Re:Balance -- Jim Peterson

Satyam's "Ghost Employees" -- An Innovative Approach to Job Creation?

On the record so far, it is safe to predict that the legal and political maneuverings around India’s Satyam Computer Services will be continue to be noisy, protracted and inefficient. But the answer will come quickly to one question:

Did or did not former chairman Ramalinga Raju loot the company by diverting the payroll of 13,000 fictitious employees, out of some 53,000, as alleged by prosecutors and, as of today, at least, denied – or at least not admitted – by both Raju himself and the company.

Whatever the answer -- with its broad implications for the company and its shareholders and gate-keepers, as well as for Indian governance and regulation of companies and their auditors – the process to get there should be rapid.

The investigative work program to unpack such a charge could be written by a second-year auditor – once again exposing that the roadmapped mopping-up of “forensic accounting” relates to the challenges of contemporaneous financial auditing as does the slog of post-battle casualty clearance to the smoky uncertainty of real-time warfare.

Legitimate employees demonstrate their presence far beyond their ID numbers and payroll entries, however susceptible to manipulation those high-level records may be. There are company accruals and payment obligations for taxes, social charges, pensions and benefits. They create hiring and departure dossiers. They occupy real office space, work stations, telephones and computers – all requiring the documentation and outlay of considerable real sums. And as alleged, a 25% padding of their rosters would affect everything in a company environment from cafeteria turn-over to usage of paper towels to the frequency of parties for maternity leaves.

What would have been in it for Raju to bear the cost side of over-stating his employee head-count? All the associated expenses, if fictitious, could have been exposed by a walk through a job site or an expense ledger. While if real, they would have been an impossible drain on the company’s margins – not to mention requiring a team of co-fraudsters to dummy up the records.

Volume padding is one of the oldest corporate scams. Barry Minkow created bogus job locations in the 1980’s to boost the turn-over of ZZZZ Best – but that Ponzi scheme was aimed at inflating the public company’s stock price. And a decade earlier, the perpetrators at Los Angeles-based Equity Funding used the unusual device of over-stating liabilities (to pay death benefits on non-existent insurance policy holders) – but they found a way to extract a pyramid of real cash through the use of reinsurance.

So there was the rub for Raju, and the challenge to the prosecutor’s assertion: ghost employees don’t generate revenue.

Or do they?

Padded jobs rosters, inflated client billings and systematic over-charges are also devices as old as time, as any manager knows who has ever pushed back against a service provider’s generous billing.

To realize revenue on the scale alleged in Satyam, however, would require a massive fabrication of client billings, at the very least – even if disconnected from legitimate employee numbers and expenses – plus the possibility of warehouses full of bogus time records and other job-related footprints. Again, all of this was subject to ready exposure through the most elementary form of inquiry and verification – whether by a client, internal auditors or outside monitoring and scrutiny.

Or is it the case, despite the world’s largest companies on Satyam’s client roster, presumably exercising some level of due diligence in bench-marking Satyam’s staffing and employee productivity against its peers, that the entire Indian out-sourcing industry is so lacking in basic control and oversight mechanisms that irregularities so allegedly pervasive – and, necessarily, collusive – could escape detection for so long.

The implications of that speculation will await exploration when the post-battle forensic hyenas have finished their scavenging. For now, expect that the porous nature of the Indian investigative process, which has already furnished so much to chew on, will continue to serve up a buffet of future morsels.    

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In Appreciation: Peter Fleming -- The Accountants Lose a Friend

I'm in mourning. New York super-lawyer Peter Fleming died on Wednesday.

In times when big disputes are managed to inevitable settlements by lawyers working as case administrators, the specialized courtroom trial bar has lost a brilliant character, whose equal is unlikely to be seen again soon.

Closer to home, the accounting profession has lost a unique source of wisdom and advice. Having seen and defended the auditors at their weakest and their worst, Peter brought his counsel with wit, candor and affection – but also with a piercing accuracy that challenged evasion, euphemism and flabby reasoning.

It is no bad foundation for a high-profile advocate to be tall, dapper and sharp of tongue and wit. Peter’s tools also included a pitch-perfect ear for the metaphor that would illustrate his argument.

Drawing on the experience of a football-coaching son, Peter compared the hazards of that role with the well-intentioned but constrained ability of an audit engagement partner:

Both do their best to train and discipline the youngsters in their charge, and to teach them the complexities of their playbook. Then when the team takes to the field, they are limited to coaching anxiously on the sidelines, while the action takes place in a combination of energy and improvisation, largely beyond their ability to provide guidance or control.

Peter made no attempt to temper his dismay at the ambiguity and self-inflicted harm of the large auditors’ confused messages. “You’re killing yourselves in court with all these books of standards,” he said. “Juries don’t understand and don’t buy the excuse of ‘professional judgment’.”

