The Satyam scandal: Now what?

Mea culpa: I did not see through the biggest scam in the Indian market in years. I have to admit that I misjudged the promoters of Satyam when I defended them and the company recently.

But then, I am in good company -- the independent board members of Satyam (including the dean of the Indian School of Business, a Harvard Business School professor, and an erstwhile star at Intel), the institutional investor community, the Sebi, retail investors, and the external auditor -- none of them, including professional investors with detailed information and models available to them, detected the malfeasance.

So it would have been practically miraculous if someone like me, depending solely on public information, would have been able to detect the fraud.

Furthermore, I continue to maintain that the proposed investment in the real estate sector could well have been a reasonable idea. That is, if only Satyam's alleged $1 billion cash reserve had actually existed. Besides, I reiterate that the World Bank -- which fired its CIO for allegedly seeking bribes from vendors, possibly including Satyam -- is in no position to point fingers at anybody.

The Satyam fiasco: Complete Coverage

Nevertheless, I am shocked that a fraud of this magnitude was not detected for years.

There are a few axioms that we work with -- we believe there is a certain level of integrity in those we do business with, and that fraud is the exception, not the rule. Without a fundamental level of trust, it becomes difficult to transact business.

The Satyam incident corrodes the individual's faith in the system. The casual observer is left wondering what other skeletons are going to tumble out of which other companies' closets. Obviously, this is going to have an effect on India Inc as a whole, and this could not have come at a worse time, given the global jitters.

It is surely going to be more difficult for other Indian IT service players to win business now, given that they will be tarred by the same brush. Competitors from other low-cost locations such as China, the Philippines, Vietnam, and Eastern Europe will certainly take advantage of the situation.

This is something the IT services industry, facing as it is the threat of a serious reduction in business as fallout from the general market malaise, did not need.

Undoubtedly, this is going to hurt the prospects of foreign money flowing into India in the near future as well; and it was anyway looking a little shaky in the aftermath of the Mumbai invasion and the prospect of war with Pakistan. This will help extend the liquidity crunch and will depress the stock market.

After all, India, running a substantial current account deficit, has been using inflows to help fuel its rapid growth. At a time when the incoming US President is warning of trillion-dollar deficits, India is quite likely to suffer from a cash crunch.

The overall growth prospects of the country, therefore, may also be affected. Thus, it is a disaster on any number of fronts.

People have been quick to compare the Satyam incident is to the Enron scandal and to the Bernie Madoff Ponzi scheme. It might be equally apt to compare it to the sub-prime crisis, because the magnitude of the scandal, and its possible effects, are so large.

And it raises some serious questions: what causes this kind of behaviour? What can be done to detect and prevent it?

Why do people get into fraudulent behaviour? Perhaps, it just became a habit. There was a statement in the Satyam letter to the Sebi that gives a clue -- it talks about 'riding the tiger, not knowing how to get off without being eaten.' Apparently once the books began to be falsified, the company embarked on a slippery slope wherein it could not right matters without things falling apart.

I suspect that in the intensely competitive IT services market, Satyam as the smallest of the big four players was under pressure to show extraordinary results in order to survive.

Was there anything more complicated? Was there unaccounted-for money being funneled in and out of Satyam? It is a known fact that rural Andhra Pradesh has rich landowners who have significant untaxed agricultural income: maybe there were informal arrangements whereby they funded -- and expected high returns from -- Satyam.

What is the solution to problems like this? It is probably not more intrusive government regulation. Despite the noises being made in America blaming all finance-sector problems on a lax regulatory environment, it is not clear that more paperwork is the answer.

Consider Exhibit A: Sarbanes-Oxley. The enormous amount of effort companies are forced to put into compliance with Sarbanes-Oxley did nothing, so far as can be seen, to prevent the occurrence of the sub-prime mess.

Nor did it prevent Satyam -- because of the listing of its ADRs in the US, subject to SoX provisions -- from doing what it did.

More regulation, especially in bureaucrat-heaven India, will probably just choke businesses to death, as in the dreaded days of red tape and the erstwhile, suffocating, License Raj -- which, incidentally, did enrich those that had the right contacts.

One answer may well be technology. There are applications that can recognize known patterns that indicate fraud. Some may include data mining to identify new patterns of fraudulent behavior.

But then machines can only go so far, and there is the danger of false positives. Therefore, human intervention will be required.

The accounting profession has instituted Governance, Regulatory and Compliance practices. A combination of technology and human oversight that closes process loopholes may provide some relief.

These might have, for instance, caught the $7 billion Societe Generale fraud of last year.

But it has always been true -- as demonstrated in the 1841 book "Extraordinary popular delusions and the madness of crowds" -- that there are scamsters and those willing to be taken in by them.

'A sucker is born every minute,' said circus-man P T Barnum a century ago. That clearly remains true today.