricted its autonomy or operational efficiency.

16

Applicability of Clause 49: All companies which were required to comply with the requirement

of the erstwhile Clause 49 i.e. all listed entities having a paid up share capital of Rs 3 crores and

above or net worth of Rs 25 crores or more at any time in the history of the entity, are required to

comply with the requirement of this clause. This clause does not apply to other listed entities,

which are not companies, but body corporates, incorporated under other statutes. Clause 49 will

apply to these institutions as long as it does not violate their respective statutes, guidelines or

directives.

Clause 49 - Corporate Governance The company agrees to comply with the following provisions:

I. Board of Directors

(A) Composition of Board: (i) The Board of directors of the company shall have an optimum

combination of executive21 and non-executive22 directors with not less than fifty percent of the

board of directors comprising of non-executive directors.

(ii) Where the Chairman of the Board is a non-executive director, at least one-third of the Board

should comprise of independent directors and in case he is an executive director, at least half of

the Board should comprise of independent directors.

(iii) For the purpose of the sub-clause (ii), the expression ‘independent director’ shall mean a

non-executive director of the company who:

a. Apart from receiving director‘s remuneration, does not have any material pecuniary

relationships or transactions with the company, its promoters, its directors, its senior

management or its holding company, its subsidiaries and associates which may affect

independence of the director;

21 An executive director is the senior manager or executive officer of an organization, company, or corporation. The

position is comparable to a chief executive officer (CEO) or managing director. An executive director is usually

remunerated for his or her work.22 A non-executive director (NED, also NXD) or outside director is a member of the board of directors of a

company who does not form part of the executive management team. He or she is not an employee of the company

or affiliated with it in any other way

17

b. Is not related to promoters or persons occupying management positions at the board level

or at one level below the board;

c. Has not been an executive of the company in the immediately preceding three financial

years;

d. Is not a partner or an executive or was not partner or an executive during the preceding

three years, of any of the following:

1. The statutory audit firm or the internal audit firm that is associated with

the company, and

2. The legal firm(s) and consulting firm(s) that have a material association

with the company.

e. Is not a material supplier, service provider or customer or a lessor or lessee of the

company, which may affect independence of the director; and

f. Is not a substantial shareholder of the company i.e. owning two percent or more of the

block of voting shares.

There are several distinct benefits in having an independent board of directors which they can

bring to a company, ranging from long-term survival to improved internal controls. Independent

directors in the board can:

Counterbalance management weaknesses in a company.

Ensure legal and ethical behaviour at the company, while strengthening accounting

controls.

Extend the ―reach of a company through contacts, expertise, and access to debt and

equity capital.

Be a source of well-conceived, binding, long-term decisions for a company.

18

Help a company survive, grow, and prosper over time through improved succession

planning through membership in the nomination committee etc.

Corporate Governance principles all over and listing requirements assign tasks that have a

potential for conflict of interest to independent directors, examples of these are integrity of

financial and non-financial reporting, review of related party transactions, nomination of board

members and key executives remuneration.

Satyams‘ independent directors includes:

Mangalam Srinivasan,

Vinod Dham (Entrepreneur)

Krishna Palepu (Harvard professor)

M. Rammohan Rao (Indian School of Business dean)

The company in its corporate governance report for 2007 did not name Palepu as independent

director, perhaps because he received Rs 87 lakh from the company towards consultancy fees.

Each individual director received around Rs 13 lakh for the year 2007 for say 100 hours of work

(a survey in US reveals that independent directors in large companies devote 50-100 hours per

annum to carry out board responsibilities). Keeping in view the compensation levels in India, the

compensation should be considered good. It is not only in Satyam that independent directors

showed lack of commitment. In the case of Enron, WorldCom and other companies in which

corporate governance failed independent directors failed to perform effectively. If an individual

considers certain responsibilities as peripheral and if the chance of failure in performing those

duties coming to light is low, it is likely that he will shirk those responsibilities, because in that

case the cost of failure to the individual is low. Independent directors are human beings and

therefore, we should not expect them to behave differently from a rational human being. If the

regulators fail to assess the performance of the board on regular basis, albeit indirectly through

scrutiny of filings, and if law enforcement agencies fail to penalize errant independent directors,

the present corporate governance structure will remain ineffective.23 However, the solution is not 23 news.outlookindia.com/item.aspx?657476

19

simple. If independent directors are held liable for corporate fraud and severe penalties are

imposed on them, it will be difficult to induct right people as independent directors in the board

and companies will be deprived of the collective wisdom of people who can make a difference in

the performance of companies.24

The shareholders, especially the minority shareholders, also look to independent directors

providing transparency in respect of the disclosures in the working of the company as well as

providing balance towards resolving conflict areas. In evaluating the board‘s or management

decisions in respect of employees, creditors and other suppliers of major service providers,

independent directors have a significant role in protecting the stakeholders interests. One of the

mandatory requirements of audit committee is to look into the reasons for default in payments to

deposit holders, debentures, non-payment of declared dividend and creditors. Further they are

required to review the functioning of the ―Whistle Blower mechanism and related party

transactions. These, essentially, safeguard the interests of the stakeholders. The changes in the

operating environment have raised the stakes on managing business risks. Strong and effective

Corporate Governance is no longer ‘a nice to have’ but ‘a must have’ clause. The shareholders and

the Board should decide as to how many of independent directors would be adequate to have

effective governance for their company. That apart, it has to be appreciated that promoters who have

majority stake in the business and on whose confidence people have subscribed in the company must

have significant representation on the Board. In this perspective, FICCI is of the view that the limit of

independent directors should not be more than 25% including nominee directors. It is to be recalled

that as per the SEBI Regulations, companies will have to comply with the requirements of Clause 49

of the Listing Agreement by December, 2005, which provides for a minimum of 50% independent

directors on the Board. It is, therefore, inevitable that the decision on this aspect expedited to avoid

confusion and uncertainty amongst corporates.

