Governance and Control Instruments to Minimize Moral Hazard G Ramesh IIM Bangalore

G Ramesh, CPP - IIM Bangalore 1

Martha Stewart Case - US

Stewart, 63, committed illegal insider trading when she sold stock in a biopharmaceutical company, ImClone Systems, Inc., on Dec. 27, 2001, after receiving an unlawful tip from Bacanovic, at the time a broker with Merrill Lynch, Pierce, Fenner & Smith Incorporated. The Commission (SEC) mentioned that Stewart and Bacanovic subsequently created an alibi for Stewart's ImClone sales and concealed important facts during SEC and criminal investigations into her trades.

G Ramesh, CPP - IIM Bangalore

Martha Stewart Case US

By selling when she did, Stewart avoided losses of $45,673. Stewart now faces perhaps two years in prison and the liquidation of at least half of her wealth (in the hundreds of millions of dollars), all because she managed to save herself $50,000 selling.

G Ramesh, CPP - IIM Bangalore

Martha Stewart Case

Wayne M. Carlin, Regional Director of the Commission's Northeast Regional Office, said: "The Commission simply cannot allow corporate executives or industry professionals to profit illegally from their access to nonpublic information. The coordinated action announced today by the U.S. Attorney's Office shows that the consequences for those individuals will be even greater if we uncover evidence that they obstructed our investigation.

G Ramesh, CPP - IIM Bangalore

Martha Stewart Case

One of the jurors commented gleefully that this conviction was justified, in part, because it would send a message to the "rich and powerful" that they can't get away with such abuses. Martha Stewart reported to prison one early Friday to begin serving a five-month sentence for lying about a stock sale, the federal Bureau of Prisons said.

G Ramesh, CPP - IIM Bangalore

Rajat Gupta
Was once global head of McKinsey Was Charged with Insider Trading on % counts Colluded with Rajaratnam, a Srilankan His disclosure of Inside Information concerning Berkshire Hathways $5 billion Investment in Goldman Sachs Disclosure of Inside Information Concerning Goldmans Sachs negative Interim Financial Results Disclosure of Inside Information Concerning P & G Quarterly Financial Results

G Ramesh, CPP - IIM Bangalore

Rajat Gupta Case

The US Attorney is Preet Brarara Rajat Gupta surrendered to court

G Ramesh, CPP - IIM Bangalore

Your Take

How do you think it would have been handled in India?

G Ramesh, CPP - IIM Bangalore

Satyam case
Its CEO Raju, Confessed that its balance sheet included Rs.7135 (US$1.5 billion) is non existent cash and bank balances and accrued interest and misstatements. It had inflated its 2008 second quarter revenues by Rs.5880 million (US$ 122 million) and operating margins are less than a tenth of Rs.649 millions (US$135 million ). Its Board members Prof Krishna Palepu, Mangalam Srinivasan (Advisor to KSG), Vinod Dham, and Prof Ram Mohan Rao resigned. TR Prasad and VS Raju resigned later In a week's time, Prasad has resigned from the boards of six firms, as per data available on the stock exchange website.
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Satyam case
In a week's time, Prasad has resigned from the boards of six firms as per data available on the stock exchange website.

Listed in NYSE and Nasdaq class action suits filed.

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Datelines
o Dec 16th, 2008 Satyam proposes $1.6 billion (Rs.7000 crores) to buy Maytas Properties and Maytas Infra. Cancels it in 24 hours after shares in US plunged Dec 17th, 08 It says deal put off because of investors concern Dec 18th, 08 It sets Board meeting on Dec 29th to consider share buy back Dec 22nd Two independent directors say Board didnt fully sign off on takeover valuation Source: Corporate Governance failure at Satyam, Vanita Yadav and CV Baxi, Asia case Research center.
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Datelines
Dec 26th One independent director resigns Dec 29th Three more independent Directors quit. Dec 30th Prof Palepu quits. Speculation of Private equity interest in shares boosts prices Jan 2nd - Satyams say Rau family stake fell to 5.13% Jan 7th Raju resigns after admitting falsifying company accounts. Shares plunge from 179 to 6.30.

