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Why did Raju commit fraud? - Views on News from Equitymaster
 
 
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  • Jan 8, 2009

    Why did Raju commit fraud?

    While going through Ramalinga Raju's confession letter, what struck us apart from the revelations was this statement - "I have promoted and have been associated with Satyam for well over twenty years now. I have seen it grow from few people to 53,000 people, with 185 Fortune 500 companies as customers and operations in 66 countries."

    There isn't a speck of falsehood in this statement. Mr. Raju has promoted Satyam and has played an integral part in shaping up the company over the years. And under his chairmanship, Satyam has grown into a leading player in the Indian IT services space.

    So, with all this success (though partly inflated) under his belt, what made Mr. Raju commit the fraud and leave his reputation in tatters?

    Overconfidence, perhaps!

    Researchers from Wharton School (among the world's top business schools) have some interesting insights on this aspect of corporate frauds. They believe that while confidence underlies decisive, strong leadership, overconfidence leads managers to cross the line and commit fraud.

    The overly optimistic belief that promoters and executives have that they can turn their firms around before fraudulent behavior catches up with them, is at the root of such frauds. All executives do not start out thinking that they would commit fraud. But they end up being in a position where they feel that it is the only way to get out of a bad situation.

    This is what the Wharton research paper talks about - "An executive believes his firm is experiencing only a bad quarter or patch of bad luck. He also believes it is in the best interest of everyone involved - management, employees, customers, creditors and shareholders - to cover up the problem in the short term so that these constituents do not misinterpret the current poor performance as a sign of the future."

    It furthers states - "In addition, he (the executive) is convinced that down the road the company will make up for the current period of poor performance. It is the optimistic executive or an overconfident executive who is more likely to have these beliefs. He may stretch the rules just a bit or engage in what you might call a 'gray area' of earnings management. But say it turns out that he was wrong and things don't turn around as expected. Then he has to make up for the prior period. That requires continuing fraudulent behavior and he has to do even more in the current quarter."

    Mr. Raju is a clear case in point. We know this from the following statement he made in his confession letter - "Every attempt to eliminate the (balance sheet) gap failed. As the promoters held a small percentage of equity, the concern was that poor performance would result in a takeover, thereby exposing the gap. It was like riding a tiger, not knowing how to get off without being eaten."

    Another theory argues that the genesis of fraud may lie on the pressure to meet quarterly expectations. It all starts with the company cooking up false numbers so that profit expectations could be met. However, slowly and steadily, things blow out of proportions. Eventually, ads Mr. Raju has done, the manager's only option is to cook the books by falsifying documents and accounting misstatements.

    An overconfident manager with unrealistic beliefs about future performance is more likely to engage in fraud. This is because he is less likely to correctly anticipate the need for more glaring 'management' of earnings in the subsequent periods.

    Thankfully, we at Equitymaster have the right people to look up to - Warren Buffett and Charlie Munger. After this episode, our belief in them has been strengthened further.

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