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Trust and Watchdogs' Dilemmas

The failure of the regulatory regime as evidenced in the ongoing crisis has its origins in many fields. Two factors that have abetted this failure relate, one, to the conventional emphasis on macro-management and an arm's length relationship with the regulatees, and, two, to the belief that the market is endowed with the capacity to periodically readjust itself to changing requirements. This article first considers the evolutionary aspects of corporate and regulatory management. It is recognised that regulatory failure extends to many other areas. Four cases are cited to illustrate this aspect. The modus operandi of those engaged in fraudulent behaviour and how the regulatory agencies have a handicap in addressing systemic failure are discussed. While emphasising the need for a road map, the article outlines a few directions in which the first steps have to be taken.

consequences of selective implementation

Trust and Watchdogs’ Dilemmas

of the proposed remedies.

Each reform has its own seeds of institutional inadequacy that comes to light at A Premchand a later stage. Some of the leakages may

The failure of the regulatory regime as evidenced in the ongoing crisis has its origins in many fields. Two factors that have abetted this failure relate, one, to the conventional emphasis on macro-management and an arm’s length relationship with the regulatees, and, two, to the belief that the market is endowed with the capacity to periodically readjust itself to changing requirements. This article first considers the evolutionary aspects of corporate and regulatory management. It is recognised that regulatory failure extends to many other areas. Four cases are cited to illustrate this aspect. The modus operandi of those engaged in fraudulent behaviour and how the regulatory agencies have a handicap in addressing systemic failure are discussed. While emphasising the need for a road map, the article outlines a few directions in which the first steps have to be taken.

A Premchand ( retired from the International Monetary Fund and now lives in the United States.

ach age with all its accompanying technological innovations brings with it new pressures on the course and content of regulation whether selfadministrated or administrated by autonomous institutions established by public bodies. The regulatory bodies have the constant task of catching up with the growing activities of the regulatees, as new activities bring with them their own imperatives.

Over the years, both in the industrial and developing worlds, efforts have been made to establish regulatory bodies or watchdog institutions to monitor the m arket activities of the corporate sector, to a nticipate problem areas, and to formulate policy packages aimed at preventing them or to minimise the costs of the crises when they actually occur. But there is always the perception, illustrated by the ongoing financial crises in the oldest democracy and to a lesser extent in the largest democracy, that the effectiveness of the watchdogs leaves a good deal to be desired. Each time there is a crisis, more efforts are demanded to identify and punish the guilty. The mood for punishment in the public is, for all intents and purposes, similar to the conditions described by Charles Dickens in his Tale of Two Cities. Once the punishment is meted out, the public is appeased for the time being but it also demands changes in the regulatory regime whenever it believes that regulatory failures have contributed to the crisis in the first place. Experience shows that there is a fortune cycle associated with reform efforts. A good deal of enthusiasm is shown in designing the new changes and an impression is given that the proposed remedies will prevent future crises. A new comfort level is reached, and the regulatory bodies are given new mandates for implementation. No solution is, however, permanent and the new prescriptions develops their own leakages. The leakages may be inherent in the design or may be the unintended

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have their own origins in the crafty circumventions resorted to by the regulatees. Very soon the inadequacies of the regulatory regime become all too apparent as the new crisis breaks on the scene. Once again there are demands, always justified, for more reforms and renewal efforts. Strengthening the police department may not always lead to a reduction in crime as potential criminals are also engaged in formulating their strategies for beating the system. In addressing the issues of watchdog management, it is important to go beyond the institutional checks and balances, and to understand the modus operandi of the regulatees, and the extent to which the issues therein can be a ddressed by the regulators.

The purpose of this article is to illustrate the multiple dimensions of the activities of the potential offender and how the methods of investigation of the watchdogs may be inadequate for the purpose. Towards this end, four cases have been s elected for c onsideration – (i) relating to international financial institutions, (ii) relating to the clandestine export of n uclear technology with the tacit support of a government,

(iii) case of extensive fraud perpetrated by a single individual in New York, and

(iv) that of Satyam Computer Services.

