CORPORATE GOVERNANCE FAILURE AT SATYAM. Teaching Note. Synopsis

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1 VANITA YADAV C.V. BAXI CORPORATE GOVERNANCE FAILURE AT SATYAM Teaching Note Synopsis This case is about the corporate governance failure of India s fourth-largest information technology ( IT ) company, Satyam Computer Services Ltd ( Satyam ). Satyam was founded by B. Ramalinga Raju ( Raju ), along with his family members, on 27 June 1987 in Hyderabad, India. The company offers IT outsourcing services to around 690 clients, including 185 Fortune 500 companies such as GE, Nissan Motors and General Motors. Satyam is a global company operating in 37 countries and is listed on the US and Indian stock exchanges. Raju is an important celebrity in corporate India. He has been honoured with the Ernst & Young Entrepreneur of the Year award (2007), and his company has won many distinguished corporate awards. Above all, in September 2008, the company was awarded the Golden Peacock award for corporate governance excellence for the second time by the UK-based World Council for Corporate Governance. In spite of all the checks and balances in place, Satyam has been discovered to be involved in a US$1.4 billion corporate fraud scandal. The case can be used to explore the various aspects of corporate governance. First, it can be used to explain the reasons behind the corporate governance failure of a firm and the risks that a firm faces post-scandal. Second, it can be used to examine the various theories underlying corporate governance and demonstrate how good governance can be achieved in firms. The case can be used for discussion purposes in business management courses on such topics as corporate governance, business ethics, strategy and general management. Professor Vanita Yadav and Professor C.V. Baxi prepared this Teaching Note as a guideline to teaching: Corporate Governance Failure at Satyam by The Asia Case Research Centre, The University of Hong Kong. No part of this publication may be reproduced or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise (including the internet) without the permission of The University of Hong Kong. Ref. 10/475TN 1 HKU890

2 2 Conceptual Foundation & Teaching Objectives In the past several decades, awareness of matters pertaining to corporate governance has increased significantly. This is essentially a result of the democratisation of global capital, cross-border flows of funds, reforms of financial markets, fundamental changes in the industrial and trade policies of both developed and developing nations, and the phenomenal transformation of business processes due to the information and communication technology revolutions. Corporate tragedies in the last decades have had a serious impact on shareholder value and have led to searching questions on the legitimacy of the purpose of modern corporations, as these failures have betrayed stakeholders. Therefore, this case can be used as a vehicle for understanding the fundamental concepts and challenges of corporate governance. This is explained in a stepwise manner by focusing on underlying theories. The teaching objectives of the case are: 1. To help students understand the fundamental concepts and theories of corporate governance 2. To discuss the reasons behind the corporate governance failure at Satyam 3. To analyse the implications of the corporate governance failure at Satyam 4. To examine the role of independent and non-executive directors 5. To consider the future prospects of corporate governance in companies. Potential Teaching Approach and Strategy The class can be divided into small groups and the case given as a prior reading assignment. Each group may be asked to make a small presentation on one or more of the following questions: 1. What issues does this case pertain to? or what is the case about? 2. Who are the key players in the case? 3. What are the reasons behind inadequate corporate governance at Satyam? 4. What are the implications for Satyam of the corporate governance failure? 5. What is the role of independent and non-executive board members? 6. Are there any lessons to be learned from the case for the future prospects of corporate governance? 7. Explain the theories of corporate governance with reference to the Satyam case. Alternatively, if the class is large, three or four groups may be chosen randomly to make presentations, which may be followed by discussion, with key points synthesised on the board (as explained in the analysis section below). Analysis 1. What issues does this case pertain to? or what is the case about? A potential answer to this question is a brief outline the facts of the case bringing forward the corporate governance issue.

