Corporate Governance Failure Satyam Lisbon, 11th May 2015 Corporate Governance Failure Satyam Applied Corporate Finance

1. Introduction 2008: Corporate governance failure: 1.4 billion fraud; 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 1. Introduction 2008: Corporate governance failure: 1.4 billion fraud; Key figure: Ramalinga Raju (Ganesh) star of the growing IT industry admitted to have inflated cash balances and accordingly the interest earned; Satyam was awarded the corporate governance award from peacock and EY. Applied Corporate Finance

1.2. Satyam Computer Services 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 1.2. Satyam Computer Services IT consulting: advisory, infrastructure, outsourcing; Main clients: Coca-Cola, GE, Tesco, Nestlé and others; Served 184/500 S&P 500 companies; Competitors: TCS, Infosys, Wipro, Accenture & IBM. Applied Corporate Finance

1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 2.1. Corporate governance The system of controls, regulations and incentives designed to prevent fraud; Main problem: Conflicts of interests between managers and investors (separation between ownership and control); Key objective: Attempt to allign interests of management and shareholders! Agency Costs (When manager does not internalize the full cost of his actions): Empire building; Excessive perquisites (Use of corporate jet etc.); Managers being lazy. Good Corporate Governance: Mitigate agency conflicts between managers and owners; Avoid fraud; Avoid manipulation of accounting statements; Problem: Aligning Interests comes at a cost (It increases risk exposure to managers). Applied Corporate Finance

3. The Board of Directors (BoD) 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 3. The Board of Directors (BoD) Board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization; Main task: monitor managers; Provide incentives for taking the right action and punishment for taking the wrong action; In a stock corporation, the board is elected by the shareholders and is the highest authority in the management of the corporation; Typically the board chooses one of its members to be the chairman. Legal Context: Sarbanes-Oxley act of 2002: Audit committee of the board must be composed entirely of independent directors; Dodd-Frank Act of 2010: All members of a firms compensation committee must be independent board members (reduce entrenchment and improve governance); US Law: Clear fiduciary duty to protect the interests of shareholders; Most other countries: BoD needs to protect interest of other stakeholders (e.g. employees) as well. Applied Corporate Finance

1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 3.1. Typical roles Governing the organization by establishing broad policies and objectives; Selecting, appointing, supporting and reviewing the performance of the chief executive; Ensuring the availability of adequate financial resources; Approving annual budgets; Accounting to the stakeholders for the organization's performance; Setting the salaries and compensation of company management. Potencial Problems: Monitoring is costly. They need an incentive to monitor; Many directors sit on multiple boards (less attention); Outside directors are often nominated by the CEO (how independent are they?); Captured board: Monitoring duties have been compromised by connections or perceived loyalties to management; The longer a CEO has served, the more likely that the board becomes captured. Applied Corporate Finance

3.2. Incentives for Management 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 3.2. Incentives for Management Key objective: Attempt to allign interests of management and shareholders! Owning stock of company; Stock options; Compensation sensitive to performance (Bonuses and other compensation packages); Punishment by firing a manager for poor performance or fraud; Upon failure of board to act: shareholders or raiders launch control contests to replace the board and management; Problem: A manager owning large amounts of stock becomes harder to fire because of his voting rights. Applied Corporate Finance

3.3. Duties of the Board of Directors 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 3.3. Duties of the Board of Directors “Proper purpose”: Each member of the BoD must act in “good faith”; “Unfettered discretion”: Without consent of the company, Board members can not fetter their discretion in relation to the exercise of their powers; “Conflict of duty and interest”: Directors may not put themselves in a position where their interests and duties are in conflict with the duties that they owe to the company; Transactions with the company and competing with the company: Considered as conflicts of interest, therefore forbidden. Can be overridden in the company’s constitution; Use of corporate property, opportunity or information: Without consent of the company, directors may not use this. Types of directors: Inside directors: Employees, former employees or family members of employees; Gray directors: Not directly connected to the firm but have existing or potential business relationship with it (Bankers, lawyers, consultants); Potential Conflicts of interests (keep the CEO happy) Outside (Independent) directors: All other directors. Considered most likely to make decisions solely in the interests of shareholders. Yet, less incentive to closely monitor the firm. Less expertise on core business . Applied Corporate Finance