SEBI and PWC:

The Bombay High Court issued its judgment in the case of Price Waterhouse & Co.(PWC) v.

Securities and Exchange Board of India25 where the court ruled that SEBI possesses necessary

24 newsx.com/tag/satyam-scam25 http://indiacorplaw.blogspot.com/2010/08/sebis-domain-over-auditors-of-listed.html

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powers to initiate investigations against an auditor of a listed company for alleged wrongdoing.

In this case the contention was filed by the PWC and its partners and affiliates challenging a

show cause notice issued to them by SEBI pertaining to audit of Satyam Computers and their

alleged failure to detect financial wrongdoing within the company of significant magnitude that

in turn resulted in severe losses to Satyam shareholders. The financial wrongdoing included

overstatement of cash and bank balances, non-existent accrued interest, overstated debtor

position and the like. SEBI’s show cause notice sought to initiate action against PWC under

Sections 11, 11B and 11(4) of the SEBI Act and Regulation 11 of the SEBI (Prohibition of

Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003.

Although PWC raise objections regarding jurisdiction of SEBI before its member, no order was

passed on jurisdiction, which then prompted PWC to file the writ petition before the Bombay

High Court for quashing the pending proceedings before SEBI.

The key questions before the court were:

i. whether the show cause notice issued by SEBI was without jurisdiction so as to require

quashing of such proceedings; and

ii. whether the proceedings initiated by SEBI amount to an encroachment of the powers of

the ICAI under the Chartered Accountants Act.

The court analyzed the powers of SEBI under various provisions of the SEBI Act. It found

various measures were available to SEBI that could be employed in regulating the securities

markets. Those powers were of wide amplitude which would “take within its sweep a chartered

accountant if his activities are detrimental to the interest of the investors or the securities

market”. The court found that by taking remedial measures to protect the securities markets, it

cannot be said that SEBI is regulating the accounting profession. SEBI’s general domain extends

to protecting investors of listed companies and the securities markets. In exercise of such powers,

there is no reason why SEBI cannot prevent any person from auditing a public listed company.

Even though the auditors are not directly involved in the securities markets, the court found that

21

since investors rely heavily on the audited accounts of the company, the statutory duty of the

auditors and discharge thereof “may have a direct bearing in connection with the interest of the

investors and the stability of the securities markets”. The court finally ruled that the powers of

SEBI are independent of those held by the ICAI and hence SEBI cannot be said to encroach

upon the powers of the ICAI under the Chartered Accountants Act.26

The judgment is important as:

it establishes the regulatory domain of SEBI over auditors of listed companies. The court

largely arrives at its conclusions based on an analysis of SEBI’s powers to regulate the

securities market, which is then contrasted with ICAI’s powers to regulate the accounting

profession.

it establishes the role of an auditor to be closely linked with the functioning of the

securities markets. Inherent in this analysis is the fact that proper performance of audit

role in listed companies is a prerequisite for investor protection which is crucial to

maintain robust securities markets. If audit and investor protection are said to be

interconnected, it then takes us to a fundamental legal question: do auditors owe a duty to

shareholders/investors? The Bombay High Court, in this case, appears to answer in the

affirmative.

The last word is yet to be spoken in the matter, since the judgment itself indicates that PWC has

sought to file a special leave petition before the Supreme Court but the affirmation given by the

Bombay High Court clearly shows that even the Indian Judiciary is also willing to take strict

actions against those who may have had any correspondence with the Satyam as they are also not

outside the scope of judicial as well as ‘quasi-judicial’ scrutiny so that what is seeming to be a

bottom-less trench, at least the depth and what is the nature of the issue lying in that trench can

be grasped.

26 ibid

22

CHAPTER IV

SATYAM SCAM & LEGAL PROVISIONS UNDER

COMPANIES ACT, 1956

Section 291 of Companies Act, 1956 provides for general powers of the Board of directors. It

mandates that the Board is entitled to exercise all such powers and do all such acts and things,

subject to the provisions of the Companies Act, as the company is authorized to exercise and do.

However, the Board shall not exercise any power and do any act or things which is required

whether by the Act or by the memorandum or articles of the company or otherwise to be

exercised or done by the company in general meeting.

As to power of the individual directors, unless the Act or the articles otherwise provide, the

decisions of the Board are required to be the majority decisions only. Individual directors do not

have any general powers. They shall have only such powers as are vested in them by the

Memorandum and Articles.