3 3 2. Who are the key players in the case? The case protagonist is Raju, an important celebrity in corporate India. The students will also come up with names of other players, and their significance may be left open to discussion. Additionally, Raju s leadership may be analysed here. 3. What are the reasons behind inadequate corporate governance at Satyam? The case can be discussed in terms of the following categories: (i) Ethics and value system of the organisation: The value system of the leader, Raju, along with the value system of the entire organisation may be discussed here. (ii) Separation of ownership and control: The posts of chairman and managing director were not separate, which may be a major issue for companies. Satyam was centred on one individual, which led to problems. The structure of family-owned businesses may also be discussed. (iii) Board structure and veritable independence: Satyam had a good board composition but it still failed. Issues related to true independence of directors need to be brought forward. Though the case does not provide details, it does pose relevant questions. For example, did the independent directors devote sufficient time to the business? Did they bear sufficient rigor? Did they have an inquisitive mindset? On how many boards did they serve? These and other questions may be raised for hypothetical discussion. (iv) Errors in company books and audits: Should one rely on statutory auditors? How might books be manipulated? Concepts related to financial reporting standards and creative accounting may be covered here. (v) Loopholes in the Indian Regulatory environment: The Indian corporate governance model is inadequate and requires modifications. Details on Indian corporate governance can be accessed from the Government of India s website 1 that also provides online resources on various aspects of doing business in India. 4. What are the implications for Satyam of the corporate governance failure? Satyam faced many problems. These may be discussed in terms of the following subheads: (i) Difficulty in retaining clients and threats from competitors (ii) Tarnished company image and its impact on the image of the Indian IT sector (iii) Questionable role of international auditors (iv) The critical role of independent directors (v) Threat of takeover and the takeover by Tech Mahindra. 1 Department of Information Technology: Ministry of Communications and IT Corporate Governance, Government of India, Hhttp://business.gov.in/corporate_governance/index.phpH (accessed 19 August 2010).

4 4 5. What is the role of independent and non-executive board members? The role of independent directors from different international reports, such as the Cadbury Committee Report, the Combined Code on Corporate Governance, the Sarbanes-Oxley Act, and Organisation for Economic Co-operation and Development (OECD) principles of corporate governance might be studied and discussed with students. Alternatively, these may be given as out-of-class reading assignments or students may be asked to explore the details of these reports on the internet, where they are readily available. 6. Are there any lessons to be learned from the case for the future prospects of corporate governance? The following lessons can be learned from the Satyam case: (The suggested response to this question is with respect to the Indian scenario and can be further compared to and contrasted with the scenario present in students own countries or with the state of affairs of international corporate governance in the American, European and Asian regions.) 1. Regarding public policy on corporate governance, there is an urgent need to consider the institutional, legal and cultural aspects of corporate governance in India. In the past, sectoral policies of control and, more recently, regulation of select sectors have not been very effective in terms of setting governance standards and processes. The Indian Ministry of Corporate Governance, in consultation with the other ministries, needs to formulate a national policy on corporate governance. 2. The role, functions and powers of the SEBI need to be suitably expanded. Furthermore, the expertise gaps and number of professionals required in the SEBI type of regulating agencies should be attended to first, as no single regulator in India can be effective in the absence of a suitable support infrastructure and harmonisation of rules and regulations. 3. Further amendments to the Companies Act 1956 that may be required to remove any ambiguity in the present legislation and enforcement mechanisms ought to be made more stringent than they are presently. 4. There is a need to revamp the system of selection of directors on the board of companies. The recruitment and selection process is critical; otherwise, the effectiveness of boards is not achieved. 5. There is also an urgent need for induction and other types of training of corporate directors. Unfortunately, there is a supply-side constraint, as there is no specialised agency to undertake such a training role. Furthermore, the attitudes of full-time and outside directors are rarely positively aligned with training and continued learning. There should be implementation of certificate programmes and even entrance examinations before the appointment of corporate directors is finalised. 6. There should be some minimum qualifications for corporate directors, as this will promote credibility in the system of corporate governance. 7. The composition of an audit committee is prescribed under Section 292 of the Companies Act, and any departures from the rules governing such a composition should be dealt with severely. No nominee directors or any other category of directors should be allowed to be part of the audit committee, and at least one of the members should be financially literate. The audit committee should ensure that management has a minimum risk-management capability, and that auditors do not get any consulting assignments from the company. 8. The outside directors should ensure that the other board committees, such as nomination committees, are functional. Unfortunately, very few corporations have a nomination committee that provides guidelines on such issues as compensation of top management teams, recruitment and training of directors, and performance appraisal of directors.

