Introduction
The Satyam scandal is considered one of the largest corporate fraud cases in Indian history. At the time of the scandal, the firm was India’s fourth-largest company in the IT industry. One of the attributes of Satyam’s success was its corporate governance. In 2002, Satyam was awarded the “Golden Peacock National Award for Excellence in Corporate Governance” (Gaur and Kohli 1). It was rated as the best corporate governance company in 2007 (Gaur and Kohli 1). However, in 2009, the CEO, Ramalinga Raju, announced that Satyam had been engaging in fraud by altering the books of accounts to overstate the company’s revenue and profits (Gaur and Kohli 5). This paper analyzes the circumstances that led to the exposure of the Satyam scandal. It also evaluates the critical role of corporate governance in preventing financial scams and makes recommendations regarding the best practices in corporate governance.
Circumstances of the Exposure of the Satyam Scam
The circumstances of the scam’s disclosure involved an investment that did not take place and an anonymous email pointing to the company’s involvement in financial fraud. Before the revelation, Raju proposed to the board to make a significant investment in Maytas Properties and Maytas Infrastructure (Gaur and Kohli 4). The board approved the proposal, but the investors opposed it. It was later revealed that Raju’s family had a 35-36% stake in these companies (Gaur and Kohli 4). Although the investment was canceled, Raju’s family’s involvement in the frustrating deal raised concerns about the company’s corporate governance. The anonymous email sent later to the board confirmed the public suspicions and led to the uncovering of the fraud.
One can identify two reasons that led to the financial fraud at Satyam. First, it occurred due to market pressure experienced by the management of the company. Raju claimed that he initiated the fraud to protect the company from a potential hostile takeover (Gaur and Kohli 5). As Soltani notes, managers may misrepresent the company’s financial performance when the market conditions become tough but investors’ expectations remain high (256). Although Raju could inform the investors about problems in the company’s financial performance, he chose an unfair alternative course of action – to mislead investors by faking the company’s financial statements. Another reason for this financial fraud was the wish to gain personal financial benefits from the scam. Raju claimed that he did not benefit from the accounting irregularities. However, before the fraud exposure, Raju reduced his ownership stake at Satyam from 20.74% in 2003 to 8.74% in 2008 (Gaur and Kohli 5). Moreover, it was found that Raju’s family owned several other businesses. Given these two facts, one can assume that Raju could use the fraudulent money to establish other family companies.
The fraud was able to occur because the board and internal and external auditors did not perform their work properly. For example, the board did not pay attention to a significant decrease in Raju’s ownership stake. Further, auditors failed to discover that Raju’s family had 327 other companies that were not registered in the stock market, meaning that they were not obliged to follow corporate governance practices (Gaur and Kohli 6). One reason for external auditors’ turning the blind eye to the company’s financial irregularities was unusually high fees that were twice as high as the average payments received by similar companies (Gaur and Kohli 6). Thus, although Satyam’s corporate governance was seen as effective, it was poor, enabling Raju to commit his fraud.
Mechanisms of Corporate Governance at Satyam
The Board of Directors
The board of directors was one of the corporate governance mechanisms employed at Satyam. The board involved five independent directors and four internal board members. However, two of the board members were relatives – brothers Ramalinga Raju and Rama Raju – who were also the founders of the company. Yet, Satyam’s corporate governance was formed in compliance with the Indian regulations on governance standards. Its main role was to develop policies and mechanisms to achieve the company’s long-term objectives and serve the interest of all the stakeholders.
The board of directors should be characterized by transparency, independence, and financial accounting ethics, including integrity and truthfulness in making financial reports. Although Satyam was rated as the company with the best corporate governance, its board of directors did not adhere to these standards. For instance, the directors did not notice any unusual financial statements within the company. The firm’s CEO admitted that the board was unaware of the overstatement of the revenue and profits that the company was practicing. The board’s unawareness can be regarded as the negligence of duties and a possible collaboration with the major suspects in the Satyam scandal.
