Satyam Fraud’s Systemic Regulatory Implications

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From a systemic regulatory standpoint, the Madoff Ponzi scheme remains of limited significance, especially compared to the latest exposed fraud case, at the large Indian software company, Satyam Computers Services Ltd., whose shares trade on the New York Stock Exchange (in the form of American Depository Receipts, or ADRs). Its CEO released a letter yesterday disclosing an elaborate, and apparently simple, billion-dollar fraud that went undetected by the firm’s outside auditors, an India affiliate of PriceWaterhouseCoopers (PWC).

The Satyam fraud presents serious questions about systemic regulatory efficacy, particularly concerning auditing and audit firm oversight. True, it may seem outlandish that Madoff was able to use a rinky-dink auditing firm to review the books of a fund commanding billions of dollars in assets and it may be that even such small auditing firms of even private funds require as much regulatory supervision as larger auditing firms auditing public enterprises.

But the Satyam scandal presents a far more serious problem. Unlike Madoff, the company has shares listed in the United States. Also unlike Madoff, it was audited by a foreign affiliate of a large US auditing firm, PWC, whose operations apparently were outside the scope of review undertaken by the US auditing profession’s regulatory overseer, the Public Company Accounting Oversight Board (PCAOB).

Pending additional information from the newly-revealed fraud, of course, a couple of preliminary issues may prove to be lessons of the Satyam fraud. First, if foreign companies list securities in the United States, their financial statements need to be audited by a firm whose activities are subject to regulatory oversight in the United States.

Second, the fraud implicates the Securities and Exchange Commission’s recent enthusiasm for the concept of mutual recognition. This refers to a policy allowing foreign firms, especially brokers but potentially also companies and auditors, to access US securities markets without regulatory oversight here, so long as they are subject to comparable regulatory oversight at home. (I have questioned this policy before.)

Third, there is some possibility that audit failures by foreign affiliates of US auditing firms could expose the US firm to crushing legal liability. This could lead to the dissolution of one of the four remaining large US auditing firms (see my post here). Should that occur, with only three such firms standing, the country would face an additional blow to its system of corporate finance, with attendant adversity for the real economy and citizens.


Satyam’s CEO now admits that some reported assets at the company simply did not exist, including considerable amounts of cash. Cash was reported to exceed $1 billion but apparently stands at just $78 million!

Ordinarily, the audit work required to verify the existence of cash is among the easiest of all auditing exercises. One wonders how auditors could have failed to identify such false assertions.

It is likewise the case that the integrity of systems of internal controls governing cash are among the easiest to establish, maintain and audit. Satyam’s auditors gave opinions attesting to the veracity not only of management’s assertions about cash balances but also about the effectiveness of the company’s internal controls. So one also wonders how auditors could have given a clean bill of health to a system of internal control that enabled reporting large amounts of fictitious cash.

Some now will say that the PCAOB bears some responsibility for this fraud and must adjust its policies. PCAOB was created in 2002’s Sarbanes-Oxley Act in response to audit failures, chiefly by erstwhile big-five auditing firm, Arthur Andersen, at companies that turned out to be elaborate frauds, especially Enron and WorldCom. Its responsibilities include inspecting all auditing firms responsible for auditing public companies, those registered with the SEC and listing securities on US capital markets.

Reports indicate that while PCAOB conducts extensive inspections of the four largest auditing firms who together audit the vast majority of US public companies, including PWC, the agency does not conduct inspections of the foreign affiliates of those firms, such as PWC’s Indian affiliate that audited Satyam’s books. Problems apparently include that PCAOB lacks sufficient budget, although it is funded by fees imposed on public companies under a budget it submits to the SEC and the SEC approves.

The problem may grow more serious, however, as the four largest US auditing firms appears increasingly interested in outsourcing much of their auditing work to foreign affiliates, including to firms in India. Investors should be concerned about these developments, especially if the SEC were to continue to pursue its program of mutual recognition and if PCAOB mirrored that policy by relying upon foreign auditing oversight authorities to conduct inspections of auditing firms based abroad.

Hat tip: Lynn Turner

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10 Responses

  1. Jeff Lipshaw says:

    My wife, who has been an inactive CPA since 1983, said “it’s been 25 years since I was on an audit, but I still know how to audit cash!”

  2. Satyam is of course a Sanskrit word, the nominative case of satya, “true; truth,” hence “trueness” or “realness” (for that which is true is real, and ‘being true,’ as it were, is a property of reality, properly understood). It can mean “truthfulness,” “absolute truth,” “speaking truth without distortion,” etc. I’m sure Indians are having a bit of fun with the company’s name.

  3. Lawrence Cunningham says:

    Inspired by Patrick:

    On “truth,” note that Price Waterhouse’s audit opinion for Satyam, following US auditing practice, told its board and investors that the financials “present fairly” the company’s condition and results. The UK equivalent is the phrase “true and fair view.” EU countries translate “true and fair” into national languages.