3.4. Roles of the Chairman Chairing the meetings of the board; 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 3.4. Roles of the Chairman Chairing the meetings of the board; Organizing and coordinating the board's activities, such as by setting its annual agenda; Reviewing and evaluating the performance of the CEO and the other board members. Other monitors: Direct shareholder monitoring; Security analysts (Can uncover irregularities throughout their analysis); Lenders (Covenants); The SEC (Tasked with protecting the investing public against fraud and stock price manipulation. High enforcement powers but low detection resources); Employees within the firm itself (Most likely to detect fraud because of insider knowledge. Often low incentives to report fraud). Applied Corporate Finance

4. CG Model - Overview Board is diversified and international: 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 4. CG Model - Overview CEO Board of Directors Employees Executives Owner Governance Board is diversified and international: Including e.g. Harvard Business Professor, former Indian government cabinet secretary, … Management decisions could be undertaken without any involvement of other stakeholders; Directors went ahead with managements decision, irrespective of stakeholders’ interest  Board followed blind management’s decisions; Management was able to choose the four ‘independent’ board members itself due to insufficient regulations by the government; International auditing company (PwC) checked reports. Pays dividends They run the firm Need to remuner-ate fairly Management Applied Corporate Finance

4.1. CG Model – The Board Board composition: Board independence: 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 4.1. CG Model – The Board Board composition: Absence of financial acumen: Company admits lack of individual audit committee member that possesses the attributes required by Securities & Exchange Commission; Out of the 6 board members only one was a former CEO; 2 of independent directors served on 8 additional boards. Board independence: 5 out of 9 directors were declared as independent of management; Chairman and CEO were brothers and both members of management. Board committee: Lack of Nominating / Corporate Governance Committee. Notably, Harvard Business School Professor Krishna Palepu is not among them, likely due to payments of $200,000 a year noted in the filing that he received in professional service fees from the company. Applied Corporate Finance

Satayam never fulfilled its obligations towards its stakeholders. 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 4.2. CG Model – Does it work? Board Management Employees Shareholders Government From the beginning, no committing and adopting of ethical practices among entire value chain and in its dealings with a wide group of stakeholders Satayam never fulfilled its obligations towards its stakeholders. BUT manipulation for superior performance in several ways: Inflated workforce; Manipulated Balance Sheet and Financial Statements; Fictitious bills for services never rendered; … Applied Corporate Finance

4.3. CG Model - Inconsistencies 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 4.3. CG Model - Inconsistencies Board Management Employees Shareholders Government Raju built close relationships with Indian politicians and business leaders; Maytas was held by Raju’s sons  benefit from his influential political connections; Acquisition of a controlling stake in Maytas was not in consent with shareholders  acquisition is only beneficial for family; Raju stated in financial books that transfer of cash was to be used, in reality no exchange of cash took place; Inflated size of workforce by > 25%, thus, received only 60% of their salaries; Government failed in preventing shareholders and employees by insufficient regulations  ‘independent’ board member was picked by management itself. Applied Corporate Finance

4.4. CG Model – reasons to fail 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 4.4. CG Model – reasons to fail Low ethical and moral standards by top management; Need for strict separation of CEO and Chairman of the board; As opposed to Enron, at Satyam the CEO did not have any whistle-blower, he was his own whistle-blower. Successful Corporate Governance Cultural and managerial continuity Clear management structures Transparent and independent control instruments Long-term corporate financing Applied Corporate Finance

1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 5. Maytas’ acquisition Maytas (Satyam spelled backwards) was a group of two companies: Maytas Properties and Maytas Infrastructures; It was found in 1988 and they were held by Raju’s sons; Raju used its political influence to conquer several indian projects for Maytas’ group; Satyam bought land to Maytas Properties at inflated prices; As such, Satyam increased its debt due to these investments; In 2008 real estate prices started to decrease due to the crash in the Indian stock market; Satyam’s share price started to decrease and shareholders started to sell their shares. Applied Corporate Finance

