A recent seminar at Moneylife Advisory Services (MAS) addressed an issue that agitates investors and ought to worry regulators: “How To Spot Red Flags about Management”. Amit Mantri, partner of 2Point2 Capital, started the presentation with two interesting images.
A Snakes & Ladders board to depict investment traps and, second, the cover of Harry Markopolos’s book No One Would Listen which became famous only after Bernie Madoff’s ponzi scheme finally collapsed during the global financial crisis. Until then, Markopolos had written to everybody who mattered in 2001, 2005, 2007 and even in 2008, drawing attention to the fraud; but, as his book showed, no one would listen.
The fact that Madoff was sentenced to 150 years in prison in 2009 is no comfort for millions of investors who lost their savings. The US government’s effort have led to $1.2 billion being paid back to investors over 10 years, while the losses, according to a New York Times
article, were a massive $65 billion in paper wealth and $17.5 billion in cash.
It immediately brought to mind the collapse of IL&FS (Infrastructure Leasing & Financial Services), the massive 348-company conglomerate, that has defaulted on its massive Rs100,000 crore debt. IL&FS, a favourite destination for officers from Indian Administrative Service (job-seekers and on deputation), managed to hide from everybody, including the government regulators, its financial jugglery and even the number of subsidiaries and overlapping businesses it had. In fact, when the board was sacked, the government press release said that IL&FS had 169
subsidiaries, when it turned out that the number was twice as much.
Here again, former directors like DC Anjaria
(former audit committee head of GIFT City), high-profile victims, like Umesh Baveja
(former vice-chairman of Cairn Energy and founder of RAHI Aviation), institutional investors like AIDQUA Fund of Singapore and an anonymous whistleblower, had written to the board of directors and regulators several times, over many years, but no one would listen
Even today, the cabal responsible for the debacle, led by founder Ravi Parthasarathy, Hari Sankaran, Ramesh Bawa, Arun Saha, Vibhav Kapoor and K Ramachand, seems to be getting away with its members’ systematic self-enrichment
, while banks and investors face a minimum loss/ write-off of Rs30,000 crore and thousands of employees are set to lose well-paid jobs. IL&FS is not alone. Even Nirav Modi and Gitanjali Gems
seemed to have operated with the blessings and support of regulators and politicians across parties.
So the question that was posed to Amit Mantri at the MAS seminar was, ‘who is to blame for the failure to detect the fraud’? Is it the regulator, or does the buck stop at auditors and rating agencies? Mr Mantri and his firm shot to fame with an in-depth, on-the ground investigation into Manpasand Beverages, a high-flying company that made huge sales claims, until 2Point2 Capital exposed the hollowness of its operations.
But, as Mr Mantri quickly realised, other than some reputational benefit, there are only downsides to serious investigation in India. The threats and harassment take the form of SLAPP suits (strategic lawsuit against public participation) for defamation (IL&FS used this effectively to silence people), exclusion from investor conferences and denial of access to research analysts and even direct threats.
Moreover, when regulators are not held accountable for failing to respond to whistleblower complaints, they do not even deign to engage with them let alone offer protection or handhold them against vindictive action by promoters.
Employees who dare to blow the whistle are harassed, like they are all over the world, while anonymous whistleblowers are simply ignored, unless the media highlights the issue (as in the National Stock Exchange
algo scam case). Media houses like ours, that expose corporate fraud, suffer clear financial losses, especially when it involves corporates with large advertising budgets. They also face defamation suits or, at least, threats of legal action.
Corporates involved in fraudulent activities are also working with image consultants to wipe the Internet clean of previously published reports about investigation and regulatory action against them. This includes misuse of the police machinery and the Information Technology Act to intimidate writers and analysts. Given the high level of corruption in India, misusing State machinery and the legal system for a small price is very easy.
Well-known equity analyst, Ambarish Baliga, says that the reward for indulging in fraud and market manipulation is extremely high in India, while the cost of being caught is negligible. He was referring to a set of notorious and high-profile companies, which have successfully fudged sales numbers, their on-ground network, and even tax payments in order to pump up prices and play the market-capitalisation game. Many of these use round-tripped funds from tax havens to enhance their image.
The Securities and Exchange Board of India (SEBI) has regularly permitted ‘settlement’ on payment of fine for a variety of frauds including insider trading. The regulator does not even issue speaking orders that disclose the nature or extent of misdemeanour and whether the fine levied is proportionate to the wrongdoing. In most cases, it is not even a slap on the wrist; this acts as an incentive for disreputable corporates to brazen it out. The best proof of this is that hardly any industrialist, other than a Ramalinga Raju (who confessed to a massive fraud himself) of Satyam and Dinesh Dalmia of DSQ Software have done any jail time—and both examples are over a decade old.
In effect, there is absolutely no upside to exposing fraud. And, as Mr Mantri points out, our regulations do not allow short-selling, which would be a big incentive for analysts and investors in many developed markets for exposing crooked managements.
A US study, titled “Who Blows the Whistle on Corporate Fraud?”, which attempted to identify the most effective mechanism to detect corporate fraud (it studied 216 fraud cases involving more than $750 million between 1996 and 2004), concluded that “monetary incentives for detection in frauds against the government influence detection without increasing frivolous suits, suggesting gains from extending such incentives to corporate fraud more generally.” It advocated better incentives for auditors, analysts and employees to blow the whistle.
The study observed that journalists, who act as whistleblowers (accounting for 14% of cases detected), stand to gain in terms of reputation and better job prospects. The largest percentage of whistleblowers comprises employees, at 17%. Sadly, 82% of employees who blew the whistle lost their jobs. Among the other losers are auditors who end up losing accounts. The same study showed that short-sellers were responsible for exposing 15% of fraud cases and analysts 14% of them. They seemed to have a clear incentive to do so. The study recommends the need to increase incentives to specific players to expose fraud.
These findings are nearly 15 years old and the global financial crisis has led to a significant increase in incentives to blow the whistle on financial fraud. In the US, the Securities Exchange Commission (SEC) runs a successful programme
which allows whistleblowers to file information directly, or anonymously through lawyers, and be rewarded as much as 10% to 30% of the monetary sanctions against the company. The reward is paid when SEC is able to carry out a successful enforcement action and for sanctions above $1 million. This makes the process safe and effective and prevents an India-like situation, where a set of lawyers lobby SEBI to ensure low penalties. In fact, SEC issued $168 million in awards to whistleblowers in 2018 alone.
Today, a reward system had created significant incentives for employees and others to blow the whistle. This has led to serious disclosures in the healthcare and pharmaceuticals industry. In many case, the nature of disclosure is so extensive that corporates have preferred to settle, by forking out large penalties, rather than contest the charges brought by regulators.
While employee whistleblowers are, often, motivated by morality and not merely monetary rewards, short-sellers are usually focused on profits. But, taking a contrarian position requires deep analysis, since they run the risk of making monumental losses. Consequently, they have, often, helped expose corporate misconduct faster than any regulator. Moreover, short-sellers, often, send their findings to regulators and help trigger official investigations into fraudulent activity.
If the government wants to develop an early warning system for detecting corporate fraud and staunching crippling losses to the financial system, there is an urgent need to make regulators more accountable and create incentives and support systems for employees and journalists to blow the whistle. This can be through engagement with investigators and analysts, strong monetary incentives for whistleblowers and by permitting short-selling.