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Datelines
Jan 10th - The New York Stock Exchange suspended trading in Satyam, though the Bombay Stock Exchange and the National Stock Exchange of India have said they will not being doing so. By mid-morning in Mumbai, Satyam shares had slumped to 6.30 rupees, bringing the two-day decline to 91%, according to Bloomberg data. Asiatimes

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Satyam Statement on Corporate Governance

o Satyam believes that sound Corporate Governance practices provide an important framework to help the Board of directors fulfill its responsibilities.It does so by adhering to and enforcing the principles of sound Corporate Governance. The principle of "Delighting stakeholder" is part of everything we do at Satyam

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CBI Charge Sheet

Rs.7136 crores plus supplementary charges of Rs.4739 crores. Auditors relied upon forged bank confirmation letters. Failed to verify the companys current account balances. It found evidence of Talluri directing his team members to, discontinue the procedure of obtaining the confirmations from debtors and vendors in respect of Satyam Computer Services from Sep 2007 onwards The accused forged board resolutions and unathorisedly obtained loans to the tune of Rs. 1220 crores for Satyam Computers.

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CBI Charge Sheet

5 get bail. Is Satyam case losing steam? CBI hasnt yet filed charges relating to the siphoning of funds from satyam, nor has it begun its case. The court has to begin to distinguish between crimes of magnitude and normal cases. We have been issuing notices to the accused to appear before the court, but if it passes a judgment against us, what can we do? Amarjit Chopra, President, ICAI.

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Issues
Satyam had the best of the Board, Governance, Auditors, Banks and Management. Why do you think the scam happened? Was Governance the problem? Or, Deficient Institutional System? Should it have been rescued?

o Like the dogs that did not bark in Sherlock Holmes story

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Issues
Post fraud what should the Board have done? Post fraud what should the Govt. have done?

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Audit Role
o Two senior auditors of PricewaterhouseCoopers (PwC) yesterday confessed that they had received heavy amounts to deliberately overlook the fudging process in Satyam at the behest of its former chairman o According to the accounting protocol, we should not have approved the books. But we colluded and approved the figures. We were paid heavy amounts by Ramalinga Raju," PwCs in-charge of Hyderabad office S Gopalakrishnan reportedly said in his confessional statement. o They also, intentionally, omitted to verify and scrutinize documents and thereby helped in committing a brazen fraud with the Raju brothers and other directors, the source said.
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Audit Role
o In connection with the multi-billion dollar Satyam scam, the US auditing watchdog has barred from public practice two Indian auditors associated with the IT firm's former auditor Price Waterhouse Coopers. o As per an order from the Public Company Accounting Oversight Board (PCAOB), the two Indians -- Siva Prasad Pulavarthi and Chintapatla Ravindernath - have been barred from being associated with any registered public accounting firm.

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Boards Role
VP Rama Rao

Particulars

Mangalam Krishna G Vinod K M Rammohan Srinivasan Palepu Nigam Rao

TR Prasad VS Raju

12,00,00 Commission 1,00,000 12,00,000 12,00,000 0 12,00,000 11,33,333 11,33,333 Sitting Fees 80,000 40,000 10,000 1,20,000 1,20,000 1,30,000 Professional fee 79,51,000 Total Stock options 12,10,00 1,00,000 12,80,000 91,91,000 0 13,20,000 12,53,333 12,63,333 10,000 @ 5,000* 5,000* 5,000* 10,000@ 10,000@ 10,000@

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Thread of Reasoning
Capital Market is Mirror Image of Democracy Shareholders entrust corporates to the Board which in turn entrusts Management to manage the company in the interest of the shareholders. The entire focus is on ensuring alignment of goals between the Principal and Agent. The Agent will try to maximize his benefit by playing on Information Asymmetry

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Thread of Reasoning
The Principal tweaks the information system to minimize asymmetry and the incentive system to minimize the moral hazard problem.