The Audit Committee
The company had compensation and audit committees composed of four independent directors each. The Satyam audit passed through three stages, including the company’s Chief Financial Officer’s internal audit and the external auditing conducted by PricewaterhouseCoopers. The company’s audit committee would conduct the final audit, monitored by an independent board member. However, all three levels failed to report any cases of financial malpractice, which would reveal the fraud in its initial stages (Gaur and Kohli 6). Auditors are required to provide an honest opinion of the company’s financial statements and are authorized to enquire about any official of the company (Gurung and Gupta 7). Yet, even given such authority, the audit committee was not able to identify fraud. This failure by the audit committee at all three levels raised the question of a possible collaboration between the auditors and the management board.
Recommendations Regarding Governance Mechanisms
One recommendation concerning corporate governance is related to the company’s board of directors. According to Hitt et al., an effective good corporate governance practice is a separation between ownership and management (314). However, it can also lead to a conflict of interests between shareholders and managers because the latter can make decisions in favor of their interests rather than those of shareholders (Hitt et al. 315). Managers tend to act in their self-interest when the corporate governance is weak and the board does not control managerial autonomy (Hitt et al. 319). Therefore, to prevent financial fraud, the company’s board of directors should direct and control strategies adopted by managers to ensure that they comply with shareholders’ and stakeholders’ interests.
Second, independent directors should serve limited terms to prevent the development of conflict of interest. Most independent directors serve unlimited time and, therefore, become attached to their positions, which influences their ability to make competent decisions (Hitt et al. 320). Long-serving independent directors should be reappointed as non-independent, and their positions should be given to newly appointed independent directors to serve for a certain period. This will promote transparency and integrity within the board and improve the monitoring of the core organizational activities.
Additionally, executive compensation should be used wisely as a corporate governance mechanism. According to Hitt et al., managers can use earnings manipulation to increase their wealth when stock options incentives are used for executive compensation (325). A proposed solution to this problem is to impose limits on managers’ ability to sell stock when risk factors for fraud are present (Johnson et al. 143). This is meant to discourage independent directors from falsifying the company’s financial performance.
The case of Satyam also presents several lessons about auditing. First, the audit committee needs to be more operative and vigilant to be able to detect any financial issues with the organization’s reports early (Soltani 265). Second, the audit committee should not be comprised mainly of insiders. As Johnson et al. note, if insiders are the majority of the audit committee, it reduces the likelihood of managers being caught, which encourages them to engage in financial misconduct (117). Lastly, the audit committee should be given more power to access all the critical information in the company that may influence the financial reports. This may include having the power to initiate internal control measures when there are issues detected in the organization’s financial reports.
Lastly, Satyam’s case shows that there is a need to establish takeover defenses to reduce the likelihood of managers committing fraud. According to Shi et al., using such takeover defense provisions as poison pills increases managers’ intrinsic motivation and allows them to focus on strategic decisions that will result in long-term shareholders’ value (1276). If Satyam had had such a defense, Raju would have been less likely to engage in fraud to protect the company against a hostile takeover.
Conclusion
The Satyam scandal highlighted the company’s gaps in corporate governance. Fraudsters exploited these gaps to obtain money and resources from the organizations without stakeholders’ awareness. Addressing these gaps requires the organizations to maintain the transparency and integrity of the board of directors. Furthermore, there is a need for establishing a strong and independent audit committee and developing takeover defense provisions to reduce the likelihood of fraud.
Works Cited
Gaur, Ajai, and Nisha Kohli. Governance Failure at Satyam. Ivey Publishing, 2011. Harvard Business Publishing Education, Web.
Gurung, Vividha, and Chander Gupta. “A Review on Satyam Computer Failure Lessons for Corporate Governance and World.” SSRN, 2019, pp. 1-11, Web.
Hitt, Michael A., et al. Strategic Management: Competitiveness and Globalization. 13th ed., Cengage, 2019.
Johnson, Shane A., et al. “Managerial Incentives and Corporate Fraud: The Sources of Incentives Matter.” Review of Finance, vol. 13, no. 1, 2009, pp. 115-145.
Shi, Wei, et al. “External Corporate Governance and Financial Fraud: Cognitive Evaluation Theory Insights on Agency Theory Prescriptions.” Strategic Management Journal, vol. 38, no. 6, 2016, pp. 1268-1286.
Soltani, Bahram. “The Anatomy of Corporate Fraud: A Comparative Analysis of High Profile American and European Corporate Scandals.” Journal of Business Ethics, vol. 120, 2014, pp. 251-274.