Section 292(1) of the Companies Act, 1956 provides that the Board of directors of a

company shall exercise the following powers on behalf of the company and it shall do so

only by means of resolution passed at meeting of the Board:

1. The power to make calls on shareholders in respect of money unpaid on their

shares;

2. The power to authorize the buy-back referred to in the first proviso to clause (b)

of sub-section (2) of section 77A;

3. The power to issue debentures;

23

4. The power to borrow moneys otherwise than on debentures;

5. The power to invest funds of the company; and

6. The power to make loan.

DUTIES

1. Statutory Duties:

a. To file return of allotment: Section 75 of the Companies Act, 1956 requires a company

to file with the Registrar, within a period of 30 days, a return of the allotments stating the

specified particulars. Failure to file such return shall make the directors liable as .officer

in default. A fine up to Rs. 5000/- per day till the default continues may be levied.

b. Not to issue irredeemable preference share or shares or share redeemable after 20

years: Section 80, as amended by Amendment Act, 1996, forbids a company to issue

irredeemable preference shares or preference shares redeemable beyond 20 years.

Directors making any such issue may be held liable as .officer in default. And may be

subject to fine up to Rs. 10,000/-.

c. To disclose interest (Section 299-300): In respect of contracts with director, Section 299

casts an obligation on a director to disclose the nature of his concern or interest (direct or

indirect), if any, at a meeting of the Board of directors. The said Section provides that in

case of a proposed contract or arrangement, the required disclosure shall be made at the

meeting of the Board at which the question of entering into the contract or agreement is

first taken into consideration. In the case of any other contract or arrangement, the

disclosure shall be made at the first meeting of the Board held after the director become

interested in the contract or arrangement. Every director who fails to comply with the

aforesaid requirements as to disclosure of concern or interest shall be punishable with

fine, which may extend to Rs. 50,000/-.

d. To disclose receipt from transfer of property (sec. 319): Any money received by the

directors from the transferee in connection with the transfer of the company property or

24

undertaking must be disclosed to the members of the company and approved by the

company in general meeting. Otherwise, the amount shall be held by the directors in trust

for the company. This money may be in the nature of compensation for loss of office but

in essence may be on account of transfer of control of the company. But if it is bona fide

payment of damages for the breach of contract, then it is protected by Section 321(3).

Even no director other than the managing director or whole time director can receive any

such payment from the company itself.

e. To disclose receipt of compensation from transferee of shares (Sec.320): If the loss of

office results from the transfer (under certain conditions) of all or any of the shares of the

company, its directors would not receive any compensation from the transferee unless the

same has been approved by the company in general meeting before the transfer takes

place. If the approval is not sought or the proposal is not approved, any money received

by the directors shall be held in trust for the shareholders, who have sold their shares.

Any such director, who fails to take reasonable steps as aforesaid, shall be punishable

with fine, which may extend up to Rs. 2500/-.

f. Duty to attend Board meetings [Section 283(1) (g)]: A number of powers of the

company are exercised by the Board of directors in their meetings held from time to time.

Although a director may not be able to attend all the meetings but if he fails to attend

three consecutive meetings or all meetings for a period of three months whichever is

longer, without permission of the Board, his office shall automatically fall vacant.

g. To convene statutory, Annual General meeting (AGM) and also extraordinary

general meetings [Section 165,166 &169]: It is the duty of every company to hold a

statutory meeting27 and also forward a report28 at least 21 days before the meeting is to be

held which shall contain all the details as to the issued shares and their valuation along

27 S. 165 (1): Every company limited by shares, and every company limited by guarantee and having a share capital,

shall, within a period of not less than one month nor more than six months from the date which is the company is

entitled to commence business, hold a general meeting of the members of the company, which shall be called “the

statutory meeting”.28 S. 165 (2): “the statutory report” means that which the Board of directors shall, at least twenty-one days before

the day on which the meeting is held, forward to every member of the company

25

with the details of the issuer i.e. the directors, the auditors, and the promoters and such

other managerial persons involved in the issue of those shares and raising the capital of

the company. The details of the above-mentioned persons shall also be incorporated in

the report. The report is to be signed by at least two directors of the company and at least

one should be a managing director. Any contravention to this provision may also lead to a

penalty of fine being imposed up to five thousand rupees upon the director or such other

officers of the company.

h. To prepare and place at the AGM along with the balance sheet and profit & loss

account a report on the company‘s affairs including the report of the Board of Directors

(Section 173, 210 & 217).

i. To authenticate and approve annual financial statement (Section 215): Every balance

sheet and every profit and loss account of a company shall be signed on behalf of the

Board of directors either by the people mentioned in the sub-section (2) of section 29 of

the Banking Companies Act, 1949 (in case of banking companies) or by the manager or

secretary along with not less than 2/3rd of the directors present of whom one should be a

managing director if present (in any company other than a banking company).

j. To appoint first auditor of the company (Section 224), to appoint cost auditor of the

company (Section 233B), to make a declaration of solvency in the case of Members

and voluntary winding up (Section 488) are also some of the provisions that bestow

certain duties upon the directors and the officers of the company.

LIABILITY

a. Prospectus: Failure to state any particulars as per the requirement of the section 56 and

Schedule II of the act or mis-statement of facts in prospectus renders a director personally

liable for damages to the third party. Section 62 provides that a director shall be liable to

pay compensation to every person who subscribes for any shares or debentures on the

faith of the prospectus for any loss or damage he may have sustained by reason of any

untrue or misleading statement included therein.