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Principal - Agency Framework

Divergent Behavior of Principal and Agent Aspects Information Asymmetry Opportunistic Behavior Non Observability of Agent Moral hazard : A moral hazard problem arises if the principal can observe neither the agent efforts nor surrounding conditions. Motivated to Mis-Represent private information
G Ramesh IIM Bangalore

Public Governance
GOVERNANCE is " the traditions and institutions by which authority in a country is exercised for the common good. This includes (i) the process by which those in authority are selected, monitored and replaced, (ii) the capacity of the government to effectively manage its resources and implement sound policies, and (iii) the respect of citizens and the state for the institutions that govern economic and social interactions among them" (World Bank)
G Ramesh IIM Bangalore

Corporate and Public Governance

Corporate Governance Operates within the Umbrella of overall Public Governance which sets the terms of institutions and transaction.

G Ramesh

IIM Bangalore

Song of the Sirens

o Can we expect that the ruling class will impose on itself a self denying ordinance? Can we expect it to disable itself, in the spirit of Homers Ulyssis, who tied himself to his ships mast, lest he be tempted by the Song of the Sirens? DN Ghosh

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Thank You

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Corporate Governance Definitions

o the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders, and other stakeholders, and spells out rules and procedures for making decisions on corporate affairs: DN Ghosh o the way in which companies are directed and controlled : Cadbury o the system of checks and balances, both internal and external to companies, which ensures that companies discharge their accountability to all their shareholders and act in a socially responsible way in all areas of their business activity.. Solomon
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What are the necessary and sufficient Conditions?

Information Asymmetry High Quality Reporting High Accounting Standards Risk Management Practices Moral Hazard Best Auditors Professional Board: Best of Breed Incentive Problems Compensation Committees Listing in NYSE: Investors reward companies with better reporting standards
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Aspects of Public Governance

o Participation - - Citizen centric o Rule of Law Institutions: Policy Making, Regulation, Justice, Time is the crucial deliverables Transparency - Right to information Information is a Public Good vis a vis private good o Responsiveness o Equity o Accountability (Gita Welch)
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Global Governance
Global governance also implies ways of sharing responsibility between the public sector (regulation and supervision), the private sector (self-regulation), and civil society (democratic oversight) Basel

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Observations by Amar Bhide

Too much controls can be counter productive Rules that protect investors and the integrity of stock markets foster antagonistic, arms length relationships between shareholders and managers. Instead of yielding long term to shareholders who concentrate their holdings in a few companies, where they provide informed oversight and counsel, the laws promote diffused , arms length stockholding.
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Observations by Amar Bhide

Institutional investors with fiduciary responsibility usually refuse to receive any private information from managers. Investors prefer a cheap exit to a costly voice. Instead of yielding long term to shareholders who concentrate their holdings in a few companies, where they provide informed oversight and counsel, the laws promote diffused , arms length stockholding.

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Amar Bhide
In both Germany and Japan, corporate investors and intermediaries are able to reach deep into the inner workings of portfolio companies to effect fundamental management change in the US, in contrast, when large institutional investors suggest that they might like to have some influence on management succession at GM - a company that has hardly distinguished itself for a skillful management they are met with icy rejection and explicit warnings Joseph Grundfest former SEC Commissioner

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Amar Bhide
Occasionally, greed, lax scrutiny, or ingenious frauds could lead to serious losses. But should good public policy sacrifice the interests of the many to guard against the imprudence or bad luck of the few?