    Idiomatic complexities yield translations suggesting somewhat differing English language correspondence. For example, Italy translates the phrase as “rappresentare in modo veritiero e corretto” or “evidenza a verita,” which seem more nearly akin to “true and correct” and “straightforwardness and truth,” respectively.

    In Denmark, the idiom suggests “right-looking and according to facts;” in Portugal, “true and appropriate.” In some tongues, the notion boils down to a single word, like “real” (France, Belgium, Netherlands, and Spain) or “faithful” (Luxembourg).

    Despite variation, I doubt that there is a language in which “fairly presents” can justify a billion dollar discrepancy.

  4. A.J. Sutter says:

    “I doubt that there is a language in which ‘fairly presents’ can justify a billion dollar discrepancy” — I’m tempted to ask what language was Hank Paulson speaking to Congress ca. September 2008; but maybe there isn’t a word for anything so small as a billion dollar discrepancy in that language.

    Your comparison to Madoff is very pertinent when looked at from another linguistic angle: Ponzi schemes and other pyramid schemes are instances of “confidence schemes”. When a Big Four firm issues an audit opinion based on outsourced work, the metaphor is no less literal: the opinion rests on a pyramid of confidence in the various layers of audit and in the groups who conducted those pieces of the audit. I wonder when we’ll start to see shaky legal services pyramids, as well.

  5. Lawrence Cunningham says:

    For A.J.–

    Billion dollar rounding errors in interpretations of Secretary Paulson’s statements acknowledged, and amplifying the confidence point, I wrote in 2003, critically of the Sarbanes-Oxley Act’s express motivation to “promote investor confidence,” that this was just what Enron and other catalysts had done—they promoted investor confidence, par excellence. To which, one of the most esteemed corporate/securities law scholars in the country replied to me: ”I feel wounded, since I drafted [the language about promoting confidence].”

    Ponzi schemes, and many responsive regulatory schemes, are all about building confidence, and that response, in my view, is false. Capitalists and regulators, both, should give investors reason to have confidence, not promote confidence. Trouble is, regrettably, both have incentives to sell confidence, rather than grounds to justify it.

    You will see this in coming regulatory reforms. My conversations with Washington power brokers these weeks suggest both that (1) we all know what reforms would be optimal and (2) they don’t stand a political chance of enactment.

    I don’t mean to present as cynical; I’m an optimist, personally, professionally and financially. But realism is the thing with regulatory reform. Billion dollar rounding errors may be in our future, whatever the language.

  6. Michael Guttentag says:

    Could you blog in more detail about “what reforms would be optimal” and why they “don’t stand a chance”?

    Also, I would agree with you that “building confidence” is not a sound objective for a regulatory agency, but this language strikes me as symptomatic of a much larger confusion about how to probably characterize the goals of regulatory intervention in capital markets. I’m not sure that giving “investors reason to have confidence” is that much better. Are you referring to the accuracy of financial statements or something broader?

  7. Lawrence Cunningham says:

    Michael–

    Thanks for the suggestion for more detailed blogging on optimal solutions and political obstacles, which I’d like to take up. As a sample, consider merging the SEC and CFTC, a proposal that is 20 years old and would enable a more comprehensive approach to regulation of financial instruments, markets and firms. Political obstacles arise because different Congressional committees exercise oversight of the two agencies and Members have deep vested interests in maintaining the advantages that come from that oversight.

    On the difference between (a) promoting investor confidence and (b) providing grounds for investor confidence, I’m referencing the broader distinction between actions, responding to crisis, (a) taken to show the public that authorities are taking control over a crisis and thus to influence psychology and (b) taken according to a reflective analysis designed to achieve substantive objectives to benefit a targeted audience. Many crisis response actions contain examples of both.

    But sometimes the only effective step authorities have amid a crisis is a kind of “show” to influence a targeted group’s psychology. The classic example may be when Britain, facing the German bombardment of London amid World War II, lofted noisy radar interference all around the capital. This was a show of determination and signal of doing something which had no technical effect on the bombing but possible psychological effect on the bombers, and perhaps on Londoners.

    I used that example in the conclusion to my 2003 article reviewing Sarbanes-Oxley, which, in the parts that talk about promoting investor confidence, and in much of the rhetoric surrounding its enactment, sought to influence the psychology of investors. When substantive changes to address a crisis are possible, as I believe they were in response to Enron and other catalysts of SOX, focus should be entirely on those changes, without resort to psychological influence. This may be a suitable topic for a future post too, so thanks for that too.

  8. Jake says:

    Hindsight is always 20/20.

  9. MDF says:

    I’m a bit surprised on your take on mutual recognition. After all, (1) nobody is talking about letting in a weak and regulatorily under-developed market such as India (it’s Australia, isn’t it?); (2) and what are you worried about — that the foreigners will expose American investors to Ponzi schemes, inadequate disclosure, and poor investment advice? We’ve got all that covered at home.

  10. nawal kishore singh says:

    i m not very much surprised with this happenings.becouse if we see it minutely we find that we r sitting on the verge of civiliastion collapes.every one is crazy and keen to get rich quick.what would be the modus ?they donot have any pain to look into and explore for .