26

b. With regard to allotment: Directors may also incur personal liability for:

i. Irregular allotment, i.e., allotment before minimum subscription is received

(Section 69), or without filing a copy of the statement in lieu of prospectus

(Section 70) - [Section 71(3)] - Under section 71(3), if any director of a company

knowing contravenes or willfully authorizes or permits the contravention of any

of the provisions of section 69 or 70 with respect to all allotment, he shall be

liable to compensate the company and the allottee respectively for any loss,

damages or costs which the company or the allottee may have sustained or

incurred thereby.

ii. For failure to repay application monies in case of minimum subscription having

not been received within 120 days of the opening of the issue: Under section

69(5) read with SEBI guidelines, in case moneys are not repaid within 130 days

from the date of the issue of the prospectus, the directors of the company shall be

jointly and severally liable to repay that money with interest at the rate of 6 % per

annum on the expiry of 130th day. However, a director shall not be liable if he

proves that the default in repayment of money was not due to any misconduct or

negligence on his part.

iii. Failure to repay application monies when application for listing of securities are

not made or is refused: Under section 73(2). where the permission for listing of

the shares of the company has not been applied or such permission having been

applied for, has not been granted, the company shall forthwith repay without

interest all monies received from the applicants in pursuance of the prospectus,

and, if any such money is not repaid within eight days after the company becomes

liable to repay, the company and every director of the company who is an officer

in default shall, on and from the expiry of the eighth day, be jointly and severely

liable to repay that money with interest at such rate, not less than four per cent and

not more than fifteen per cent, as may be prescribed, having regard to the length of

the period of delay in making the repayment of such money.

27

c. Unlimited liability: Directors will also be held personally liable to the third parties

where their liability is made unlimited in pursuance of section 322 (i.e., vide

Memorandum) or section 323 (i.e., vide alterations of Memorandum by passing special

resolution). By virtue of section 322, the Memorandum of a company may make the

liability of any or all directors, or manager unlimited. In that case, the directors,

manager and the member who proposes a person for appointment as director or manager

must add to the proposal for appointment as a statement that the liability of the person

holding the office will be unlimited. Notice in writing to the effect that the liability of

the person will be unlimited must be given to him by the following or one of the

following people, namely: the promoters, the directors, manager and officers of the

company before he accept the appointment. Further, in case of limited liability

Company, the company may, if authorized by the articles, by passing resolution alter its

Memorandum so as to render the liability of its directors or of any director or manager

unlimited. But the alteration making the liability of director or directors or manager

unlimited will be effective only if the concerned officer consents to his liability being

made unlimited. This alteration also, unless specifically consent to by any or all

directors will not have any effect until expiry of the current term of office.

d. Fraudulent trading: Directors may also be made personally liable for the debts or

liabilities of a company by an order of the court under section 542. Such an order shall be

made by the court where the directors have been found guilty of fraudulent trading. Section

542(1), in this regard, provides that if in the course of the winding up of a company, it

appears that any business of the company has been carried on, with intent to defraud

creditors of the company or any other person, or for any fraudulent purpose, the court, on

the application of the Official Liquidator, or the liquidator or any creditor or contributory of

the company may if it thinks it proper so to do, declare that any persons who were

knowingly parties to the carrying on business in the manner aforesaid shall be personally

responsible without any limitation of liability, for all or any of the debts or other liabilities

of the company as the court may direct. Further, section 542(3) provides that every person

who was knowingly a party to the carrying on of the business in the manner aforesaid, shall

28

be punishable with imprisonment for a term which may extend to two years, or with fine

which may extend to fifty thousand rupees, or with both.

LIABILITY OF RAMALINGA RAJU AS A DIRECTOR

Criminal Charges against Raju: Satyam founder Ramalinga Raju and his brother Rama Raju

were arrested as part of the crackdown by state authorities and the central government, which

disbanded the tainted IT firm‘s board on a day of fast-paced developments. Raju was arrested

and has been booked in a case of financial irregularities, Additional Director General of CB-CID

A.S. Shivnarayan said minutes after the police action. ― both are in our custody. A case has

been registered and we will produce them before the court within 24 hours, Kaumudi told

reporters outside the office Director General of Police, Andhra Pradesh.

The 54-year-old Raju, who stepped down as chairman after admitting to the fraud and Rama

Raju, who resigned as CEO and MD of the company, were arrested under five sections of the

Indian Penal Code—section 120B for criminal conspiracy, section 420 for cheating, section 409 for

criminal breach of trust, section 468 for forgery and also section 471 for falsification of records. All

the charges are non-bailable offences.29

In addition, under the Companies Act, Depositories Act and the Listing Agreement, SEBI will have a

cause of action for violation of mailing a false annual report to the shareholders. As Satyam’s ADSs

are listed on the New York Stock Exchange, action may also be taken in the US, including by the

SEC. The company may face a class action lawsuit by its US shareholders.7 Mr. Raju and his brother

could be proceeded against under the various provisions under the Companies Act, 1956 and the

Indian Penal Code for fraud, falsification of accounts and breach of fiduciary duties as a director. In

addition, they could also be proceeded against for having violated the rules, regulations, laws and

bye- laws of the stock exchanges and SEBI - in particular, the Listing Agreement. Since Satyam is

listed on the New York Stock Exchange, they could also be prosecuted under applicable law of the

United States of America. In addition to the above, there could also be criminal proceedings and civil

shareholder lawsuits that could be brought against him and his brother in India and in the US.

