Lessons From Satyam: India Needs A Bankruptcy Act

The Satyam saga has proved that India needs a proper bankruptcy act modeled on the American Bankruptcy act; specifically the Chapter 11 provisions are worth emulating. "Bankruptcy" is a fact of life for all corporations big or small. It isn't a bad thing; it is basically survival of the fittest. When weak companies fail, the correct response isn't trying to save or trying to bail-out the company; the correct response is the allow the weak ones to fail, manage the fallout and allow the successful ones to flourish.

Corporate Bankruptcy
Bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a debtor ("involuntary bankruptcy") in an effort to recoup a portion of what they are owed or initiate a restructuring. In the majority of cases, however, bankruptcy is initiated by the debtor (a "voluntary bankruptcy") that is filed by the bankrupt individual or organization.

How Are Assets Divided in Bankruptcy?

1. Secured Creditors - usually banks - are paid first.
2. Unsecured Creditors - such as suppliers, and bondholders, have the next claim.
3. Shareholders - people who own common stock - have the last claim on assets and may not receive anything if the Secured and Unsecured Creditors' claims are not fully repaid.

What Is The Basis Of Division Of Assets?
The investors who take the least risk are paid first. For example, secured creditors take less risk because the credit that they extend is usually backed by collateral, such as a mortgage or other assets of the company. They know they will get paid first if the company declares bankruptcy.

Bondholders have a greater potential for recovering their losses than stockholders, because bonds represent the debt of the company and the company has agreed to pay bondholders interest and to return their principal.

Stockholders own the company, and take greater risk. They could make more money if the company does well, but they could lose money if the company does poorly. The owners are last in line to be repaid if the company fails.

Indian Scenario
India's current laws make bankruptcy an extremely poor option. India has liquidation and rehabilitation regimes, but they don't work. There are no dedicated courts or judges, no professional cadre of trustees or administrators, no mechanism for an expedited hearing on a bankrupt company. Under a 1985 law, it's possible to revive and rehabilitate what is termed a "sick company." But by the time a company in financial difficulties becomes a "sick company" as per the definition in the law it is already too late to do anything. Months and years are lost while the situation at the company continues to deteriorate. In the end everybody loses.

India also has something called a 'Corporate Debt Restructuring System'. It's under the aegis of the country's central bank, the Reserve Bank of India. This allows a creditor to propose an out-of-court restructuring, which would prevent other secured creditors from putting a company into liquidation. However the system isn't binding on unsecured creditors and foreign banks, Theoretically possible for an unsecured creditor to petition the court for liquidation. But usually judges discourage such a move or keep the matter pending.

How Bankruptcy Would Help Satyam
The real danger is that the loss of confidence can lead to a downward spiral in which clients move projects to other companies, employees leave in droves, projects are disrupted which forces Satyam to pay damages leading to a messy implosion of the company.

If India had some sort of Chapter 11 bankruptcy provisions Satyam could have filed for a 'packaged bankruptcy'. The new members of the board along with the lenders would then be the people in control. This will reassure clients who are worried about the projects that Satyam is executing for them. Satyam also faces a problem of liquidity. It has dwindling cash levels and has to pay employees salaries, lease rentals, daily expenses. Within a proper bankruptcy framework Satyam will be able to borrow money from banks - this is called "Debtor-In-Possession Financing" or DIP financing. With DIP financing in place Satyam would be able to make a fresh start albeit under strict conditions. After stabilizing the business, the new management can try and sell off Satyam in whole or in parts. This way job losses can be minimized and there will be no disruption to the client's projects.

Resources On The Web

1. Read about the basics of Chapter 11 bankruptcy here
2. Read about Debtor-In-Possession Financing here
   
3. Thomas Friedman, New York Times columnist has strong views on the importance of bankruptcy to a modern economy.
4. The Economist has an article on European Bankruptcy Laws
   

Satyam Computers: "Raju Ban Gaya Gentleman"

'Satyam' is a Sanskrit word which means 'truth'. This is ironic considering that the Chairman of Satyam Computer Services, B Ramalinga Raju issued a statement revealing that the company's sales, profits and balance sheet is fictitious. He added that the company's accounts are fictitious due to overstating of profits in the last few years. Raju said that the company's balance sheet which carries inflated cash and bank balances of Rs 5040 Crore (as against Rs 5361 crore reflected in the books) is non-existent. He added that an accrued interest of Rs 376 crore is also non-existent. The company has understated liability of Rs 1230 crore on account of funds arranged by Mr Raju. The overstated debtors position of Rs 490 crore (as against Rs 2651 reflected in the books).

View the company Media release here
View the submission made to the Bombay Stock Exchange here

In a nutshell, this is the biggest corporate fraud in Indian History.

The revenue and profits have been inflated and the stated cash on the books is non-existent. The company was declaring huge margins when in reality the margins were only about 1/8th of the declared margins. Such large-scale manipulation went on for so long and nobody smelt a rat.

Certain questions become relevant at this time.

Show Me The Money

The promoters of Satyam a few years ago owned almost 25% of the company. Over the years they sold their stake reducing their stake to just 3%. Where did the money go?

Future Of The Company

Will Satyam survive this ordeal? Will clients and/or employees desert the company? Is any white knight interested in taking over the company?

Future Of The Employees

What will happen to the 53000 employees of Satyam? There is a distinct possibility that thousands may lose their jobs. The fallout has to be managed properly. The IT Services Industry is in the midst of a slowdown so the probability that competitors will absorb laid-off workers(if any) is low.

The Role Of The Auditors

Price Waterhouse are the Chartered Accountants for Satyam. What was there role in this fraud. Were they deceived by the Satyam management or were they co-conspirators? Read the auditor's report of Satyam Computers in March, 2008.

The Role Of The Management

It seems highly implausible that a fraud of this magnitude could have been orchestrated by just one person. What about the CFO of the company? The Board Of Directors? The Senior Management like unit-heads and vice-president level guys? How deep does this go?

Impact on Indian Stock Market

The reaction by the stock markets was swift and brutal. Satyam's share price plummeted by 77% from Rs 178 to Rs 41. The broader markets also fell with the Sensex falling 750 points. What about the long-term impact? How will FII's perceive this event? Will it lead to a permanent derating of India?

More questions are certain to arise over the next few days and weeks. What is certain is that the issue has the potential to damage India's reputation as an investment destination so, the fallout from the mess has to managed properly.