1 Working of the Visible Hand

The working of the visible hand was evident in the transformation of a firm into a corporation. The latter was an artefact that was designed, developed, refined and frequently adjusted to the changing needs and requirements throughout much of the 20th century. The experiences of the oldest democracy and the biggest democracy have some common points, but in both cases, the firms had to pass through many loops and gates before emerging in their current form. The evolution is not complete as the ongoing financial crisis whose quantitative dimensions are not as yet f ully known, is contributing to new forms of public-private partnership patterns in

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corporate financing, restrictions or executive remuneration packages and forms of financial reporting to the public and to the specified public watchdog institutions.

As the operations of the firm began to grow, the functions and structure of the top management began to change. Basically, the expanded corporation began to have distinct lines separating the top management and the line managers; the former were primarily responsible for the formulation of strategies, for the establishment of operation departments and levels, and for specifying the process of coordination among the various levels. The new functional departments included those that were responsible for purchases and procurement, for inventory control, for marketing, and for the management of the finances of the corporation. These d epartments needed professional and trained managers, contributing in turn to the growth of managerial enterprises that were managed, not by family patriarchs but by professional managers (Chandler 1977).

This period also witnessed the growth of accounting as a management tool. The pressures for these requirements came from both within the corporation and outside. Within, accounting data was given crucial importance in the estimation and controls of costs. From outside, there was pressure to develop uniform conventions for the treatment of various categories of equipment. Thus, for example, a separate accounting convention came to be set up for the treatment of liquor and beverages in the hotel industry as early as 1927, and it continues to be followed all over the world even today.

Accounting systems themselves came to be developed to include cost accounting, management accounting (which experienced both a rapid rise and decline) and activity-based costing (ABC).1 Meanwhile, the professionalisation of management also contributed to the growth of the companies that were funded by hordes of shareholders and trading of stocks b ecame an everyday affair and second nature to a large number of individuals. Mass production, mass distribution, and mass financing also contributed to the generation of new concerns for greater regulations.

The focus of the regulatory watchdogs (which were for the most part non-existent in the early decades of the 20th century) was also changing along with the changing colours of the landscape or regulation. Before the advent of the New Deal in the US, the primary emphasis which was done through legislation such as Sherman Act was on shaping the market to avoid the creation of unregulated monopolies. The goal was to reduce the restrictive practices (a feature that also characterised the e xperience of government of India during the 1960s). With the New Deal and with the spread of the shareholder capitalism and growing exchange of shares through the sale and purchase of shares in the m arket, the focus shifted to the protection of the shareholder and to the prevention of the insider trading. Towards this end a S ecurities Exchange Bureau was set up to monitor these transactions.

Moreover, financial reporting standards were also developed so that uniform fi nancial statements evaluating the financial wealth of the companies could throw more light on the traded activities. Thus far the role of the regulatory bodies was to maintain an arm’s length relationship with the regulatees so that objectivity could be assured to the whole process of regulation. This changed, however, after the second world war with the enactment in the US of the Full Employment and S tability Act. It became clear that the maintenance of financial stability required more attention to the aggregate demand and to achieve the two objectives specified in the Act. Government became the coordinator and allocator of last resort. But this posture was not cast in concrete, as during periods of crisis, the government became the allocator of the first resort and with that the role of watchdogs also changed. There have been more developments during 2002, whose impact is c overed below.

Indian Experience

It is now appropriate to consider briefly the experience of the biggest democracy. For much of the period prior to Independence the focus of regulation was on the managing agency system then prevalent. This system was abolished after Independence and a new effort began to codify the company law that would thereafter govern the corporate sector. The formulation of the biggest piece of legislation ever e nacted took sometime. The new comprehensive law covered many aspects such as the composition of the board of directors, appointment of auditors and their rotation, remuneration packages of the employees (each company had to append, to its annual report a list of employees drawing more than Rs 2,000 per month, a figure that would be considered ridiculously low in the present context) and restrictive trade practices. It had a regulatory apparatus in that there was a board which was to adjudicate in trade disputes and others. Outside the frame of this law, the government was also engaged in the establishment of term lending institutions in addition to the subsidiaries of the Reserve Bank of India.