Further, the news reports seem to suggest that the Government is considering referring the matter to

29 http://www.livemint.com/2009/01/09225139/Satyam8217s-Raju-brothers-a.html

29

the Serious Frauds Investigation Office and also mulling a concerted series of actions involving the

SEBI, stock exchanges, Company Law Board etc.30

Mr. Raju and his brother could be prosecuted under S. 477A of the Indian Penal Code, 1860 for

falsification of accounts and under S. 418 and S.420 of the Indian Penal Code, 1860 for cheating

with knowledge that wrongful loss may ensue to person whose interest offender is bound to

protect. In addition to the above-mentioned provisions, certain other provisions of the Companies

Act to provide for imprisonment for violations by the directors and officers in default may be

attracted. In addition, they could also possibly be prosecuted under Section 406 of the IPC for

criminal breach of trust.

Under Section 621 of the Act, violations of the sections of the Act are cognizable offenses and

are therefore bailable. However, the offenses may be compounded which may lead to more

serious charges.

The offence under S. 477A of the IPC carries a maximum punishment of 7 years imprisonment

and/ or fine and is non- bailable. The offence under S. 418 of the IPC carries a maximum

punishment of 3 years imprisonment and/ or fine and is bailable. The offence under S. 406

carries a maximum punishment of 3 years imprisonment and is a non-bailable offence. The sons

do not seem to be directly implicated since they are involved with Maytas and not with Satyam.

Raju in his letter states that none of his immediate family members had any knowledge of the

fraud.

The entire board of Satyam will share liability. Although Raju in his letter states that the other

board members were not aware of the fraud, the independent directors will still face liability

questions because they will have to prove that they were not in breach of fiduciary duty. The

independent directors also owe a duty of care and a fiduciary duty to the shareholders of the

Company. Unless the facts on record indicate that they were aware of the fraud or that they were

blatantly and grossly negligent in their duties, it may not be possible to bring any proceedings

against the independent directors. If they had not been aware of the falsification of the financial

30 http://satyamscam.in/2009/01/satyam-scam-and-its-legal-implications/

30

records of the company, one could not hold them responsible for relying on the genuineness of

the accounts as provided to them, as they had been audited by a reputed accounting firm.

CHAPTER V

SATYAM SCAM: LEADING THE PATH FOR

MORE SUCH FRAUDS

In India the Satyam scam may be grabbing the headlines, but corporate frauds are likely to be

uncovered in many countries. In the leading capitalist economy, the United States, such

corporate frauds have been rising sharply in recent years, according to data from the official

investigating agency, as the accompanying chart shows. Between 2001 and 2007, the number of

corporate fraud cases that were opened by the FBI (covering both corporate fraud per se and

securities and commodities fraud) increased by 43.7 per cent, even though convictions barely

increased. And in 2008, the number of scandals that has come to light, and the sheer extent and

audacity of several of them, almost defy description.

A quick look Enron case can help one understand how these frauds have started to occur or

happen.

Enron:

The scandal of Enron was the gigantic scam that has unfortunately set the bar for all the

other scandals that have followed since 2001. This was a financial scandal that could

occur because energy sector liberalisation and financial deregulation in the US allowed

for trading in electricity and natural gas futures, partly because of intense lobbying by

Enron and similar firms. While the resulting energy price volatility adversely affected

consumers, it delivered high speculative profits to what was originally a power

generation firm but rapidly became dominantly an energy trading firm. Enron then

created as number of offshore subsidiaries, which provided ownership and management

31

with full freedom of currency movement. This also allowed any losses in such trading to

be kept off the balance sheets. As a result, Enron appeared to be much more profitable

than it actually was. Naturally its share price also zoomed, allowing the managers to

benefit from the capital gains that they received from their employee-stock options and

performance-related bonuses. It is easy to see how this created a dangerous spiral: those

handling the finances had major incentives (and then increasingly felt extreme pressure)

to cook the books so as to show growing profits, even as the company was actually losing

money.

As the dotcom boom in the US finally went bust in 2000, it became even harder for

Enron’s managers to carry own with this creative accounting, until at last it became

impossible to keep up the pretence. Ultimately the company could not even be

restructured but had to be liquidated. Thousands of Enron employees lost not only their

jobs, but also their savings and pensions, which were tied up in company stock. Fourteen

of the company’s managers were accused, faced trial and sentenced on various charges of

fraud, misleading the public, insider trading and other malfeasance.

The role of the auditing company – Arthur Andersen, one of the then Big-Five

accounting companies – obviously came under scrutiny. Remarkably, however, it was

found that it could not be held legally responsible for what was clearly criminal

negligence and dereliction of duty over a prolonged period. Instead, the only charge that

could be brought against it was obstruction of justice, for shredding documents related to

its audit of Enron. And even that was overturned by the Supreme Court in 2005 on

grounds of flaws in the instructions to the jury! However, because the US Securities and

Exchange Commission did not allow it to audit public companies, it could not retain

viable business and the company collapsed.

