Examples of market failures
Satyam Computers chairman admits books cooked for years January 2009
The chairman of India's Satyam Computer Services Ltd. quit Wednesday after admitting the
company's profits had been doctored for several years, shaking faith in the country's
corporate giants as shares of the software services provider plunged nearly 80 per cent.
The company's balance sheet — riddled with "fictitious" assets and "non-existent" cash —
contained a $1 billion US hole that could no longer be concealed after a deal intended to
save the struggling company was scuppered, chairman B. Ramalinga Raju said in a letter to
News of the fraud dragged down the benchmark Sensex stock index 7.3 per cent to 9,586.88
with Satyam's shares plummeting nearly 78 per cent to 40 rupees. The accounting scandal
raises questions about the quality of corporate governance in India and is likely to
reverberate around the region.
"It is one of the biggest frauds the Indian capital market has seen. People have been taken
by surprise by the gravity of the event," he said. "After overstating profit and understating
debt, the company's net worth is zero."
Raju said that none of the other board members had any knowledge of the company's real
financial situation and apologized to all stakeholders in his letter, claiming that he had not
benefitted from the doctored results.
The founder of the outsourcing giant Satyam may have admitted to the largest corporate
fraud in Indian history when he made up $1 billion out of thin air, but Satyam's auditor,
PricewaterhouseCoopers, could pay the price.
Investors are expected to go to court to recoup some of the billions of dollars in equity
destroyed as problems at the company came to light. And, in fact, two U.S. law firms
announced Thursday that they intended to file class-actions suits against Satyam.
But most investors are not expected to go after the cash-strapped company. Instead, they
will aim at Satyam's deep-pocketed auditor.
"Price Waterhouse has signed the balance sheets, and so they are responsible if there has
been a falsification," said Ravi Nath, an attorney with the New Delhi law firm of Rajinder
Narain. The firm has already been contacted by several Satyam investors who wish to sue
the company's auditor, Nath said. Auditors are certainly dependent on information they get
from a company's management, Nath said, but "they do have to verify that information."
How Serious Was the Fraud at Computer Associates? October, 2004
The $3.3 billion securities fraud case against Computer Associates has been called the last of
the big Enron-era cases. Certainly, there are some parallels: Each case involved a multi-
billion dollar fraud that required participation by a wide group of top executives and others
further down. But the cases of the Houston energy-trading firm and the Islandia, N.Y.,
software giant are also different. Enron executives engaged in an extraordinarily complex
hoax, creating a raft of outside businesses that could be used to conceal the firm's
mammoth debt. Computer Associates executives are accused of something far more prosaic:
Examples of market failures
keeping the books open a few days after the end of the reporting period so revenues could
be counted a quarter earlier than it ought to have been.
Late in September, the company agreed to pay $225 million in restitution to shareholders to
settle a civil case brought by the Securities and Exchange Commission and to defer criminal
charges by the U.S. Department of Justice. At the same time, a federal grand jury brought
criminal charges against former Computer Associates chairman and CEO Sanjay Kumar and
the firm's former head of worldwide sales, Stephen Richards. Both men were forced to resign
in April, about two years after the scandal broke. A number of other executives were
implicated as well.
The SEC said the scheme began in 1998, possibly earlier, and continued through September
2000. In all, the company prematurely reported $3.3 billion in revenues from 363 software
contracts. This violated Generally Accepted Accounting Principles, or GAAP, which state that
revenues should not be counted until both parties have properly signed a contract. During
the four quarters of fiscal 2000, for example, the practice improperly inflated revenues by
25%, 53%, 46% and 22%, respectively. The SEC said the goal was to meet or beat per-
share earnings estimates of Wall Street analysts, a key to keeping a company's stock price
The victims in the case were the shareholders who were led to believe the company was
more profitable than it was, Richardson says. They paid more than they should have for the
stock, or kept in when, had they known the truth, they would have sold. These shareholders
suffered enormous losses once the practices were revealed. When the company stopped the
practice at the end of the first quarter of 2001, it fell short of the Wall Street earnings
estimate and the share price fell by more than 43% in a single day.
In theory, investors should care little whether a deal is signed by the end of the quarter or a
few days later, so long as the details are accurately reported. But in practice, investors tend
to focus on the quarterly revenue and earnings targets. "People, for whatever reason, are
fixating on certain numbers in the financial statement. If it's not in the quarter, it's not as
good," Richardson says.
At Computer Associates and many other companies, big portions of executives'
compensation depend on meeting specific goals. Inflated figures meant Computer Associates
executives were paid more than they should have been - extra compensation that came from
shareholders' pockets. (moral hazard)
Richardson argues that boards of directors and their compensation committees in particular
should be careful not to inadvertently give executives incentives to cook the books. An
executive sitting on a huge block of options about to vest may well get "a very myopic focus"
about meeting analysts' revenue and earnings projections, he said, noting that directors
should be especially vigilant at such times. (moral hazard)
Richardson does not believe the Computer Associates case and others like it point to the
need for regulatory reform. The accounting flexibility available to public companies is
necessary, he notes, even though it makes some breaches hard to detect. "Everything in the
financial statements is a result of choice - of some exercise of financial discretion. If you
eliminate choice, statements will be meaningless."
