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India's lessons from Satyam

26 January 09 13:20 GMT

By Kaushik Basu
Professor of economics, Cornell University

What a tragic fall. B Ramalinga Raju, founder of Satyam Computer Services and an icon of India's software success, is now a prisoner in Hyderabad's Chanchalguda jail.

It appeared initially that he had committed the crime he confessed to - namely fudging the balance sheets of his company to show higher profits and greater reserves in order to bolster shareholder confidence and rake in more investor money.

It turned out, however, that he had not committed that crime. His company did have the large profits and reserves he had shown on the books.

The alleged crime now is that he pilfered that money - an astonishing $1bn (£720m). If so, the shareholders would not have been deceived with wrong information but would simply have had their money stolen.

Ponzi fraud

But if it is this crime, it could actually be a saving grace for India.

By turning out to be not one of those budget-fudging crimes that leave investors and customers wondering if the entire industry is tainted, this may do less damage to the larger reputation of India's software industry.

Nevertheless, now that India, with all its recent economic reforms, is breaking away from the shackles of the Licence Raj (the red tape required for business between 1947 and 1990) it has to be prepared to grapple with the more novel crimes associated with market capitalism - the crimes that come from giving more licence to the Rajus.

The fundamental crime that appears in a variety of forms in modern market economies and is often difficult to detect because it can appear in so many guises is the Ponzi scheme.

It is possible to argue that what Ramalinga Raju initially claimed was that he was guilty of a Ponzi fraud.

The classic Ponzi is what was recently allegedly performed by America's Bernard Madoff. His investment company collapsed with an outstanding liability of $50bn, leaving hundreds of thousands of investors stranded with all their money gone.

He promised investors high returns. Then, instead of using the money received from investors to create wealth, he allegedly kept a large part for himself, got more money from new investors and used this to pay the promised high returns to the early investors.

As his reputation spread, more and more people gave their money to him and he continued with the same strategy. With each wave of fresh money received, he allegedly kept a large share for himself and used the rest to pay off old investors.

The trouble with this scheme is that it can survive only by continuously expanding the number of investors.

Since human population is finite, it is a matter of arithmetic that a Ponzi scheme has to eventually collapse.

That happened in the case of Bernie Madoff; that happened to Charles Ponzi (1882-1949), who has the honour of having this particular fraud named after him, though schemes of this kind go back to antiquity; it also happened to those who ran Calcutta's infamous Sanchaita Finance Company in the 1970s.

What makes Ponzis difficult to detect is that they often come intertwined with serious investment.

Productive company

Take a company like Satyam.

To start with, this is a productive company that actually converts investor money into valuable goods and services. Suppose in a year of faltering profit, this company nevertheless gives out good returns to its shareholders by utilising the money received from new investors.

It is now beginning to mix productive activity with Ponzi. In fact, since the new investment is not used productively, but to pay off early shareholders, it is possible that, by this very act, the next year's profits will be low and the company will be under pressure to expand its Ponzi activity.

Such hybrid-Ponzis are difficult to identify. After all, companies occasionally do some returns-smoothing to stabilise some of the year-to-year profit fluctuations.

In small measure this does no harm, and can in fact be a desirable form of insurance against market vagaries.

It is when this practice becomes addictive that one is in trouble.

Just as there is no easily detectable time when a heavy drinker becomes an alcoholic, the start of corporate budgetary crimes is difficult to pin down.

These are some of the hazards that India has to be prepared to deal with. One hopes that a part of the safeguard against this will be the individual integrity of business leaders.

But, as we know from history and experience from around the world, there will always be the black sheep in a group, whether it be the software sector, pharmaceuticals or banks; and for this a newly industrialising nation needs carefully crafted laws and continuous vigilance.

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Here are some of your comments.