During and after the 1960s, the pattern of staffing of companies moved away from families to trained professional managers, and reliance was placed to a larger extent on the stock market activities of the ordinary shareholders. The influence of the shareholder while substantive in theory was not even marginal in reality as institutional investors such as the Life Insurance Corporation began to acquire and exercise greater clout. The government was also engaged, with the support of the self-regulating bodies, in specifying the accounting standards and the type of the financial statements that were to be furnished by every company.

After 1992, with the introduction of the liberalised economic regime, regulation of the stock exchange became more important and the separate agency the Securities and Exchange Board of India (SEBI) was founded. There are now several types of regulation in the financial sector – one for the stock exchange, one for the financial sector (excluding the governmentowned banks), and other types of activities. The common intent behind regulation is to promote fair trade practices, to protect the investor and the shareholder, and to protect the consumer. As an extension of these objectives, and under the broad supervision of the Bank for International Settlements various measures have been taken to strengthen the capital requirements of the financial institutions

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and also envisage limits on securitisation and the possibilities of addressing and covering the risk. This once again illustrates the continuum of regulation, and the constant efforts to update the systems to catch up with the requirements of the diverse fields. Notwithstanding these e fforts, the gaps in the system and their efforts became evident stressing once again the need for constant reinforcement. One such major calamity occurred in the working of the Enron in the US.

Enron as ‘Pioneer’

Toward the end of the 20th century, Enron was briefly held up as a pioneering company that initiated trading in the generation and distribution of electric power. Its techniques of operation were considered to be very advanced and very soon there were the learned professors from brand name business schools writing books applauding the contributions of the Texasbased Enron. It took only a few years to discover the real nature of its operations and to ascertain the factors contributing to its reported success. The reality, it was found, was different and behind the r eported high performance, there was large-scale forging of the books through the creation of off-budget accounts and r ecording of profits that were never there. When the revelations came there was a wash out in the market, and thousands lost their jobs and thousands more lost their savings and investment.

The regulatory agencies finally got their act together and launched the prosecution of Enron on charges of criminal conspiracy to defraud its employees and shareholders. More important, the experience revealed the inadequacies of the regulatory regime and these were sought to be addressed through what became known as Sarbanes Oxley (respectively, a senator and a congressman who introduced the legislation) that became operational from 2002. It emphasised the importance of disclosure, and to strengthen that it provided for a uditor independence, improvement of internal control system and overall improvement of the corporate accounting system and the establishment of an oversight board to keep a tab on the corporate world. The regulations that came into force were, as usual, considered to be hard by the r egulatees, some of whom, particularly the foot loose financial sector shifted their operations to London where the financial oversight was reported to be administered with a lighter touch than in New York.

Change in Management Thinking

The saga of regulatory reform both in the US, and in India, reveals a major change in the philosophy of management. Previously, the management both internal and external, placed emphasis on constant verification and engaged itself in a process of micro-management. It was soon found that it needed to be replaced by a system of macro-management. The underlying principle of micro-management was that an individual was not to be trusted until he was proved to be trustworthy. Macromanagement placed emphasis on the role that trust played in corporate governance and in public affairs. The gradual development of management information systems permitted many opportunities to monitor the activities of operational levels. The same philosophy had influenced the a pproaches of the regulatory agencies. The agencies were not be intrusive but were to facilitate an orderly growth and management of the markets. Toward that end, the overall regulatory system was e nvisaged to be comprising several layers

– self-regulation, regulation by autonomous agencies, regulation by government departments, regulation through legislative oversight, and where possible, a s ocial audit of the viability and sustainability of the regulatory agencies. It was expected that developments in the market that escaped the notice of one level would be captured at other levels, and that on the whole, the regulatory system would stand reinforced at various points of the process.

Furthermore, the oversight mechanisms sought to introduce a public dimension to the management of the corporation through the appointment of independent directors on the boards that were endowed with the responsibility of managing the corporate affairs, while serving themselves and the interests of the consumer, investor and the citizen. In principle, the design of the regulatory system was now seen as becoming adequate even as it was maintaining an arms length relationship

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with the regulatees, enabling them to b enefit from the trust extended and from the independence given to manage their own affairs.

