Postings

Panic - the story of modern financial insanity

I just read a fascinating book titled 'Panic - the story of modern financial insanity' compiled by Michael Lewis. He has compiled over 50 pieces including some of his own articles. It looks at four different crises a) the 1987 market crash b) the Asian financial crisis and LTCM collapse c) the bursting of the internet bubble d) the current credit and financial crisis. The format is interesting, it covers articles from different periods before and after the crisis struck and gives the varying perspectives of leading people.

The 1987 crash story was very interesting from my perspective, because I followed it and wrote about it in 1997 with my Partner, Brandon Becker (at the law firm I worked for in Washington D.C.), who is mentioned in the book. He was one of the chief authors of the report by the SEC (where he headed the market regulations division, before joining the law firm) which attempted to analyse why the 1987crash happened, why in one day stock prices fell by over 22% without any apparent economic cause or major shift in perception. We wrote the piece in 1997, trying to figure the learnings over the decade from the 1987 crash, which continues to evade a single or even multiple straightforward explanations even after such a long period after the event. Here is the piece "Looking Backward - Looking Forward".

Highly recommended - though not yet available in India - thanks to a friend who had it specially shipped to me from the world of Amazonia.

Improved disclosure on pledged securities

Here is the contrarian view of the improved disclosure decided by the SEBI Board yesterday. It is too little too late.

I've been going hoarse talking about a complete re-writing of the disclosure norms in India which leave so much to be desired. Three years of work has already gone into this project by a committee I chaired - work I began long before I joined SEBI and ended, while I was there. Both the process and the budget have already received in principle approval of the Board in the past.

So as not to repeat what I've been saying for so many months now, here is the link to my previous postings on 'integrated dislosures'. Post of 14 Aug 2008 and 28th Nov 2008

Can we have some action on this front - effective yesterday? Or will we introduce one rule at a time everytime a new fraud comes to light? So there is hope in a million years.

Insider trading - short swing profits

I wrote a piece in the Economic Times recently on the 'short swing profit' rule, which was proposed some time back. However, what has been passed by the regulator is a short swing prohibition. This kind of prohibition is unprecedented anywhere in the world and was passed without the time tested rule of posting proposals for public comment. Here is the piece before I puzzle you with the lingo:

The Securities and Exchange of India (Sebi) recently made some changes in the regulations pertaining to insider trading. The amendments prohibit transactions in securities by designated insiders within six months. In other words, no securities may be sold for six months after being purchased by a designated insider (or sold before being purchased).

The origin of this regulation arises from a US law commonly referred to as the ‘short swing profit’ rule. This rule exists only in the US market. It states that any purchase/sale followed by a sale/purchase within a six-month period resulting in a profit by a designated insider must be handed over to the company where the insider works. The phrase also includes 10% shareholders of the company who must also do the same whether they are insiders or not. It is assumed that insiders have a long-term investment in the company and are not expected to make rapid buy/sell transactions, which are apparently based on at least some level of superior access to information.

If one were to categorise the rule, it pertains more to corporate governance than insider trading. Liability is imposed strictly without any necessity for guilt or wrongfulness and conversely a direction to surrender profits made in a short swing transaction does not imply any form of guilt. I had discussed this and other proposals for changes to the insider trading regulations in a working paper of Indian Institute of Ahmedabad (IIM-A) in 2003.

To introduce a similar rule in India, Sebi, while I was there, had brought out a concept paper and sought public comment on it in January. The paper sought comments on the rule generally, and also on three specific issues.

Firstly, it sought a definition of the new category of ‘designated insiders‘ and whether 10% owners of shares should be included in this class. Secondly, comments were sought on what types of transactions need to be exempted from those which result in short swing profits including transactions approved by a regulatory authority, employee benefit plans, bona fide gifts and inheritances, mergers and acquisitions. Thirdly, whether the last in-first out method should be used to calculate profits.