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Alternative Reforms
o o o o o o o o o Prudential Regulation Self Regulation Norms Standards Ratings Accreditation Third Party oversight Transaction cost of Information Policing and fraud detection still required

Reform Process Model

o Rise In disequilibrium o (dissatisfaction with existing supply of pub / pvt goods) Supply of Goods (a new mix) Articulation of demand (Demands for a new distribution)

Reaction to demand (Govt. reacts to business)

n

G Ramesh IIM Bangalore

Exante control (incentive mode)

Expost Mode (penalties)

Recurrence (More control)

Bigger Scam Is it a Converging equilibrium or Diverging Equilibrium

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Dirty Bomb: unlikely to cause many deaths dirty bombs are called weapons of mass disruption. Additionally, containment and decontamination of thousand of panic stricken victims, as well as decontamination of the affected area might require considerable time and expense, rendering affected areas partly unusable and causing economic damage.

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Irrational Exuberance
Ultimately, in a free Society, we cannot protect people from all the consequences of their own errors. We cannot protect people completely without denying them the possibility of achieving their own fulfillment. We cannot completely protect society from the effects of waves of irrational exuberance or irrational pessimism emotional reactions that are themselves part of the human conditions. Shiller: Irrational Exuberance

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Thank You

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Reform or Regulatory Deficit?

o By and large, the structure is very weak in cooperatives and NBFCs for historical reasons, local practices, and multiplicity of regulators and laws. Old private sector banks have very poor auditing and accounting systems. New private sector banks generally good on accounting, but poor on accountability. More modern and computerized, but less risk conscious. One thing which is common to all is that corporate governance is highly centralized with very little real check on the CEO, who is generally also closely linked to the largest owner groups. Boards or auditing systems are not effective. o Bimal Jalan : Former Governor, RBI.

Governance Improvement in Practice: Differentiated Strategies in Five Countries

Institutional and Civil Service Reform: Transparent Privatization in Ecuador Salary Reform in Bolivia Disclosure of Assets in Bolivia and Georgia Economic Policy: Deregulation and Delicensing in Bolivia Revamping Customs in Ecuador and Latvia Tax Administration in Latvia and Ecuador Tax/Customs Code Reform in Albania Financial Controls: Procurement Reform in Bolivia, Ecuador and Georgia Public Oversight and Civil Society: Ombudsman in Albania and Bolivia Private Sector Coalition in Bolivia Diagnostic Surveys and NGO monitoring in Ecuador and others

Corruption

Legal-Judicial: Revamp of Supreme Court in Bolivia Competency test and firing of judges in Georgia, Albania and Latvia Mediation in Albania

www.worldbank.org/wbi/govern

Comments
Problem is not systematic: India is not perceived like Russia it is neither everyones darling not the plague. Mauro Guillen Companies in emerging economies have trouble raising capital at low costs. The literature shows the reason why they want to list in the US in spite of higher level of governance is to raise capital at lower cost. The fact that Satyam listed its ADRs in the US, but still had such a serious governance problems makes this case particularly disturbing.
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Comments - Disown and Distance

The reality is, at the end of the day, even as audit committee member or as an independent director, I would have to rely on what the management was presenting to me: Singh, an independent director Kamath: while the occurrence of such events in a major company is a matter of deep regret, CII believes it would be inappropriate for this to the basis of questioning of general standards in other companies. This is a fraud that has been perpetuated over the years and top management has been involved in it so many years, keeping the auditors in dark KPMG Rekhy.
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Corporate Governance Definitions

o the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders, and other stakeholders, and spells out rules and procedures for making decisions on corporate affairs: DN Ghosh o the system of checks and balances, both internal and external to companies, which ensures that companies discharge their accountability to all their shareholders and act in a socially responsible way in all areas of their business activity.. Solomon

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Locus of Failure
-Governance Issues
Board / Risk Management Overseeing / Appointments / Stock Exchange Listing Compensation Agency Issues Wrongly Incentivized, Misalignment / Goal Incongruence Information and Reporting Operational / System Design Performance Issues / Audits / Reports

Control Failure