But, as it is to be expected, the regulatory system is never complete and fool proof. The existence of the regulatory m achinery does not by itself ensure that its actual working is being effective. There are several gaping holes, some of which merit attention here. First, the coverage of each sector tended to be too large to be e ffectively covered by a single regulatory agency. There are far too many companies working and everyday there are more e ntering the field. The regulatory agencies are thus forced to be more selective than comprehensive. The selection may be purposive or random but in either event there are many corporations that tend, by the luck of the draw to be outside the active monitoring net of the regulation system. Potential criminal activities or noncompliance with the law in those cases may come to light at too late a stage. S econd, there is often a disconnect between the task, laws and related conventions governing the relationships between the regulators and regulatees.

Relations between Regulating Agencies

The relationships between the self-regulating levels and other levels are never clarified in law. It represents a grey area where conventions are still being developed; and the content of these conventions vary from one field to another. Some of the regulatory agencies many not even have the power to interrogate those involved in the alleged violations. For example, the SEBI had to file a case with the S upreme Court in order to get permission to interrogate the officials of Satyam Computers who were already in the protective custody of the police. In the US, the percentage of cases making it to the judicial process is very low as prosecutors want a “solid case” before launching the trail process. The solidity of the case depends not on the auditor, but on the judgment of the prosecutor who has to fight the case in court. No case will be taken up when and where the confidence levels of the prosecutor are too low. Third, the regulatory agencies have a hard time in deciding to

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be more active than they are. If they show more enthusiasm, they are considered to be more intrusive, interventionist, and harassment oriented. If they were to stick to what they perceive to be the proper procedure, then they are alleged to have been captured by the regulatees. A balanced approach is like walking on a knife’s edge and not many officials are willing to take that step. Fourth, many of the activities of the regulatory agencies involve naming and shaming the corporations and its management for the alleged violations and misdeeds. The efforts end there and do not go to addressing the systemic leakages that permitted the alleged crimes in the first place. As long as the systemic leakages are not addressed the root causes of the violations remain unaddressed. F inally, far too much emphasis is placed on independent directors of the board to look after the public interest. In reality, the independent director has his own concerns, and dilemnas – whether to take a more interventionist role or to assume a quiet monitoring role of an elder statesman. The former may be viewed as an e ffort at substituting the role of management, while the later is likely to be considered as too placid and pliant. It he becomes the champion of the public interest, there is a distinct possibility that he may be

o stracised and may become a silver bullet fighting disparate causes.

In addition to the above, there are other ways in which the regulatory system is completely subverted. It is now in order to consider the four cases referred to earlier.

2 Four Cases

Chronologically, the first case relates to the activities of A Q Khan who was variously described as the “Father of the I slamic Bomb”, and who was the recipient of all the awards that were within the reach of the government of Pakistan, and whose activities came to a halt (or at least so it was believed) in 2004, when revelations about the transfer of nuclear technology to other countries came to be known to the public. The issue became so prominent that an immediate resolution and punishment for the crimes committed had to be meted out.2 Toward this end a meeting was arranged with the President of Pakistan Pervez Musharraf, who was also its military chief at that time. During this meeting, Khan reportedly sought an official pardon but instead was told to make a confession to the people of P akistan and that he should offer an apology to them. In addressing the nation, Khan said

It pains me to realise in retrospect that my entire lifetime achievement of providing foolproof national security to my nation could have been placed in serious jeopardy on account of my activities which were based in good faith (emphasis added) but on errors of judgment related to the unauthorised p roliferation activities (ibid: 390).

A Q Khan and a Network

The alleged crimes involved transfer and sale of nuclear materials and technological know how to other countries. Khan had a network of officials that were e ngaged in the import and export of nuclear materials and other technological devices. If individuals who were not part of any officialdom had carried out these activities they would have been normally arrested, tried and condemned to prison. But since this involved the operations of a high level official who was also considered to be a national hero, he was restricted to his home and public activities were forbidden. Admittedly, Khan’s activities were spread over several years and the regulatory a uthorities that were in charge of regulating these activities maintained a silence, as it was believed that Khan had received s upport from the highest political and a dministrative levels.

