Another kind of risk | Value Research Whenever businesses and the economy falters, scams and scamsters get discovered
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Another kind of risk

Whenever businesses and the economy falters, scams and scamsters get discovered

There's a hackneyed saying that 'when the going gets tough, the tough get going.' As I've written earlier during the pandemic, this will undoubtedly prove to be true about many businesses. All businesses will suffer, but the strongest ones will suffer less and recover faster. As a result they will come out on the other side even further ahead of their competitors.

However, there is a sort of a reverse of this saying too. Good times, even moderately good times, enable marginal or questionable businesses to sweep problems under the carpet and pretend that they do not exist.

On January 7th, 2009, at the height of the global financial crisis, B. Ramalinga Raju, the founder and CEO of Satyam Computer Services announced, in a letter to the company's board, that he lied about the operations and financials of the company on a grand scale. Eventually when the dust settled, it turned out that the company had booked fictitious revenue of Rs 5,300 crore over six years from 2002 to 2008. The total amount of financial irregularities amounted to Rs 7800-odd crore.

Essentially, Raju and others used this fake financial strength in order to raise more money which they used for large real estate purchases. During the boom time, they had apparently become obsessed with land development on a gigantic scale. As the 2008 financial collapse accelerated and the land business unravelled, they found it impossible to maintain the illusion and had to come clean. Of course, none of this would have been possible without the involvement of the auditors but that's a separate story.

Around the same time, just a month earlier, there was a confession of financial fraud in America too - a far bigger one. On December 10th, 2008, a top-level investment advisor and financier, Bernie Madoff confessed that his investment advisory business was a Ponzi scheme. His fabled investment performance was not real and basically he just shuffled fresh money from clients to other clients when they wanted to sell. In size, the Madoff scam was 10x of Raju, with about USD 61 billion involved.

The ultimate cause of Madoff and Raju confessions was the same - the music stopped. It's easy to maintain an illusion that businesses and investments are fine when businesses and the markets are functioning well, and people are by and large optimistic. Lenders and investors are willing to hand out a long rope, and IOUs don't turn up so often. As markets froze, and pessimism took hold in 2008-09, it became difficult for people like Raju and Madoff (and many smaller crooks) to maintain their illusions.

Might something similar happen now? I don't mean scandals identical to the earlier ones. Each scandal makes regulation tighter, at least as far as looking out for an identical scam goes. In India, the controls, checks and responsibilities on the auditing businesses are far tighter now and the Raju kind of subterfuge is unlikely, at least on that scale.

However, besides outright fraud, many businesses will be found to have been sailing close to the wind in terms of taking risks and stretching the rules. In any case, tighter accounting has not prevented scams like Yes Bank, CG and Cox and Kings, to name just the ones that spring readily to mind at the moment.

For investors, this is a time to pay special attention to corporate governance. Businesses that have promoters who have questionable reputations, or even those which just come from industries like real estate where questionable practices are common must be looked at with even more than normal suspicion. As the pandemic rolls along and then subsides, much of the economy will get going in some shape or the other. What will not get going are businesses which will turn up to harbouring some kind of scam even if the scale is smaller than that of Satyam.

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