Now, Sebi has come out with a entirely different regulation which, instead of handing over profits to the company by designated insiders, simply prohibits opposing trades in a six-month period by an existing class of directors/officers/designated employees. The new regulations also prohibit exposure to the derivatives market of the company’s stock. This is an extreme approach to the problem of insider trading.

Firstly, it is too broad. It prohibits every transaction if one has occurred within six months of the other. To treat every insider as a criminal and impose these chains is hardly fair.

Secondly, it converts a corporate governance measure into an anti-fraud provision with heavy penalties attached even though no fraud is attached to a simple transactional violation by an insider without any inside information. Thirdly, the language seems to suggest that buying one share will prohibit that person from selling a million shares for six months. There is no reference to the bought shares or to the numbers to which the prohibition applies.

Similarly, there is no last-in first-out or other measure of restriction on the shares bought and sold, it is a blanket prohibition. Fourthly, the clause suffers from basic errors. This includes equating primary market with initial public offers (the latter is a narrow part of the former). Fifthly, there are no exemptions for genuine transactions — so a person who gets employee stock options (Esops) on a regular basis will never be able to sell his shares.

There are no exemptions for court-approved mergers, so a purchase of one share will bar mergers involving sale of the shares of the company. No exemption exists for a pre-planned and systematic sale of securities, say 25,000 shares every quarter. Lastly, 10% shareholders who can be assumed to have access to inside information are not included in the definition of designated insider.

Even, if the basic prohibition is retained, which itself, in my opinion, is unfairly harsh towards honest people, the scheme suffers from lack of exemptions from hundred types of genuine transactions conducted by insiders. Inadvertent violations, with no inside information, will be common. Following the restrain will be very difficult and there will be frequent requests for exemptions, clarifications and dilutions. Much of this could be avoided if the law was put out for public comment in the shape it has come out in.

Satyam - new revelations - Board of Directors minutes

Stop press - update: Minutes of the audit committee meeting of Nov 2008 satyamAudit.pdf (don't miss the World Bank misrepresentation on pg. 8/9)

The Satyam Board of Directors' meeting's minutes of the infamous 16th December 08 are out and they make for interesting reading. Here is a copy in pdf. See page 2 bottom "evaluation for Maytas Infra has been based on the SEBI (Substantial Acquisition and Takeovers) Regulations, 1997 and for Maytas Properties based on the evaluation done by Ernst and Young one of the Big four accounting firms".
Comment: SEBI(SAST) regulations do not provide 'evaluation' - only a floor price and E&Y has hotly debated whether it had valued these for this context. Similarly, today's papers say the law firm Luthra & Luthra had not done any property due diligence except for the IPO of Maytas Infra.


"In view of the non disclosure agreement with the valuer, we are not able to disclose the name of the valuer to the public, Mr. Srinivas further informed" page 5.
Comment: This is legal trash, in any relationship of this nature - even high fiduciary relationships like attorney-client, the privilege of confidentiality belongs to the client. A valuer has no fiduciary relationship in the first place, secondly, there is no basis for such a confidentiality treatment even in contract, unless there is something very fishy going on.

An assertion is made about Maytas Properties having a land bank of 6,800 acres on the same page - however, a CNBC report could verfiy only 100 acres of this land (I have posted previously on this). This view is consistent with the statement on the bottom of page 6 that only 110 acres of 6,800 acres has been pledged with banks for loans. Obviously, you can't pledge more than you own. Practically every aspect of the presentation made was based on misrepresentation.

While there are so many gems in these minutes - it is clear the independent directors only asked enough questions to cover their rear. Obviously no meaningful questions were asked, at least not with any seriousness. This is reflected in their immediate satisfaction with any answer given, howesoever irrelevant and absurd.

Lesson learned for new Board: Get rid of the top management, as least those named in the minutes. Send them on a paid leave without bonus, if natural justice needs to be met, but don't let them into any office premises.

Satyam I - what likely happened

In my FT piece, I discussed what was wrong with the story of the Raju confession, rather than what may be the correct story. Clearly, no one except those who carried out the fraud would likely know the story. Here is what may have happened as pieced together from my conversations with some of the people who are close to the action. Remember this is a semi fictional work, do feel free to discount it.