The best way to address cases like that of Computer Associates is through rigorous
enforcement of existing rules and severe punishment for violators, he suggests.
Examples of market failures
WorldCom billionaire faces jail for life March 2005
After being found guilty of orchestrating the biggest corporate crime in US history, Bernie
Ebbers, former chief executive of telco WorldCom, faces spending the rest of his life in jail.
In a decision that will resonate around the global corporate community, Ebbers was found
guilty in Manhattan's federal court on nine charges related to the 2002 collapse of WorldCom
carrying a maximum sentence of 85 years and a maximum $US2.25 million ($2.84 million)
Ebbers' conviction is considered a major victory for US government prosecutors because he
is the highest-profile executive to stand trial for fraud since a series of corporate corruption
scandals hit the US over the past five years, including the Enron and WorldCom collapses
But in 2002 a woman working in the accounts section discovered that chief financial officer
Scott Sullivan - the other half of Wall Street's famed "Scott and Bernie show" - was cooking
the books by writing down certain expenses and adding them to revenues. She alerted
WorldCom's external auditors and the game was up.
In the following months a staggering $11 billion accounting fraud was unravelled and
WorldCom was forced into bankruptcy.
The court also heard Ebbers had debts of $US400 million that were backed by WorldCom
shares. His motive for committing the fraud, they said, was to prevent the WorldCom share
price falling so his personal fortune would not be reduced.
Stock brokers say investors are more confident as company heads continue to be convicted
of fraud. A.G.Edwards financial consultant Vic Sullivan says stock holders can be confident
their companies are better regulated. Sullivan said "We are seeing some definite
improvements, and that clearly will help investor sentiment. And the stock market has gone
up a lot since all this put in place, too."
Sullivan says companies are having to spend more money to meet regulatory requirements,
but investors can be confident that investment information is legit.
Many questions raised:
Why doesn’t regulation prevent these problems?
Why aren’t auditors finding these errors?
How could the board members not be aware of the problems?
How does management compensation play into this?
What private market forces could motivate management to disclose relevant information?
Examples of market failures
Notes for in class QUESTIONS:
Although due process takes place in developing regulations, this does not always result in
the right result when the regulation is implemented. The regulator may not know the
“correct” amount of information required and the mandated disclosure could provide
insufficient, misleading or irrelevant information.
To the extent that penalties for breach of regulation are not sufficiently severe, management
could decide that the reward from an opportunitistic action outweighs the cost of the fines
Role of Auditors
Typically, an audit adds credibility to the information on which the opinion has been issued.
However, there have been many examples where audit firms have not identified the
concerns that are arising in the firm’s financial statements and have consequently been sued
for their role in allowing the misleading/fraudulent information to be released. In these
cases, the auditor has not maintained objectivity and has been persuaded by the client to
provide an unqualified opinion (ethical issue) or the audit firm has not had enough
information/training to be able to identify errors.
Human Resources Development Canada audit 2000(Canada) – “auditors’ examination of project files
for programs delivered by grants and contributions was so abstract and poorly executed that nothing
whatever can be concluded from the work”.
Arthur Anderson – shredding audit documents after the SEC launched an inquiry
Stanford Financial Group (2009) SEC accused the Texan-born businessman of perpetrating an $8bn
fraud on investors around the world – Stanford used a small 3 person audit firm to provide an opinion
on his statements and he deliberately held back critical information from the auditors (pressuring them
to accept the information he did provide)
Board of Directors
Directors should be familiar with the key business issues of the company but in order to
monitor what is taking place, they need full, timely relevant disclosure. To the extent this
information is lacking in any of these qualities, then directors may not be aware of the
extent of the problems that are occurring.
In the Worldcom case, there is a comment that “boards of directors and their compensation
committees in particular should be careful not to inadvertently give executives incentives to
cook the books”. We know that moral hazard exists (management prefers not to work hard)
and that companies pay management bonuses and other compensation in order to motivate
them to work hard. We also know that the rational manager wants to maximize his/her
utility and this can leads to decisions which help the manager increase his/her compensation
at a cost to the company. If compensation is based on share prices (i.e. options about to
vest) this motivates managers to make net income look good so that share prices go up.
Typically, making net income look good involves some form of earnings manipulation by
management. This means that the net income is not being reliably reported and investors
could make the wrong decision based on the information being provided. If management
exercises the share option and sell their shares, they are able to obtain a higher selling price
for their shares than the real underlying value of the share (thus hurting other investors).
Examples of market failures
Private Market Forces
Note: this is a non-contractual source of private info production (market prices provide motivation)
Capital Market - if investors find out about any manipulation, this will increase the firm’s cost of capital.
This will adversely affects mgr since it will reduce share price so manager is motivated to minimize any
Managerial Labour Market Mgrs are motivated to maximize the market value of the firm in order to
minimize cost of capital and increase their value on the managerial market. This creates an incentive to
release full & credible info to the market (increases investor confidence in firm).
Takeover Market - Mgrs are motivated to maximize the market value of the firm in order to minimize or
prevent the chance of a takeover bid. Similar to the Managerial Market, this creates an incentive to release
full & credible info to the market (increases investor confidence in firm).