Adelphia Communications Company:

Another scandal of that period that has even more similarities to the Satyam case is that

of Adelphia Communications Company, which was earlier celebrated as a rags-to-riches

story of two brothers (John and Timothy Rigas) who had originally founded the company

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on the basis of a $300 cable license. When the company declared bankruptcy in 2003

because it was forced to disclose more than $2 billion in off-balance-sheet debt, it

emerged that the Rigas brothers had used complex financial and cash management

practices to transfer money to various other family-owned entities. In addition, federal

prosecutors successfully accused them of salting away at least $100 million personally.31

Refco:

Similarly, the Refco case related to what would earlier be called straightforward

embezzlement but is now seen as a complex system of sophisticated financial

irregularities. Refco, a finance company that specialised in commodities and futures

contracts, was a private company that went public in the August 2005. Its share prices

immediately rose by more than 25 per cent because of its apparent history of high

profitability. In October 2005, just before its collapse, it was the largest broker on the

Chicago Mercantile Exchange. Refco’s downfall came about when it emerged that its

Chief Executive Officer, Richard Bennett, had hidden about $430 million of bad debts

from both the rest of the company’s board and its auditors. He was able to do this through

the simple and ridiculous expedient of buying bad debts from Refco, so as to prevent the

company from having to write them off, and then paying for these bad loans with money

borrowed by the company itself!

What is most extraordinary about the Refco case is that this fraud was revealed only a

few months after the company had made its first initial public offering (IPO) of shares.

Before such a public listing, due diligence and detailed examination of accounts are

required of the investment banks that manage the IPO. In Refco’s case, the IPO was

handled by the top names in banking: Goldman Sachs, Credit Suisse First Boston, and

Bank of America. Yet none of them had uncovered this huge hole of $430 million in bad

debt that the CEO declared within a couple of months, nor had they even noticed the

peculiar practice that the CEO had used to cover it up. So in this instance it was not just

the auditors (the smaller accounting company Grant Thornton) that were found to be lax

31 http://www.networkideas.org/news/feb2009/news02_Corporate_Frauds.htm

33

and inadequate to the task. While Richard Bennett was sentenced to 16 years in prison in

2008, no action was taken against any of the others involved who had been at best very

derelict in their duty.

Various examples of past and present show that there are bright chances of the corporate fraud

even after Satyam incident as they are neither new nor they are going to become new because the

procedure may be different from time to time but it is the investors who to bear the brunt.

Comverse Technology :

In 2006, Comverse's founder and former Chairman and CEO, Jacob “Kobi” Alexander

and two other former executives, former chief financial officer David Kreinberg and

lawyer William Sorin reported manipulated stock options for their personal gain and

operated slush funds. As part of the scheme, the former executives misguided investors

about New York-based Comverse's stock option grants. The result, Comverse, a maker of

software, systems and related services for multimedia communication and information

processing applications overstated its net income and earnings per share between 1991

and at least 2002.

The three former executives allegedly earned millions of dollars and face multiple

charges of conspiracy, securities fraud, wire fraud, mail fraud, money laundering and

making false filings to the Securities and Exchange Commission (SEC).32 Back dating of

stock options is reported to have victimised Comverse shareholders and prospective

investors.

Alexander, an Israeli citizen, was arrested in Namibia in September 2006. He is free on

bail while the US awaits his extradition to try him on account of 35 criminal counts

related to securities fraud, including stock-option backdating. Alexander reportedly plans

to plead not guilty to these charges. He recently won a Namibian court bid to postpone an

extradition hearing until March 4, 2009.

32 http://sec.gov/news/press/2006/2006-137.htm

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Siemens:

In 2006, Reinhard Siekaczek, a former senior manager of the German group Siemens

received a two-year suspended prison sentence and was fined $128,349 for creating slush

funds and companies to acquire contracts abroad. Siemens accepted that the scandal

involved nearly $1.8 billion described as unclear payments. Siekaczek admitted to his

crime and told the court that although he tried to stop the organised bribery, top managers

did not take action. The judge said it was not clear whether those executives were also

involved or had received the payments. Heinrich von Pierer, the former chairman, and

Klaus Kleinfeld, who took office as chief executive, lost their jobs following the scandal,

which surfaced in November 2006. However, they denied any involvement and were not

charged with any misappropriation. 

Computer Associates:

In 2004, Sanjay Kumar, former CEO of Computer Associates was found guilty of being

part of a $2.2 billion accounting scandal. He was tried for charges including conspiracy,

securities fraud and hindering justice. Kumar was accused of developing a company

practice called the “35-day month”, in which the sales people were asked to complete the

deals after the quarter and take out the timestamp from papers. This was done with the

intention of inflating the company’s software sales figures to meet analyst expectations.

According to charges against Kumar, he also encouraged the company’s employees to

misinform the prosecutors and the SEC lawyers when the government began the

investigations in 2002. Kumar was sentenced to 12 years and was fined $8 million for

false reporting software licence revenues and for lying to investors. Five other former

executives of the company also pleaded guilty to charges of fraud. Computer Associates

entered into a deal between Computer Associates and government investigators to protect

the company against prosecution.

WorldCom:

The former CEO of WorldCom, Bernard Ebbers, was found guilty of the $11 billion

scam that led to the fall of the company in 2002. This is considered the biggest corporate

fraud and bankruptcy in the history of the US. Ebbers was blamed for being over-

35

enthusiastic about maintaining the company’s share price high. According to the US

government, Ebbers instructed chief financial officer Scott Sullivan to conceal billions of

dollars in unmanageable expenses and recognize illegal revenue from 2000 to mid-2002.

Ebbers faces charges of securities fraud, conspiracy and charges of making false filings to

the SEC, which can bring imprisonment of up to 85 years.