Sometime before Sept 2008, Raju and some insiders decided to take away some money. This could either be a personal theft or more likely to be a transfer to Maytas or other property companies owned by Raju. Between September and December 2008, and after the last limited audit by the outside auditors, this money was 'lent' to these affiliates (though it is difficult to imagine writing a cheque for 7,000 crore rupees (Rs.70 billion)). The lending was expected to be accounted for in the shady purchase of the two Maytas companies in the Dec 16th Board meeting at an inflated value - rubberstamped by a convenient Board of Directors. As the shareholders forced the hands of the directors to reverse the purchase of the two companies, Raju was left with a gaping hole which could not be accounted for. Just before the next limited audit was to start - he decided to come clean - but only in a half baked story of inflating profits over 7 years. He missed several details, including the obvious one - that it is easy to inflate profits, it is nearly impossible to inflate cash/bank balances without the connivance of nearly every person associated with the listed entity, chief amongst them the auditors.

Note: The key link if this hypothesis is true lies with the various banks, as the money would have been stolen using the banking channels. I read an interesting piece about the management being quizzed sometime back asking them why huge moneys were kept in 0 interest current accounts instead of a fixed deposit. The last annual report gives the names of all the unscheduled banks with amounts deposited with each; but the bulk of the deposits are with scheduled banks and no breakup is given. So who are these banks and can someone please go quiz them? Can we get the RBI use its clout to do some investigative work on the banks.

Satyam - lessons for India Inc.

Here is a piece I wrote for the Financial Times Op-Ed stating why we should not believe the confession letter. More importantly, I think this event will impact the reputation of corporate India. India Inc needs to clean up its intestines to remain trustworthy.

Here are excerpts:
"The first thing I did, when I saw the now famous letter of B. Ramalinga Raju of Satyam Computer Services confessing to carrying out a $1bn fraud, was to compare the initials on the letter with his signature in the 2008 Annual report. They don’t tally even remotely. I was reminded of the paradox of the statement ‘I always lie’.

Raju claims that he had inflated profits and cash while understating liabilities and became addicted to the lies to keep up with analysts’ expectations. While most of the media has taken the confession letter as containing the broad truth, after all a voluntary disclosure of fraud can’t be so unbelievable, it clearly hides more than it reveals. The only thing certain is that Raju has made at least this much money vanish from the once venerable quartet of India’s software giants. How he did this and with whose complicity is not clear, though he claims in the letter that he was alone in this fraud.

A quick back of the envelope analysis shows that - if his letter is to be believed - in the second quarter of 2008 Satyam made an operating profit of Rs.610m ($12.5m); given 53,000 employees, each employee would have earned an operating profit of $3.75 per day. This number stretches credulity by a wide margin.

In short, we have not even begun to uncover the nature and quantum of the fraud.
...

One of the scourges of India’s corporate landscape is the existence of related party transactions and private investment holding companies. These will need to be reduced if not eliminated in the larger companies, for them to gain the trust of increasingly suspicious international investors. It is common for control persons to own shares of listed companies through private companies and trusts.

Also, the system by which independent directors are appointed and compensated will have to be examined carefully so that they are neither fiduciaries of the promoters nor so cosy with the management that they sleep through board meetings. The audit committee which has an important task of asking the right questions from the internal/external auditors and the chief financial officer, free from the presence of management will need to be held accountable. The mythical creatures called independent directors will also need to face music if they are unable to demonstrate independence. This can best be ensured if the minutes of the board meetings and audit committee meetings are released in full detail.

The utopian time of raising equity at any price named by companies has gone. In these difficult times for companies to raise capital, or even hold on to existing shareholders, the companies must comply with ethical processes to remain relevant. After all the pain, the Satyam episode may be a blessing in disguise and a wake up call for corporate India to come clean and build on a more solid foundation."

Satyam - introduction to series

I'm going to run a series of pieces on Satyam - please ignore the series if you have had more than your fill of the issue. As more facts seep in, I will keep updating the series as new facts are unraveled, recall, there are very few facts in the public domain except a dubious confession letter.

