Poonam Mehra National Institute of Securities Market

Overview  Financial markets involve allocation of resources  Financial institutions are intermediaries  Finance markets are unique Financial operations are complex High Technological Innovation Three Premises: inter-temporal trade, risk and information  Pervasive Market Failure  Case for Intervention

Principal-Agent problem  Principal: Owners of Capital, represented by Regulator  Agent: Financial Institutions  Example from the mutual fund Industry  Issues: Management Capability of the institutions unknown to regulator: Adverse Selection Inability to monitor the Institutions: Moral Hazard Residual Risk

Adverse Selection  Principal lacks information about the type of the agent  It refers to the case of hidden information  Example: Quality of risk management techniques varies across institutions  Should the same regulation apply to all?  Solution: Screening Signaling

Screening  Uninformed party (regulator ) offers a contract  Tries to screen the different pieces of information the informed party (financial institutions) has  Menu of Contracts: Self-select Group  All choose the same: Bad may mimic the good  Carrot and Stick Approach  Problem: bad drives out the good

Signaling  Signaling: contract offered by informed party, tries to signal its abilities Adoption of Best Practices Ongoing relationship: Reputation Contract with right incentives and credibility Delegation ○ Internal Audit ○ External Audit

Moral Hazards  Moral Hazard arises when the principal cannot monitor what the agent does  Moral Hazard gets reflected in the form of hidden action  There is no perfect solution to the problem  Solution to Moral Hazard Use of Incentives : Pay Structure Regulation

Pay Structures and Risk  Established controls may not induce favorable action by agents  Agents respond to pay off structure  Loss due to downward risk < potential upward gain  i.e. a convex pay structure induces agents to take more risk  Typical pay structure induces differential response to risk and return

Pay off structure and Risk Red: risk averse Yellow: risk lover Success of risky action Reward to Agent Minimum bonus outcome Basic Salary Bonus Cap

Regulation  In banking industry, moral hazard could arise due to action of managers investors  Possible solution Official regulation Encouragement of Private sector lending Impose cost on those who commit mistakes

Forbearance  Ex ante: high punishment and strong incentive required to ensure good governance  Ex post: is it always sensible for regulators to stick to original rules  May be not  Other factors affect decision of the regulator Political: an election year International reputation Other parties affected  All this factors may lead to forbearance  Forms of forbearance Delayed intervention and disclosure Financial aid

Cost –Benefit Analysis of Forbearance Advantage Disadvantage  Systemic Consequence  Forced liquidity may not always yield proper value  Going Concern Value  Bankruptcy entails high cost  If forbearance fails Actual cost to public increases Lock in effect  Reduces future Incentive to follow regulation  A cost benefit analysis of forbearance is not possible ex ante

Size Matters  Forbearance applies more to large/ core sectors  Big Firms feel regulation is more for Smaller Firms  Large Firms are more diversified and more credit worthy  “Too Big to Fail”- doctrine  Medium Sized Firms may be induced to expand the balance sheet  Large Firms may take excessive risk

Example: Bail out to RBS RBS bailout costliest worldwide Government's total bailout of the bank equals 45.5 billion pounds or about 74 billion dollars. Consequently percent of the stakes of the bank were held by the government Issues: Series of bailout: example of lock in effect Provide stability Alternative was bankruptcy Ex post: bank survived Tax payers as stakeholders may gain in the medium and long term

Individual vs. System  Erosion can be caused by Behavior of institution’s managers Adverse Market Movement  Manager should be blamed more for their individual fault, whether due to lack of effort, lack of skill, willingness to take excessive risk  Not punishing a manager in case of market movement may encourage herding behavior  Extreme outcomes cannot be predicted

Case Study: Satyam  Satyam Scam in the contemporary corporate world: A Case Study in Indian Perspective  Founded in 1987 by B. Ramalinga Raju  Provides IT services  Listed in NYSE & Euronext  7 th Jan, 2009 Raju confessed of manipulating accounts by $ 1.47 billion & resigned  In the study, we try to look at liability of: Promoter, Director Independent Directors Auditors

Confessions of Mr. Raju  Inflated (non-existent) cash & bank balances of Rs crores on the balance sheet as of September 30, 2008  Non-existent interest of Rs. 376 crores accrued  Understated liability of Rs crores on account of funds  Overstated debtor position to the tune of Rs. 490 crores  For 2 nd quarter of 2008 alone, artificial cash and bank balances were raised by Rs. 588 crores

History of Ownership Pattern (% of Equity Holding) DatePromoter s holding (%) Mutual Funds (%) - Non- Promoter s Banks, FI's, Insurance Cos. (%) - Non- Promoter s Foreign Institutio nal Investors (%) - Non- Promoter s Corporate Bodies (%) - Non- Promoter s Individual s (%) - Non- Promoter s Other Non- institutio ns (%) - Non- Promoter s Custodia ns Total equity holding (%) Mar Mar Mar Mar Mar Mar Mar Mar Source: Study by Prof. Subrata Sarkar, IGIDR