Interestingly, the Satyam saga is similar to the Global Trust Bank, whose rise and fall

was a story in itself.33 The edifice of GTB was built on falsified accounts in an attempt to

shore up valuations. The scandal surfaced when its then head Ramesh Gelli tried to

diversify into insurance by making an honourable exit from the bank. But that did not

happen and GTB was ultimately merged with the Oriental Bank of Commerce.

Even in the Global Trust Bank case, the auditors were none other than

PricewaterhouseCoopers and the Reserve Bank of India had then imposed a ban on their

auditing bank accounts.

What Ramalinga Raju attempted and failed is exactly the same. Whatever be his public

pronouncements, the promoters tried to maintain a high valuation for the company and to

ensure this the books were fudged. Just as Gelli tried, he sought to wriggle himself out by

moving into real estate and infrastructure by buying the two Maytas companies. When

the deal was stalled, his fate was sealed. The other interesting element in the story is that

both these shares – GTB and Satyam – figured among the 10 scrips that were operated by

Ketan Parekh (named as KP 10) in the infamous stock market scandal years ago.

According to a KPMG survey, India Fraud Survey 2008, the trend of corporate fraud and

misconduct is likely to continue. The respondents of the survey believed that the maximum

potential of committing fraud existed within the organizations including the senior management

and the employees. According to the survey, the inherent responsibilities and trust associated

with senior positions, ability to override internal controls, internal knowledge and access to

confidential company information that came with managerial position created a risk that of fraud.

The survey found that the most prevalent form of theft would be IP or frauds related to e-

commerce and IT.

33 http://www.bullrider.in/satyam-scam-raju-pwc/

36

With the overall incidence of frauds rising in corporate India, there is a need for India Inc to deal

with fraud risks firmly. “The overall incidence of fraud is rising in corporate India in the last two

years,” the KPMG Fraud Survey Report 2010 said. Survey responses, specifically from the

financial services and consumer markets industry segments, see a higher level of fraudulent

activities within their industry.

The survey indicates ‘procurement’ and ‘sales and distribution’ as the most vulnerable areas

across industries susceptible to fraud risk. “The need of the hour is for organisations to realise

the importance of putting effective internal control mechanisms in place, so as to manage risks,”

KPMG Forensic Head, Deepankar Sanwalka, said. “Accountability is no longer restricted to a

company as a whole but also streams down to each and every individual. It has become

imperative for companies to be vigilant and aware and not just act when fraudulent situations

arise,” he said.

Financial statement fraud emerges as a major issue for investors. An overwhelming 81 per cent

of the respondents of the survey perceive financial statement fraud as a major issue in India.

Ineffective whistle-blowing systems, inadequate oversight of senior management activities by

the audit committee and weak regulatory oversight mechanisms are the reasons for the growing

worries as well as the increase in the number of frauds that one can see in the industry today, the

report said.

“Managing the risk of fraud is essentially no different to managing any other type of business

risk. All that it requires is resilience to combat that fraud,” KPMG Forensic Executive Director,

Rohit Mahajan, said.

Bribery and corruption have come to be viewed as an inevitable aspect of doing business in India

by many Indian companies, the report said. Almost 38 per cent of the respondents believe that

bribery is an integral feature of industry practises and is most rampant in seeking routine

regulatory approvals and to win new business from prospective clients, it revealed. According to

53 per cent of the respondent companies, e-commerce and computer-related fraud will be a

source of major concern in the coming years with supply-chain fraud, a close second followed by

bribery and corruption and intellectual property fraud, the report said. However, whatever be the

37

type of fraud, 75 per cent of the respondents indicate that, except intellectual property (IP) fraud,

fraudulent activities were perpetrated by employees, reaffirming that the enemy within poses the

highest risk, it said.

These events in history show a deceitful tendency spurred by excessive pressure to meet “analyst

expectations”. The question is whether the Satyam episode will make other executives focus on

productivity rather than resorting to such malpractices, or whether stringent regulations are

required to protect investors.

PART D

SATYAM SCAM: Concluding Remarks on

‘REFORMS’ OR ‘NO REFORMS’?

Companies Bill, 2008 points to a new era when maybe it will be easier to tackle frauds like

Satyam as the crux of the Proposed Bill is to strengthen the position of ‘Independent Directors’

and at the same time also enforce stringent norms for corporate governance issues. In this respect

certain key areas of the Bill have been highlighted below:

The Bill requires public listed companies above a prescribed size to reserve a third of all

seats on the board for independent directors. It requires that independent directors (or

their relatives) not do business with the company which amounts to more than 10% of the

turnover of the company in the past two years. Permitting financial transactions with the

company up to this point creates a potential conflict of interest. The listing agreement

under the SEBI Act prohibits independent directors from a material financial relationship

with company but does not define the term ‘material’.

Unlike the 1956 Act, the Bill limits the number of directors on the board of a company to

twelve, excluding the nominees of lending institutions. Specifying a cap goes against the

38

stated objective to “provide a framework for responsible self-regulation” by allowing

decisions to be left to shareholders.

The Bill prohibits auditors from providing certain services, such as accounting and

financial services; to companies they audit in order to prevent conflict of interest. While

prohibiting the same range of services as specified in the Bill, the 2003 Amendment Bill

(now withdrawn) also allowed the government to add to the list of prohibited services.

The 2008 Bill does not give the government the flexibility to notify other prohibited

services.