1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 5. Maytas’ acquisition Maytas’ acquisition deal was announced in December 2008, before a series of events that putted into question Satyam’s governance procedures and ethical practices; Raju proposed to buy the group for $1.6 Billion; Purpose: cover the fraud done by Raju as shareholders as the market would see a big payment where in fact there would be no transfer of cash; From a shareholder value perspective, the Maytas’ acquisition would represent a benefit for Raju and his family, as they would cover fraud by Raju and Satyam would sustain the activity of Maytas Properties; As the real estate prices began to fall in the beginning of 2008, the future of Maytas Properties seemed unsecure; Nevertheless, this acquisition would not represent wealth creation for the company nor added value to shareholders. Applied Corporate Finance

5.1. Diversification strategy 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 5.1. Diversification strategy Once the three firms (Saytam, Maytas Infrastructure and Maytas Properties) had nothing to do with each other and they operated in very different business activities, there were a lot of disadvantages for this acquisition: The market doesn’t like diversified companies and it usually trades them at discount (conglomerate discount); Conglomerate companies are usually evaluated at a smaller value than the sum of the parts; There is an overextension of company’s resources in order to maintain its infrastructure and operations and available resources will start to decrease; There would be no synergies; There is a lack of expertise and focus once operations in different business activities require different skills; Theoretically, the single advantage is that a diversified company can reduce its change of financial damage in case any of the companies lags. Applied Corporate Finance

5.2. Saytam’s board and Maytas’ acquisition 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 5.2. Saytam’s board and Maytas’ acquisition Shareholders criticized this acquisition plan as they saw no benefits for the company and only for the family; Satyam’s board was severely blamed by media and shareholders for agreeing with the Maytas’ transaction; Nevertheless, independent directors could not do much in this case once Saytam depended on PwC to present an accurate picture of the company’s financial affairs and for them it seemed reasonable to acquire Maytas Properties and Maytas Infrastructure based on the available financial statements; Also, independent directors were not really independent from the controlling family as they were directly invited by Raju to join the company. As such, they tended to favor his interests; Independent directors did not perform their role of acting in the best interest of the company. Applied Corporate Finance

6. How was it possible for Satyam’s management to falsify its books? 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 6. How was it possible for Satyam’s management to falsify its books? Raju omitted the real values in the company books and also for the auditors, giving a false and better image to the market of the real situation of the company; So, Raju used creative accounting to cover the fraud in the company; Creative accounting consists in accounting practices that follow required laws and regulations, however deviate from what those standards intend to accomplish; Although these practices are legal, the loopholes they exploit are often reformed to prevent such behaviors. Creative accounting can be used to manage earnings and to keep debt off the balance sheet; Also, corporate government of India is not adequate in the sense that it is based on the Anglo- Saxon model which has some limitations in terms of its applicability in the Indian environment. Therefore there are some loopholes in the Indian regulatory environment. He was accused of cheating, criminal conspiracy, inflation invoices, profits, faking accounts and violating number of income tax laws. Applied Corporate Finance

6.1. What checks and balances were not in place? 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 6.1. What checks and balances were not in place? Although Satyam received several awards for corporate governance, on the 7th January 2009, Raju confessed the manipulation of the accounting books and the following discrepancies were found: “Raju sent a letter of resignation and confession to Satyam’s board that admitted to US$1.4 billion worth of fraud.” US$ Inflated Actual Cash and Bank Balance 1.03BN 65M Accrued interest 7.7M Non-existent Liability 252M Undisclosed Confession: The balance sheet had inflated and non-existent cash and bank balances. (US$7.7 million interest earned was non-existent) Understatement of liabilities and overstatement of money False operating margins (24% vs 3% of actual revenue) Misleading cash and bank balances of US$1.03 billion vs actual cash and bank balances of US$65 million Applied Corporate Finance

1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 6.2. What and who failed? Auditors from PwC have a big responsibility in this situation and on the manipulation in the accounts. Auditors did not ask about the truth of the bank’s statements created by Satyam’s corporate financial officer; Also, PwC did not bothered to check and verify those accounts; There was a serious neglect of fiduciary duties of auditors such as: Objectivity, integrity, free of conflicts of interest and truthfulness; Duty to the public; An accountant can only have a fiduciary duty to clients when it provides services such as: tax services, asset management and general business consulting, which is not the case of PwC relating to Satyam. Applied Corporate Finance

