Free exchange

Indian cooking

The makings of the Satyam scheme

HOW do you convince 250,000 shareholders, a board including four professors, and a “big four” accounting firm that you have over $1 billion in cash that does not in fact exist? India is still rubbing its eyes in disbelief at the audacious illusion conjured by B Ramalinga Raju (pictured), the founder of Satyam, which was once India’s fourth-biggest IT company and is now its most spectacular corporate scandal.



that Mr Raju’s colourful


is not as forthcoming as it appears. He claims to have inflated Satyam's profits over “several years”, cooking the books slowly like the best Hyderabad biryanis. But others think perhaps Satyam’s cash did exist until recently. Now, they conjecture, the money is probably buried in a “land bank”, invested in real estate and property deals that may, or may not, have gone sour.

Economists have shown some ingenuity in detecting the tell-tale signs of private fraud in public data. Most pertinent to the Satyam case may be a paper by Marianne Bertrand, Paras Mehta and Sendhil Mullainathan, which found evidence of “tunnelling” in India in the 1990s. Tunnelling is a term coined in the Czech Republic to describe the transfer of assets out of a company (as if by an underground tunnel) to the detriment of minority shareholders. The word was introduced into economics by Simon Johnson, Rafael La Porta, Florencio Lopez-de-Silanes and Andrei Shleifer.

In India, the tunnels run through business groups arranged into “pyramids”. The top of the pyramid is a firm controlled by a business family or corporate “promoter”. That firm will then hold controlling stakes in a number of other businesses, which will, in turn, own stakes in a third tier of firms at the base of the pyramid. In this way, the promoters can control the entire pyramid, even though they own the lower tiers of firms only at one or two removes.

Assets can be transferred from the bottom to the top of the pyramid by any number of devices: cheap loans, mischarging, or outright acquisitions. If the family transfers Rs100 to a "peak" company (in which it owns, say, a 20% stake) from a second company owned 20% by the first, the family benefits, because it now has a claim to 20 rupees (ie, 20% of Rs100) not four rupees (20% of 20% of Rs100).

Ms Bertrand, and Mssrs Mehta and Mullainathan show that when firms at the bottom of the pyramid benefit from a positive shock in their industry (which shows up as a jump in the industry’s profits), firms at the top enjoy a sympathetic rise in their earnings as well. Firms at the bottom, on the other hand, do not enjoy the full benefit of their windfall. The three economists even put a figure on the fun. They calculate that firms at the bottom enjoy only Rs62 of a Rs100-shock to their industry. Firms at the top, on the other hand, enjoy a Rs3 benefit from a Rs100 shock at the bottom of the pyramid.

You would need to do a lot of digging to tunnel Rs 70 billion rupees out of a company. But remember that the firms at the top of Mr Raju's pyramid (Maytas Properties and Maytas Infra) were both heavily into construction.

(Photo credit: Reuters)

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