First, the confession story doesn't add up. The facts don't really exhibit internal consistency. Something else is up.

Second, what should be done at this very moment by regulators (i.e. ad hoc and immediate as opposed to the longer investigations and recriminations).
What should regulators do - SEBI, exchanges, MCA, SFIO, Finance Ministry, Police, US-SEC, NYSE and the most important regulator of all - the shareholders.

Third, what are the provisions of law which could be used against a) Satyam b) Ramalinga Raju c) independent directors ca) audit committee d) auditors e) merchant bankers. And who will pay what in terms of money, industry bars and jail sentences.

Forth, which are all the types of action possible against these people and the limitations and at least vague time lines

Fifth, 10 questions to the audit committee.

Sixth, can we prevent this elsewhere and in the future?



While I pen this, listen to my podcast on the Satyam story till day before. This is my first podcast, so it is a bit experimental.

See also my piece in DNA Money today 'Confession to seek lower penalty'.

See also Joseph Leahy's piece in the Financial Times and Heather Timmon's piece in the New York Times to see the international coverage this has generated.

See my main blog.

Satyam - couldn't get worse?

Whoa, big news on Satyam - Ramalinga Raju has confessed to his Board to 'cooking the books' for the past several years. The scale is breathtaking - witness actual operating profits for Sept 08 quarter is Rs. 61 crores ( Rs. 610 million); while the well cooked books show Rs. 649 crores (Rs. 6.49 billion). And this is only one quarter figures and that too the admitted amount. Reality will need to wait for some investigations. Here is the letter he wrote to the Directors, SEBI and the exchanges:

Satyam_Conf.pdf

See my previous blogs on Satyam:

Satyam - name and reputation are upside down

Satyam - name and reputation are upside down - 2

Satyam Board - thy name is mud

Lawsuit against Satyam for over $1 billion

Satyam - from storm to maelstrom

Satyam – resignation and poor advice

Satyam - Board of directors quorum

Of course I had my detractors - see comments in my blog - who thought I was being too harsh on Satyam. Will post comments in the p.m. after finishing my class. Co-incidentally, I am teaching securities fraud next week.

See my main blog.

Financial crisis

Today, I along with Prof. Arpita Ghosh, my colleague at the institute, spoke on the financial crisis at the ‘IIM-A Doctoral Colloquium 2009’. A member from the institute in the audience had some views, many of which I don’t agree with.

a) Markets are efficient. The crisis does not prove that herd behaviour took place.
My take: Markets are random and unpredictable, but that is not saying the same thing as the markets are efficient. There clearly is herd behaviour and the assumption of the ‘greater fool’ theory in financial bubbles throughout history. Daniel Kahneman, winner of the 2002 Nobel, and many others in that line have very interesting thoughts on the reasons for the herding and group foolishness. Starting from the tulip mania (certain tulips were $75,000 each (in today’s money) before falling to $1 each in a few months time), the south sea bubble, the florida land bubble, the internet bubble, the present worldwide land and property bubble are but a few examples of rational people going berserk all at the same time. As Charles Mackay, the expert on bubbles said in his famous book – "Men go mad in crowds, and they come back to their senses slowly and one by one." rings true.

b) The US government should not have intervened and let the markets decide its appropriate level and the economy would have find its feet.
My take: I think, the US government should have intervened – the stakes are too high and much as we may hate the suited financial guys for their greed, the world in times of acute financial distress does need help from the biggest players of them all (though growing relatively smaller and smaller) – the government. At the same time, the way it has intervened leaves much to be desired. While allowing all the financial institutions to fail would have extracted too high a cost on the real economy – the existing practice of bailing out without imposing a cost on the shareholder and managers of these firms is a sad example of ‘privatizing profits, nationalizing lossess’. Clearly, when a company has been economically bankrupted, there is no case for the government to bail out the company’s shareholders who are holding the risk capital of the company (See AIG, Fannie, Freddie, Citi). The government needed to wipe out the existing shareholders – and over a longer term get saner people in control – neither of which it has done in the US. Indications of crony bailouts are also becoming more apparent with former wall street alumni in the government directing the actions of the bailout in the teeth of the will of their parliament. See an excellent piece on “How to Repair a Broken Financial World” by Michael Lewis and David Einhorn published three days back in the New York Times.