It was clear to all that no individual, even a superman, had the capacity to undertake the activities that Khan shouldered without support from the centres of power. But the general, who was also the president of the country lost no time to d eclare that there was no evidence of government involvement in the scandal. If i ndeed that were true, and if Khan has i nitiated and conducted all the activities ascribed to him, then he should be hailed as a hero except that his actions were mostly illegal.

Was this a regulatory failure in that all the agencies including the law and order forces kept quiet while the assiduous e fforts of Khan to build a nuclear devise, and disseminate nuclear technology were going on unabated? Or was it a case where at the instance of the top policymakers and to serve the “broader national interest” the agencies were asked to be quiet while the desired results were procured? This also raises the question whether “good faith” was adequate as a justification for the actions taken? Moreover, when the state is itself engaged in subverting its own agenda by silencing the regulatory authority, what then is the future of the e ffectiveness of the watchdogs? Should the nexus between the political and a dministrative classes be allowed to come in the way of effective functioning of the regulatory agencies? Some of these issues are considered below.

Wolfowitz Episode

The second case, which relates to the president of the World Bank, came into public view in 2007. Two years before that Paul Wolfowitz, who previously served the Republican governments in various activities was appointed as president of the World Bank. As has been the case during the last few years, the representatives of the European and other developing countries go through the motions of demanding that due process should be applied to the selection of the president and that it should be done on merit. But, in practice, it is very much the prerogative of the US to appoint the president of the Bank. In this case too, the choice of the US prevailed and Wolfowitz took office with an agenda to fight corruption in general in the developing world and more specifically in the Bank lending programmes. While the objective was laudable, it was not expected that he himself would leave the office on allegations of corruption.

During Wolfowitz’s brief tenure, it came to light that he extended, in contravention to the normal practice, favourable treatment to his partner. (It is no longer fashionable to describe her as girlfriend. It is less clear whether the description “partner” confers any higher status on the relationship.) The Staff Association of the World Bank brought this up, and the lady in question was moved to a relatively high position in the Department of the State of the US government. Even there, it was a lleged that the president of the World Bank took a personal interest to ensure

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that his partner was well placed. The Staff Association considered the whole matter as an ethical lapse (when officials in a dvanced countries engage in corrupt activities, they are described in the press as ethical lapses. Comparable actions in developing countries are treated as a part of the endemic corruption prevalent there). The matter once again reached the executive board, and finally the president was persuaded to leave office. While r esigning from his office, however, W olfowitz drew pointed attention to that fact that all his actions were taken in consultation with the executive board, and, like Khan, “in good faith”. The board did not categorically reject its own tacit role although there was a good deal of opaqueness about the matters that were brought to them in this regard by the president, and the opinions provided by them.

It should be noted that the law relating to the World Bank did not provide for any regulatory authority to monitor and evaluate the activities of its president. As such, there was no regulatory failure, for, to start with, there was no specified regulatory authority; the executive board merely stepped into this vacuum. But was a president permitted to undertake questionable actions even if they were in good faith? What then is the nature of the actions t aken in bad faith? These aspects were not probed by the institutions that keep advocating adnauseum the need for the rule of law. The World Bank did not try to answer the question whether this was a case of misplaced trust.

Madoff’s Swindle

The third case taken up here relates to the $65 billion scam (the estimate could be higher) associated with Bernard L Madoff of New York (Chernow 2009). Madoff followed the by now familiar Ponzi scheme of paying off the current investors from future contributions and in the process generously enriched himself and the members of his family by liberally transferring the assets of the company. In the pervasive context of the boom felt during the last decade of the previous century and the first part of this decade, the r eturns that he paid his investors, who were drawn largely from the Jewish community of which Madoff was himself a member, were high and consistent. In fact, some analysts pointed out that his consistent performance was not in conformity with the stock market trends and that therefore there was some scam going on. But the regularity authority did not heed these comments, and when finally the r evelations came, it was too late to correct the colossal adverse impact on his investors who, in many cases, lost their lifetime savings. More important, as one investor said “Madoff murdered people’s sense of financial trust and security” (ibid: 30). The statement made by Madoff in the court suggests that he had initially thought his fraud would be short-lived, but found it so attractive that he carried it to a point of destroying the wealth of many families. Whether the wealth accumulated by him would be allowed to be retained by him or would be restituted remains to be seen as the final verdict of the judiciary is yet to be