The Satyam scam has been rightly called "India's Enron". After Enron, the popular wisdom on Wall Street was:" If you see one cockroach on the floor, there are bound to be others hiding under the mat!" This so-called "Cockroach theory" has been proven to be very valid even now during the current financial crisis worldwide. More cockroaches have been found almost daily all over the world, even in countries where everyone believed they did not exist. Given the traditional and long-standing tenacity of endemic corruption existing at all levels of Indian society - both in politics and especially in India's corporate sector - I will not be surprised if you would find an army of cockroaches under the mats of every business house in India. Does India Inc have the courage to look under the mats?
S. Kumar, Finland

Give it a break, not everybody is clean and above board, people make mistakes and this thing about Indians being criticised the most when they do something wrong is ridiculous. If somebody in the West does the same it does not even make headline news for more than a day. Look at the recent financial crisis and the Iraq war cock-up, nobody is complaining or writing articles too much on these topics! I think we should learn from our mistakes and highlight what is being done to mitigate them, not write article after meaningless article which ultimately serves no purpose.
Yadu Mandayam, London, UK

I am astonished that everyone in India seems so surprised and shocked about the Satyam scam. Corruption is ingrained in India's fibre and this culture of corruption is the foundation for the country's politics. Even with the Satyam scandal the grubby fingerprints of the state's political leadership is so clear - however, the media conveniently skims over this fact. I am a retired "big four" accounting firm partner and was talking to a senior partner of an accounting firm in Bangalore. His opinion was: "The only corporate entities who are clean and whose accounts you can trust are the Tatas and Infosys."
Bobby Zachariah, India

The Satyam fraud is indubitably the biggest ever corporate scam witnessed by India Inc. The phenomenon is worthy enough to be coined as "Corporate Terrorism". We have begun to live in an era of unprecedented capitalism and the time is right to enact special laws and set up fast track courts to quickly bring corporate terrorists and their henchmen to justice. Another thing that requires a fix is the "system". If you provide a tool that can be misused, it shall be misused. A stark example of this is the gun culture of the West. There the tool is the gun misused in schools, here the tool is the "system" misused by corporate terrorists.
Meetul Kinarivala, India

I think the author is getting carried away and is not aware of the ground realities. The fraud in Satyam is not because there were no profits. The profits were always there but only thing is the promoter siphoned off money and invested in real estate. This a plain case of robbery, the only difference is that the thief was in midst of everyone, wearing costly suits and travelling in luxury cars.
Subramanyam, India

If people are to be instilled with confidence that Indian commerce is being regulated in a sound manner, than the trials of the accused have to be conducted in an honest manner. The usual traditions of evidence disappearing, witnesses recanting, and cases being stretched for ten years can't be done here.
Ashwin K. Sethi, Singapore

Nice article highlighting crucial areas. In India and in western countries, the more the company makes money the less the controls are exercised. This sort of hero-worship culture has to stop. Every auditing company should have a fraud section with wider powers to highlight, help, warn and ultimately take to court the culprits, however senior or respectable they may be. All his assets, even if written in trusts for all his relations, should be frozen and used for paying employees salaries.
V Subramanian, UK

I would not be very surprised to hear some more stories like Satyam unfolding in a country where the private sector is very ambitious/strong and the government is not aggressive enough. The benefits of free market are many, but when completely unchecked, the consequences can be dreadful. The Indian government should step up, keep up with the huge potential of its private sector, but at the same time should make strong financial regulations so that the economy will continue to prosper with less stumbles like Satyam.
Sandeep Gautam, Nepal

Show no mercy to such scoundrels who tarnish the image of the corporate world. The full force of law must serve the most stringent deterrent punishment. This will present an example and will prevent others from following in Raju's footsteps.
Satish Kelkar, India

Well, Satyam's case is also a warning for: a. Role of directors - who were all respected names and kept their eyes and ears closed as they sat on the board and never questioned b. Auditors - What were the auditors doing c. Banks - Banks which were supposedly holding Satyam's money in their bank accounts, which turned out to be non existent d. Dependency on one IT provider: Companies will now think twice before awarding their whole IT operations to one service provider.
ash, london

This correspondence is now closed.

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