He wanted a simple and focused message. “Spare me all the technicalities. You can distill all your guidelines on quality and expectations down to one sentence,” he would say. “Can this audit work be defended with a straight face to non-experts in a jury box?”

That advice never sank in with the profession’s leaders. We hadn’t spoken for close to a year, Peter and I, but for a certainty he’d have given a familiar snort of disdain, along with an expletive, at the sterile debates over endless politicized differences between competing systems of international accounting standards, and the persistent inability of the profession to avoid repeating the same performance failures he’s seen for half a century.

And then he’d sit at the trial strategy table, with both genuine personal regard and professional devotion to the battle. Polishing his arguments, he would fill up the ashtrays, in defiant disregard of what he viewed as petty rules infringing on his cigarette addiction, while he immersed himself in the single-minded defense of his troubled client’s difficult position. 

To obtain his advice, over the years it was my privilege to have it, you took his smoking habit as part of the package.

From the report that he died this week of complications from lung surgery, there was one closing argument he couldn’t win.

Madoff and Satyam, Dead in the Water -- Scuba Diving as a Risk Metaphor

With a winter blizzard swirling outside, it’s a good day to adopt a lesson from my last Caribbean resort experience into the curriculum of the MBA course on Risk Management that I will teach later this month.

The context is certainly rich: between the collapse of Bernard Madoff’s investor scheme and the revelation that Satyam Computer Service’s balance sheet was a work of fiction, effective risk management is once again found wanting on a broad scale.

So there is relevance both for students and to the theme of my usual writing -- the challenge for investors and other users of financial information to find reliable guidance for their decisions, especially in the current troubled state of the worlds’ capital markets.

In a blue-water lagoon during a recent school holiday, I had a near-disaster in my quest to obtain my scuba diving certificate. I had a surprise equipment failure on my very first dive. A calm and beautiful undersea experience was turned in an instant into scary and airless gasping.

Back on the boat, having survived a breakdown that had not ever occurred in the experience of our captain, the dive master or any of her students, I was in a state of high-adrenalin calm. I hope never to repeat those intense and time-frozen moments. But I was ready to go back down again.

Why?

First, life is full of contingencies. If I had ignored or disrespected the pre-dive training that provided me with the hand signals to communicate my distress – if I had been too deep to be able to surface on my own depleted lung capacity – if I had yielded to the urge to panic – the result could have been dire and I might not be writing this at all.

I have written – here – on the importance of comprehending the importance of those unpredictable but highly consequential events that occur much more frequently than we perceive: October 1987 -- September 11, 2001 -- Long Term Capital Management -- Virginia Tech. In his eponymous best seller, Nassim Nicholas Taleb calls these the “Black Swan” events -- the very ones that cannot be anticipated, but that have disproportionate influence in our lives.

Users of any system designed and operated by human beings – whether a diving apparatus or a subprime mortgage derivative valuation model or a corporate audit – have the responsibility to know of the non-zero risk of failure.

Although it is the essence of random events that they cannot be predicted, their possibility does give the chance to think ahead. Pay attention to your dive master, the better to cope with an accident. Wear your seatbelt, to avoid becoming a traffic statistic. To reduce the chance of lung cancer, stop smoking.

And to avoid a collapsed portfolio, don’t put all your investment eggs in a basket woven out of improbable stories, untestable strategies and irrational enthusiasm (Mr. Madoff, q.v.).

The liability release form that I had signed, back on the dock, was miles away from my thoughts or any possible influence on my reactions, fighting off panic at a depth of twenty feet just above a reef. The reality of high-stress experience is disconnected from the compliance requirements of licensing authorities, regulators or politicians.

Instead, an effective approach to unpredictable hazard is to mitigate the risk directly through research and preparation. Rehearse the divers’ emergency procedures. Pay attention to the flight attendants’ safety speech. Get a second opinion to validate an initial cancer diagnosis. And get better investment advice than available in the country club’s locker room.

Another is to measure and manage the downside consequences. Don’t dive deeper than experience supports. Allocate investments under a managed plan; the long-term requirements to manage a retirement or a charity’s endowment make them a poor place for excess concentration or exotic long-shots.

As a beginner, I’ve got no more competence to do deep-water salvage diving than I do to trade foreign currency derivatives. If I tanked in either one, I would deserve the consequences.    

The lessons from my underwater accident should not be pushed too far. Life has risks, and they can’t all be eliminated. Who can tell how any of us would react under other kinds of sudden deadly threat – an icy night road or a gunpoint robbery or exposure of a giant corporate fraud scheme?

But as I learned under the sea, about the combination of advance preparation, calm at the crisis point and plain uncontrollable luck, the first two are subject to our individual influence and responsibility. And they will affect the outcome, whether involving a blown air tank or a blown portfolio.

I intend to keep diving, just as I intend to keep investing. In either case there is a non-trivial chance that I might end up dead in the water. But if so, it won’t be for reasons within my own control or responsibility.