5 5 9. Reduction of the number of independent directors in recent amendments to the Companies Act is an arguable point as the number of such directors is now reduced to one-third from one-half. This implies that adequate numbers of directors are not available for various board committees. 10. There is a need for the appointment of a compensation committee for all corporations because it is not presently mandatory except in the sick industrial undertakings (see Companies Act for details) under the provisions of Schedule 13 of the Companies Act. 11. In regards to financial and non-financial disclosures, the independent directors should use their experience to guide the management in making mandated disclosures. 12. Outside lawyers should be appointed as corporate directors because corporations face multiple legal issues in expansion, modernisation and diversification of their business activities. 13. There is an urgent need to put in place a performance appraisal system for corporate directors. Considering the high incidence of duality among chief executives, as well as significant board domination by chief executives, it is necessary to ensure that there is some sort of horizontal appraisal process might be implemented as part of peer review among the board members. In the absence of such an appraisal process, there are serious shortfalls in the accountability of corporate directors. 14. One of the most difficult issues in corporate governance in India is the engagement of boards in strategy development. Unfortunately, the debate over Satyam-type episodes does not include discussion of any particular aspect of strategy formulation, implementation or evaluation. There are difficulties for chief executives in engaging their boards in strategy development, to say nothing of knowledge constraints, which prevent corporate directors from contributing to strategy development and then monitoring its implementation. 15. One of the methods of making corporate boards more effective is to ensure a transparent board process. Given pressures from the owners and the inevitable information asymmetry between and among the corporate directors, there are higher and numerous agency costs. Furthermore, there is increasing evidence of divergence of objectives and interests among shareholders, the board and management of corporations, and hence serious corporate governance problems persist. The practice of noting dissent from outside or even nominee directors ought to be encouraged. This is obviously the role of the non-executive chairman of the board and also the company secretary, since the latter records the board proceedings and is furthermore expected to safeguard the board process. 16. Boards also need to be concerned with the management and financial accounting polices followed by corporations, as this cannot be solely left to the auditing firms. After all, accountability for financial disclosure is to be demonstrated by the management of the company under the advice and supervision of the board. 17. It is the duty of the boards of companies to impress upon the management that corporate governance processes and practices not be confined merely to compliance with various laws; many other critical aspects are involved. Corporate governance is a process of selfregulation, and corporations need to abide by a code of conduct. Once the internal mechanism is sufficiently sound, it would not be too difficult for a corporation to meet even the most stringent regulations and legal requirements imposed by external corporate governance mechanisms. 18. While it is hoped that independent directors are effective, the debate over corporate governance in India seems to be silent on the roles and expectations of directors. This is unfortunate because the law does not make any distinction once a board assembles to deliberate on the agenda set before it. Why then is so much expected from only the

6 6 independent directors, not only in their role on the board but also in their roles on audit committees and other committees? 19. One of the most critical functions of a board is to monitor the chief executive, which is where the problem lies in cases where boards are dominated by such an individual. 7. Explain the theories of corporate governance with reference to the Satyam case (Optional). The case can be used as a tool to explain the some of the theories of corporate governance, for example: 1. Agency theory: principal agent conflicts of interests can be discussed. 2. Stakeholder theory: The implications for various Satyam stakeholders can be discussed using the stakeholder theory. 3. Political theory: Government s role in the Satyam s case can be discussed using political theory. Most of these theories are elaborated in detail in many books on corporate governance [see References for a list of relevant materials]. Synthesis Corporate governance issues have become critical to businesses across the globe. The growing interest in this field calls for an in-depth understanding of the subject. This case addresses some of the vital aspects of corporate governance, specifically the roles of independent directors and government intervention. This teaching note provides an overview for case analysis and discussion. References Baxi, C.V. (2007) Corporate Governance: Critical Issues, Excel Books: New Delhi. Clarke, T. (2007) International Corporate Governance: A Comparative Approach, Routledge: London. Das, S.C. (2009) Corporate Governance: Codes, Systems, Standards and Practices, PHI: New Delhi. Das, S.C. (2009) Corporate Governance in India: An Evaluation, PHI: New Delhi. Fernando, A.C. (2006) Corporate Governance: Principles, Policies and Practices, Pearson Education: New Delhi. Harper, J. (2007) Chairing the Board: A Practical Guide to Activities and Responsibilities, Kogan-Page: London. Harvard Business Review Paperback Series (2000) Harvard Business Review on Corporate Governance, Boston, MA: Harvard Business School Press.

7 7 Naciri, A. (ed.) (2008) Corporate Governance around the World, Routledge: London. Solomon, J. and Solomon, A. (2004) Corporate Governance and Accountability, Wiley & Sons: New Delhi. Tarantino, A. (ed.) (2008) Governance, Risk, and Compliance Handbook, John Wiley & Sons: New Jersey.