Liability as a Director, Promoter  Criminal Conspiracy  Cheating  Criminal breach of trust  Forgery  Falsification of records  Additional charges Breach of fiduciary duty Violation of companies’ Act Misrepresentation of BS and P&L statement Omission & falsification of company documents Serious Frauds Investigation Office US shareholders can file law suit Arrested on these charges Non-bailable

Liability of Independent Directors  Counterbalance weakness of management  Ensure legal and ethical behavior  Extend the reach of company  Clause 49 of listing Agreement At least 50% of the board should comprise of non- executive directors At least 50% of the board should comprise of non- executive directors Independence of Judgment No material Relationship No Pecuniary Relationship No Pecuniary Relationship  Under SEBI and Company Law, all directors cannot be held responsible as institutional and independent directors are nominated and nominated directors are not legally liable

Liability of PWC in Satyam Case  PWC was paid double the normal fees usually paid to auditorsdouble  Re-appointed seven times  Section 227, 233 require auditors to accurately, fairly and diligently review and audit company account  Failure results in a penalty upto Rs. 10,000  Section 62, 63 says any persons issuing false propsectus is liable to 2 years imprisonment and fine upto Rs. 50,000  ICAI can initiate disciplinary proceedings against an audit firm Leading to disqualification from eligibility to act as statutory auditors Suspension/debarment

Conclusion  Satyam: one of the very successful and sought after companies can also go wrong Questions the belief “large or successful institutions should be above regulation”  Moral Hazard Monitoring difficult Independent directors need to be made liable Auditors: How reliable they are?  Relook at Regulation

History of Board of Directors Classification March 2008March 2007March 2006March 2005March 2004 B Ramalinga RajuPromoter Executive Director B Rama RajuPromoter Executive Director, Promoter Executive Director Ram MynampatiDirector in whole time employment Mangalam Srinivasan (Dr.) (Mrs.) Independent Director Krishna G PalepuNon-executive, Gray Director Independent Director Vinod DhamIndependent Director M Rammohan Rao (Prof.) Independent Director T R PrasadIndependent Director V (Prof.)Independent Director V P Rama Rao (Retd.) (I.A.S.) Independent Director C Satyanarayana (Retd.) (I.A.S.) Independent Director Board Size % of Independent Directors Source: Study by Prof. Subrata Sarkar, IGIDR

Board of Directors: Financial Year 2008 Directors NameDirector Designation Director Classification Board Meetings Attended Total Number of Directorships Total Number of Committee Memberships B Ramalinga RajuChPromoter Executive Director 430 B Rama RajuMDPromoter Executive Director 341 Ram MynampatiExec. Director & President Director in whole time employment 440 Mangalam Srinivasan (Dr.) (Mrs.) DirectorIndependent Director 320 G PalepuDirectorNon-executive, Gray Director 430 Vinod DhamDirectorIndependent Director 190 M Rammohan Rao (Prof.) DirectorIndependent Director 464 T R PrasadDirectorIndependent Director 494 V (Prof.)DirectorIndependent Director 442 Source: Study by Prof. Subrata Sarkar, IGIDR

Directors’ Remuneration: Financial Year 2008 Directors Name DesignationSalarySitting FeesBonus/ Commission Other payments Total Remuneration B Ramalinga Raju Ch18,00,000 24,43,35560,43,355 B Rama RajuMd16,80,000 10,47,72544,07,725 Ram MynampatiExec. Director & President 3,52,28,512 Mangalam Srinivasan (Dr.) (Mrs.) Director 80,00012,00,00012,80,000 Krishna G Palepu Director 40,00012,00,00079,51,000*91,91,000 Vinod DhamDirector 10,00012,00,00012,10,000 M Rammohan Rao (Prof.) Director 1,20,00012,00,00013,20,000 T R PrasadDirector 1,20,00011,33,33312,53,333 V (Prof.)Director 1,30,00011,33,33312,63,333 Source: Study by Prof. Subrata Sarkar, IGIDR

Auditor Details for Satyam Total Audit Fees ( in lakhs) Out of Pocket Expenses* Non-Audit Fees* Total Payments to Auditors* Non-Audit Fee % Mar 2001Price Waterhouse & Co Mar 2002Price Waterhouse & Co Mar 2003Price Waterhouse & Co Mar 2004Price Waterhouse & Co Mar 2005Price Waterhouse & Co Mar 2006Price Waterhouse & Co Mar 2007Price Waterhouse & Co Mar 2008Price Waterhouse & Co Source: Study by Prof. Subrata Sarkar, IGIDR