Over the months I have shared experiences supporting my course’s core proposition – that improved choice-making is possible, even under turbulent and threatening conditions, through awareness of the avoidable traps, biases and errors – examples here, here and here.

This being a large and open topic, I invite your suggestions for my students' benefit of other “teachable moments.”

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Fraud Outsourced to India: Satyam Computer Services -- Is it Enron, or Parmalat?

As this blog celebrates its first birthday, there are two related reasons why I am unconcerned about the supply of new material for its second year.

To start, the crystal ball seems fully functional – based on my calls of December 16 promptly coming good – here – “two predictions as the Bernard Madoff story brings a sorry year to its welcome close:”

    “The first is the safe but unfortunate bet …that at least one remorse-driven suicide will further color an already tawdry tale.

    “The second is that before the books are closed on the reporting of dismal corporate results for 2009, an entirely new multi-billion dollar operational and accounting scandal will erupt somewhere in the world – outside the investment scams and the already battered financial services sector.”

The first was sadly realized within the week – here – with the self-inflicted death in New York of French fund manager Rene-Thierry Magon de la Villehuchet.

As for the second, yesterday's resignation of Satyam Computer Service’s Ramalinga Raju, in a letter to his board confessing cash manipulation and a balance sheet inflated on the order of $ 1 billion, introduces large-scale public company scandal in a new region of the world, with consequences that will reverberate all around.

In addition, my belief in web-based communications and the developing capacity to inform and shape serious discussion of complex issues is reinforced by the emergence of new and innovative means – in particular, the launch by Bruce Carton, at his enormously informative Securities Docket, of the Securities Litigation and Enforcement Channel, with Tuesday’s webcast, “The 2008 Year in Review” – linked at his site and well worth a listen.

Bruce’s contributors were four experienced and insightful bloggers -- Kevin LaCroix (D&O Diary), Tom Gorman (SEC Actions), Francine McKenna (Re: The Auditors) and Walter Olson (Point of Law) -- all on my list of valued resources and worthy of attention.

As noted, the two events are related, in this way: During the webcast, the unsurprising outcome of a listeners’ poll on compelling issues for 2009 was that the risk of “Big Four auditors at the brink” was only a distant trailer. 

But that indifference is incorrect, as is about to be shown by the world of hurt quickly to fall on Satyam’s auditors, PricewaterhouseCoopers.

Comparisons with Enron and Arthur Andersen are being drawn, but are mis-placed unless PwC in India somehow manages a similarly self-inflicted indictment. For the post-scandal environment, the better comparison is with Parmalat, the family-controlled Italian dairy conglomerate whose € 20 billion “black hole” in 2003 has since swallowed up careers and treasure at both its audit firms.

The reason is that India, like Italy, is an immature venue for the handling of large-scale financial scandal – which makes the possible reactions of its regulators and politicians both unpredictable and extremely dangerous.

In Parmalat, Italian bankruptcy legislation was re-written after the fact, to enable a newly-empowered special administrator to pursue civil claims both at home and abroad – which he has done with enthusiasm to the tune of nine-figure settlements from Deloittes and proceedings still on-going against Grants.

Meanwhile that country’s antiquated and ponderous criminal justice system is unlikely to complete its prosecutions within the lifetimes of any of its targets – thus displaying an inability with credibility to render either punishment or deterrence.

Because even the scandal-scarred American experience has included the pell-mell excesses of the Sarbanes/Oxley law of 2002 and the Public Companies Accounting Oversight Board, can better be expected from public servants in India, never before exposed to corporate mischief on this scale?

In Satyam, the Ministry of Corporate Affairs, the Securities and Exchange Board and the accounting regulator, the ICAI, have all rushed to announce investigations – processes that, in a country lacking a base of experience with the scrutiny and exposure of serious financial manipulation, will make the posturings of America’s comical Henry Waxman look positively statesmanlike, and will more closely resemble a concoction of Gilbert & Sullivan.

While PwC’s practice in India will be put at risk for its personnel, its permission to practice and its very survival – along with whatever litigation risk may lurk in that country’s untested civil system -- there is the double-whammy of globalized shareholder litigation exposure for multi-national enterprise. Because Satyam’s securities included ADR’s traded on the New York Stock Exchange, the first of an anticipated parade of class actions was already filed on the very day of the company’s downfall.

Mumbai is so far from the American media centers, whose attention to financial scandal is short-lived and US-centric in any event, that Satyam will be a one-week story in the mainstream spotlight.

So although the company’s name may indeed be “truth” in Sanskrit, the amount extracted from the story will depend on those staying with it. Here, it’s the bet that the consequences of Satyam for PwC will be protracted, disruptive and expensive – with onward effects for the entire large-company assurance franchise.

And for those tempted to disagree – I have been two times right in the last month alone.

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