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Patterns in governance failures

April 13, 2009 16:29 IST

Birders look for patterns and distinguishing marks -- the head, the wings, the underside and the tail, the size, the colour, the beak, whether it is the morning after an overnight rain in early spring, or the onset of winter, to identify birds.

The bird watchers, David Sibley and Julian Yoshida would tell you from a knowledge of these patterns that a particular flash of wings at a certain place, at a certain time of the day may point to an orange crowned warbler.

Studies of celebrated cases of corporate frauds in different countries and times show that governance failures also fall into identifiable patterns. It might be of interest to find out what these patterns are and draw lessons, though admittedly the pattern-repetition only proves that it is not easy to learn lessons when there is a specious association of money and ambition.

Not only fools, but also quite a lot of other people are recurrently separated from their money in the moment of speculative insanity.

A new company is set up or an existing business is taken over by a person who has ambitions to grow rich and he marries his personal pursuit of money with the growth of the business.

The initial business model is sound, but that does not satisfy the grand design, the person has in mind. (For example, Calisto Tanzi, the son of poor farmer inherited the small dairy business from his father in remote Parma in Italy and dreamt of making it the 'Coca Cola of Milk' for Europe.

Ken Lay, the son of a poor Baptist minister and farmer, sat on a tractor at the age of twelve and imagined becoming rich and famous. Ramalinga Raju comes from a family of farmers, was ambitious and rose from humble beginnings to fulfil his father's dream.)

The board of the company is packed with men and women of repute and knowledge, which brings a measure of respectability to the company behind which it hides comfortably. Reputable auditors also enhance the  respectability.

(For example, Arthur Anderson was Enron's auditor; Grant Thornton was Parmalat's auditor; Enron had a board and an audit committee whose members were the envy of corporate America. Satyam had well-respected academicians and technology experts in its board).

The objective of the company shifts to rapid growth and quick rise in profitability at whatever it takes and the business model is changed to meet these demands; a period of high leveraged-growth follows, under the assumption of availability of unlimited liquidity at all times, and all modes of leveraging and exotic derivatives are resorted to.

(For example, Enron changed its business from being a energy producer to a derivative trader; Robert Maxwell grew through highly leveraged acquisitions in a short span of 10 years; the celebrated Denis Kozlowski of Tyco Global, made 1,000 acquisitions between 1992 and 2001.)

At one point of time, the support of the political infrastructure and knowing people in high places becomes important (Calisto Tanzi courted politicians, bankers, bureaucrats; Ken Lay was close friend of the First Family of the US; Robert Maxwell was a long-time member of Labor Party; political circles in Andhra Pradesh were home to Ramalinga Raju).

There is a period of extraordinary business success of the company, and the company and those behind it win plaudits and accolades. (Enron became one of America's most-admired companies; Satyam Computers won awards in corporate governance). There is an air of unerring confidence, arrogance and bliss within and outside the company.

The persons become the acknowledged gurus of management (Jeff Skilling, Robert Maxwell, Bernie Ebbers, Ramalinga Raju). This is also the period of high philanthropy, of Beluga caviar and Moet and Chandon parties, of high life and Armani suits and buying up football clubs and F1 participation (like Tanzi).

A selected few know the truth about numbers but they collude because the show must go on. Protest is silenced. There is an inexplicable smell in the company, but its source cannot be traced.

But financial numbers need to be good in the eyes of the external world, so those who verify the numbers need to be befriended and given incentives to keep the show going (Calisto Tanzi got Grant Thornton to certify a fake Euro 4.5 mn account in the Bank of America for 10 years; Arthur Anderson certified all the transactions of Enron in the SPVs; Price Waterhouse certified non-existent cash in Satyam's balance sheet).

In this period of joy, the Board also basks in glory; the independent directors are happy; the company can do no wrong, when every thing is going so right. So they forget to ask the right question or ask why (In the book Rogue Trader, Nick Leeson remarks about the inability of Barings' Board to detect his fraud, "People at the London end of Barings were all so know-all that nobody dared ask a stupid question in case they looked silly in front of everyone else.").

The board functions, audit committee meetings are dutifully held, the remuneration committee meets and gives high bonuses as rewards for good work. God is in his heaven and all is well with the world.

Then suddenly one day there is an external economic shock (Robert Maxwell ran into problems because banks in UK in the late eighties were under pressure and had to recall the loans; there was a dot com bubble burst in 2000, before Enron collapse; Satyam happened in the backdrop of macroeconomic problems).

The state of disequlibrium due to high leverage or paper profit or absence of cash in business due to funds diversion, can no longer be hidden; truth ultimately prevails and then all hell breaks loose, followed by a long period of extreme deprivation.

The obvious moorings of governance -- the board, audit committees, financial numbers -- are washed away. Like cancer there is little time left between detection and death (Enron was finished in 23 weeks; Barings collapsed in 6 weeks; Satyam did not take more than 15 days).

The epilogue is that government and regulators pull out all the stops to prevent recurrence, or the political system searches and finds scapegoats who can take their share of the blame.

In the Oliver Stone movie Wall Street, Gordon Gekko (Michael Douglas) tells Bud Fox (Charlie Sheen), an ambitious stock broker, 'It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.'

Later in the movie he advises the shareholders of Teldar Paper that 'Greed is good' and that 'Greed is right, greed works.'

Greed lies at the heart of all governance failures too and we, who hopefully are now a little bit more aware and wiser of the consequences of greed, may differ with Gordon Gekko.

The Author is a former Executive Director of SEBI and is currently associated with the World Bank and the Global Corporate Governance Forum of the IFC.

Pratip Kar