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given. The case illustrates that notwithstanding all the protection offered by the regulatory agencies, there are frequent cases of embezzlement and fraud that are discovered at too late a stage to prevent extensive damage already caused.

Satyam Fraud

The fourth case that still remains to be fully understood relates to the case of Satyam Computers. The board of directors of the firm included former senior officials of the government of India, and academicians drawn from the Harvard Business School and Indian School of Business. The final bombshell about what was going on inside the company and the sea of difference between the image sustained over years and the reality came in the form of a statement reportedly written by the chairman himself (although there are sufficient indications to suggest that it was the product of a committee “think”) and released to the wider public on 9 January 2009. In this statement, the chairman admitted that the company was in serious financial straits and that the daily cash position was unsustainable, and that the balance sheets published for the previous quarters and years were, for the most part, “fictitious”. He made it a point to say that it was his “conscience” (which apparently had little role when the financial picture of the c orporation was systematically falsified), which tipped him to state the reality. He took personal responsibility for all the a ctions by making it clear that “none of the board members, past or present, had any knowledge of the situation in which the company was placed” – an aspect that strains the credulity of the public. Is it possible that the finances of a big company with extensive trading activities could be altered by the chairman who has little proficiency in the complexities of corporate accounting? These and many other aspects remain to be cleared and await the completion of the investigation. But the chairman also made it clear in the statement as guidance to the new management that for “mobilising support from the government, a board member is well placed”. That board has since been r econstituted and several other measures have been taken by the government both to i nvestigate the extent and methodology of fraud, and to ensure that the company can carry on its work (most recently a nother IT company has taken controlling interest in the company). Although the thickets and cobwebs contributing to this alleged fraud and consequent loss to the investors have been there for sometime, neither the institutional investors (who had a major role) nor the regulatory agencies had any notion of what was going on until the tipping point came from the chairman himself.

The four cases illustrate (with the exception of the World Bank president) that the actions of some individuals can have calamitous effects on the public in general and more specifically on the investing public. The alleged crimes took too long to be detected, and it would appear that the so-called surveillance systems set in place by regulatory agencies have not proved to be particularly effective. In part, this is due to the methods adopted by the alleged fraudsters and in carrying out their fraud. Some of these methods merit explicit discussion here.

3 Modus Operandi

There are broadly three sets of factors –

(a) trust and political patronage; (b) administrative actions; and (c) limitations of audit that contribute to difficulties in i dentifying the various irregularities and a lleged criminal actions.

The people involved in all the four cases discussed above had gone out of their way to create a public image for themselves as men of integrity and as people who were dedicated to public service. The first factor in this approach relates to the efforts d evoted to get community support, in particular from the community from which they came. Thus, Khan cultivated the i mage among his Muslim brethren that he alone had the capacity to save them from the threats posed by the contagious country. To strengthen his base, he also engaged in large scare charities. In a similar vein, Wolfowitz made consistent efforts to gain the support of the now discredited neoconservative movement in the US. Madoff took investments only from the Jewish community and he gave them the impression that he had no other motive except to provide financial service. In fact, it appears that he was maintaining an i mage of the reluctant businessman in that he would always emphasise in the dealings with the clients, to keep a margin and not to invest their entire life savings with him. In the case of Satyam, it is known that Ramalinga Raju the former CEO, was a great supporter of the Raju community from West Godavari district and that he gave liberally to charities in his native place. Furthermore, it is reported that he deposited Rs 50,000, in the name of each female child born in his native village in a bank so that it could be used for future education and other purposes. Also, he e stablished an ambulance service, which is a partly funded by the state government of Andhra Pradesh, which prides itself in its exemplary service.3 In the context of this unusual public benefactor image, and associated trust, it is difficult for any regulatory agency to suspect fraudulent behaviour. But then it has to be recognised that trust is a misplaced quality for the regulator. It does not, however mean, that all corporations should be suspected. What this requires is a better judgment of regulation, in particular, as to when and how it should be invoked.