7. Controlling shareholders and agency costs 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 7. Controlling shareholders and agency costs Agency costs will be generated by the divergence between the interests of the controlling shareholders and those of the outside shareholders and also conflicts of interests between shareholders and management; So, the goals of different parties of the company are not aligned; In the particular case of Satyam, there are less agency costs that result from the separation between management and ownership as the independent directors are appointed and invited by Raju and, as such, management tends to follow the ideas of the family (the controlling shareholder). Applied Corporate Finance

7. Controlling shareholders and agency costs 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 7. Controlling shareholders and agency costs In this particular case where there are controlling shareholders/families, the most common agency costs are the following: Controlling shareholders tend to extract benefits from other stakeholders since they have a strong influence over other shareholders and over management members; The effectiveness of the evaluation of the board of directors decreases as the board is not independent from the controlling family and tends to follow its ideas and advices even if it is not in the best interest of the company and all shareholders. This is more probable to happen when the board of directors is nominated by the controlling shareholder; As such, companies with controlling shareholders (family companies) tend to underperform non-family companies; Having this, it is possible to conclude that agency costs increase as there is a relation between the board of directors and the controlling shareholder. Applied Corporate Finance

8. Possible Alternatives 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 8. Possible Alternatives Sell the company; Rebranding; New management; Publication of new governance code. Applied Corporate Finance

1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 9. Follow up If : Raju had never suggested Maytas’ transaction? The board had not approved it giving shareholders no reason to revolt? There had been no deal to cancel? If he had not attempted Maytas buyout, probably this scandal would not have come to light! Would this scandal be discovered but for Maytas deal? Raju, the founder of Satyam Computer Services, one of the fourth largest software services company in India, was sentenced to 7 years in prison after his self confession. Applied Corporate Finance

9. Follow up After the scandal, the following events took place: 2009: 1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up 9. Follow up After the scandal, the following events took place: 2009: Satyam was barred from doing business with the World Bank for 8 years Tech Mahindra, owned by Mahindra Group, bought 46% of Satyam  Mahindra Satyam 2011: Raju gets bail from India’s supreme court 2012: Tech Mahindra announced its merger with Mahindra Satyam 2013: India’s enforcement directorate files a charge sheet against Raju 2014: Securities and Exchange Board of India bared Raju from the capital market for 14 years 2015: CBI court hold Raju and other 9 officials guilty of cheating. Between these people held guilty there were 2 former partners at PwC. Applied Corporate Finance

1. Introduction 2. Corporate Governance 3. Good practices 4. Satyam’s model 5. Maytas’ acquisition 6. Creative Accounting 7. Agency costs 8. Alternatives 9. Follow-up Conclusions Low moral and ethical standards by top management brought fraud forward Acquisition of Maytas did not represent wealth creation for the company nor added value to shareholders; The only advantage of the diversification strategy is that a diversified company may reduce its change of financial damage in case any of the companies lags Conflict of interest due to nepotism Loopholes in the Indian regulatory environment simplified the fraud Increasing agency costs due to the relation between the board of directors and the controlling shareholder US$ Inflated Actual Cash and Bank Balance 1.03BN 65M Accrued interest 7.7M Non-existent Liability 252M Undisclosed Applied Corporate Finance

Lisbon, 4th May 2015 Q & A Applied Corporate Finance

References http://www.aicpa.org/interestareas/personalfinancialplanning/resources/practicecenter/profe ssionalresponsibilities/pages/fiduciarystandardofcare.aspx http://iica.in/images/Evolution_of_Corporate_Governance_in_India.pdf http://www.researchgate.net/profile/Shanthy_Rachagan/publication/228249202_Agency_Cost s_in_Controlled_Companies/links/546de61c0cf2a7492c5637c4.pdf http://www.sciencedirect.com/science/article/pii/S1755309112000445 http://www.dnaindia.com/money/report-satyam-scam-a-lowdown-as-court-readies-to- announce-its-verdict-2067138 Applied Corporate Finance