The 1956 Act restricts transactions between a company and its directors, and certain other

entities, on the grounds of possible conflict of interest. Government approval is required

in most cases. The Bill restricts such transactions only for public companies but broadens

the definition of a related party to include managers of the company. The approval of

shareholders, rather than the government is now required which means that share-holders

have more say in these matters now.

The Bill does not require that the partners of a firm which audit the company be rotated

on a periodic basis. The Naresh Chandra Committee had recommended compulsory

rotation of audit partners of a company every five years. The Irani Committee, however,

had suggested that such decisions be left to shareholders of the company34

The Bill requires all listed companies above a prescribed size to reserve a third of all

seats on the board for independent directors. Clause 49 of the listing agreement under the

SEBI Act, which companies sign with stock exchanges, require those companies with a

non-executive chairman to reserve one third of all seats on the board for independent

directors. Those companies with an executive chairman must reserve half of all seats on

the board for independent directors

Thus, it can be seen that the government is also striving hard to maintain status-quo in the market

of India and at the same time protect the interest of the investors but not at the cost of placing

unreasonable restrictions upon the Board and its members except to the extent of placing only

34 Clause 127 of Companies Bill 2009

39

certain restrictions which are necessary. In comparison with developed countries that impose

stringent penal and criminal consequences for poor corporate governance, penalty levels in India

are considered to be inadequate to enforce good governance. 71 percent of the respondents

considered penalty levels to discipline poor and unethical governance to be low. 22 percent of

the respondents were either undecided or did not know if the penalty levels are low.35 These

statistics reflect the minds and thoughts of the legislators and the need of the hour to bring some

new laws to effectively curb these economic offences.

The Satyam scam may be grabbing the headlines in India, but corporate frauds are likely to be

uncovered in many countries. In the leading capitalist economy, the United States, such

corporate frauds have been rising sharply in recent years, according to data from the official

investigating agency, as the accompanying chart shows. Between 2001 and 2007, the number of

corporate fraud cases that were opened by the Federal Bureau of Investigation (covering both

corporate fraud per se and securities and commodities fraud) increased by 43.7 per cent, even

though convictions barely increased. And in 2008, the number of scandals that have come to

light and the sheer extent and audacity of several of them almost defy description. This is

remarkable because after the huge corporate accounting scandals of the early part of the decade,

exemplified by the Enron scandal and the subsequent exposure of significant firms such as

WorldCom, Adelphia and Peregrine Systems, the U.S. government took steps to enact legislation

that would regulate corporate markets specifically to prevent such frauds.

The Sarbanes-Oxley Act, which was passed by the U.S. Congress in 2002 and is officially

known as the Public Company Accounting Reform and Investor Protection Act of 2002, was

meant to strengthen and tighten corporate accounting procedures. It established a new quasi-

public agency to oversee, regulate, inspect and discipline accounting firms in their roles as

auditors of public companies. It also specified tighter rules for corporate governance, including

internal control assessments and enhanced financial disclosure.

All this, it could be supposed, would operate to prevent any Enron-type scandals from occurring

at all. Indeed, those who opposed the Act argued that it created a complex, over-regulated

environment for U.S. companies and that it reduced their competitive edge over foreign firms. It

35 “The State of Corporate Governance in India: 2008” Report available at “in.kpmg.com”

40

now turns out that far from being too restrictive, if anything the Sarbanes-Oxley Act was not

effective enough. After the spate of corporate financial scandals that actually resulted in the

collapse of several companies in the early part of the decade, corporate fraud has apparently

continued almost unabated even in the U.S. One reason for this may have been in the design and

implementation of the law, which did not take into account the crucial features of such scams,

and the structure of incentives that both allowed and encouraged such malpractices to occur. 36 It

may be also thus concluded that looking for a solution in line with the laws of the developed

countries may not be truly fruitful in nature as it might not lead to the desired result or even

prevent such corporate frauds.

Financial crimes are no less heinous than the crimes dealt with by the Code of Criminal

Procedure. Need a new law to tackle such financial crimes is inevitable. It is a sad fact of life that

the Economic Offences Courts, set up with much fanfare two decades back, have proved a damp

squib. The ICAI has been dormant for several decades as can be seen from the fact that in the

first two decades of the formation of the accounting standards board, the ICAI issued only 15

accounting standards; it woke up in the past two years and rushed with 12 more standards and

more are in the offing.

Whereas these standards were not mandatory in the initial years SEBI has made it compulsory

for the entire corporate sector to fall in line and comply with these accounting standards. It is in

this context that the need for internalising our accounting standards arises. One can also emulate

the US example (though their scenario is also writ with numerous scams and frauds) and

establish a permanent Public Accountability Board. It is also necessary that SEBI is vested with

powers similar to those enjoyed by the SEC in the US.

36 “While corporate fraud can impose significant costs on the economy when left unchecked, the evidence shows that

market mechanisms discipline much bad behaviour while the criminalisation of corporate behaviour, coupled with

bringing highly complex cases before juries that can neither understand the issues nor their instructions, imposes

significant costs on the economy by deterring socially efficient risk-taking behaviour by corporations and their

executives.... The result is harm to the general public, whose members depend on a dynamic, competitive economy

for their welfare.” (Howard H. Chang and David S. Evans, “Has the pendulum swung too far?” Regulation, Volume

30, No. 4, Winter 2007-2008.) available at Frontline “Hall of shame international” by Jayati Ghosh [Volume 26 -

Issue 03 :: Jan. 31-Feb. 13, 2009]

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