c) The cause of the crisis is excess liquidity. How can it be the solution as well – i.e. pouring of huge amounts into the markets by the government is wrong.
My take: I just have two phrases for this – ‘Herber Hoover’ and ‘1932’. How can we repeat that mistake again?

d) Infrastructure spending will take years before it will have an impact on the economy and the crisis.

My take: The benefits of infrastructure buildup is relatively immediate for the crisis. Employment is generated, consumption is increased and services are consumed beginning immediately. To take an example of a hydro electric project - the dam may take a half decade to build, but the main point of the project is not the electricity but to create economic benefits on the demand side - this is of course infinitely better than the digging-holes-and-filling-them-up kind of employment generation.

See my main blog here.

Financial crime vs. bank robbery

In another excellent posting on the New Yorker, James Surowiecki (author of Wisdom of the crowds), talks about how getting caught doing financial crime (and doing the crime itself) is inversely proportionate to how well the markets are doing. Here are excerpts:

"Along with slashed payrolls, rising foreclosures, and plummeting stock prices, 2008 brought another unwelcome development: a surge in bank robberies, which were up more than fifty per cent in New York. This wasn’t shocking: we typically expect property crimes to rise in hard economic times. There is, though, one crime against property which bucks this trend: defrauding investors. On Wall Street, fraudulent schemes tend to thrive during economic booms, and to blow up when times turn tough. While bank robbers are getting busier, the Bernard Madoffs are starting to get caught.

...

This culture of credulity did plenty of damage to the economy, but now it has given way to something even more corrosive; namely, endemic mistrust. Because if there’s one thing worse than too much confidence it’s not enough. Fraud impoverishes a few; fear impoverishes the many. As long as mistrust prevails, people will keeping pulling money out of the system—sometimes even at gunpoint."

Here is the full post.

Corporate Governance - more activism

Another victory for investors, though not decisive. Anyone following the Gujarat public sector companies may recall the government of gujarat was seeking to divert 30% of before tax profits of four Gujarat government dominated public companies which are listed towards government sponsored charity. As these have non governmental private shareholders, this was an expropriation of private property, however noble the cause. It was also wholly wrong from a corporate governance perspective. All in all, it would reduce the valuation of such companies and make the cost of capital for such companies much higher, hurting the dominant shareholder, the government the most in the medium and long term. It is also similar in tactics to the diversion of cash to the promoter entity in Satyam Computers, though that was personal aggrandisement, while this is for a good motive. Here is a newsreport.

The government sought to put this to a shareholder vote. The first such vote is now in public domain (for Gujarat Narmada Valley Fertiliser Company limited (GNFC)) at the exchange websites. Here is the proposal: GNFC proposal.pdf Specifically, they tried in the first two items to amend the articles of the companies to permit this action. The government also sought to permit payment of funds from the public sector company towards the charitable activity to the extent of Rs. 99 crores (Rs. 990 million). Due to shareholder activism and since the first two required amendment of the articles by 3/4th majority failed. The third which only needed a simple majority succeeded. I'm not very clear why the first move was made if the second one could enable the diversion of funds. Be that at it may, it is at least a moral victory for the activist shareholders who shot down the 41% shareholder of the company. Here is the result of the postal ballot: GNFC Result.pdf.

See my main blog for the full post.

The Satyam Story: Many Questions and a few Answers

Colloquium, Vikalpa, Vol 34, No. 1, Jan-Mar 2009

James E Post, Jayanth R Varma, Krishnagopal Menon,Ashank Desai, Achal Raghavan, Vasanthi Srinivasan,Sandeep P Parekh, and Neharika Vohra (Coordinator)