Political Proximity

The public image of proximity to political circles is carefully cultivated. This proximity has a dual purpose. For those who are in politics, they can always use the i mage and the contribution of the corporation for political convenience and for funding election campaigns. For the corporation it is an additional umbrella that always can be selectively utilised. All the four cases discussed earlier illustrate the use of political proximity for reciprocal advantage. Khan realised very early on in the game that political patronage was an essential component of his strategy. Since there was no one else who could offer similar services to the government, the political leadership too found it advantageous to utilise the services of Khan. Wolfowitz exploited a part of his resume, as US ambassador to Indonesia, to improve his i mage as a friend of the developing world. Madoff was a member of many boards, i ncluding the well known Hofstra University in New York. Satyam became a show case for the state government and the company adroitly managed the possible benefits that came from political proximity. When such clout is demonstrated day in and day

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out, the regulator thinks many a time b efore planning an investigation into the corporation.

On the administrative front, the corporation or the individual often uses his powers to influence the members of the board of directors and to reduce their e agerness, to the extent there is any, to raise inconvenient issues. The remuneration package to the directors and auditors are so arranged at the higher end of the scale, that they have no incentive to do their professional work for which they are hired, and eagerly join the chorus of praise for the corporation and chairman. Moreover, there are many opportunities for the d istribution of patronage. Thus, they are given more lucrative contracts, and employment opportunities fro the kin of the consulting clan. In such a context, professional concerns take a backseat.

Finally, the corporations are eager to use the audit certification for their own advantage as trophies for model corporate behaviour and timely submission of audit reports – what is less known is the fact that auditors certify “to the best of their knowledge” only the annual statement. The periodic intra-year statements frequently reflect the judgment of the chairman than that of the auditor. The companies also publicise, to their advantage, the certificates given by visiting auditing teams from abroad without a hint about the limitations of the audit undertaken. Satyam Computers and its management often referred in private to the certificate of compliance given by the visiting US team that was looking into the application of the Sarbanes-Oxley Act. What is not well known is the fact that such audit is usually restricted to compliance and to the verification of whether internal and external audit agencies undertake investigative audit into specific transactions or range of activities. Such investigative audit is launched only where is a prima facie evidence implying some wrongdoing. If the launching of investigative audit is known outside, then it would have an instantaneous adverse impact on the market.

In all the above areas, the advantages for the corporation are many, while those for the regulator are few and far between. Although the agency has a higher moral responsibility to the society, at each stage there are many diversions and potential leakages that should be guarded against.

4 Implications and Next Steps

It is clear that the following regulatory problems have contributed to the long anticipated institutional and systemic failures and to the unfolding of major financial crises in the oldest democracy. (i) The solutions of one era prove to be problems in the following era. As a part of the hype generated in 1990s, regulations were so liberalised that they did not have any bite left. In the name of market creativity, a set of new financial instruments – demons of their own designs – were unleashed without a full recognition of their potential or adverse impact. Far to much leeway was given by the regulatory agencies to the market participants. (ii) This surrender of their own legitimate role reduced their e ffectiveness when they wanted to a ddress the emerging situation. The instruments they had were of no avail and they did not have new instruments to address the engulfing fire. (iii) The regulatory agencies lacked a proactive image. It looked as though they were tinkering at the margin rather than addressing the core issues.

(iv) There was also the popular view that regulatory agencies were captured by the regulatees and the political class. The credibility of the agencies was in total ruin.

The next steps should first aim at the herculean task of restoring the credibility of the regulatory agencies. That can only be done through specific steps and concrete actions. It has to be first recognised that regulation is a vast field and covers many disparate areas. The opportunity for revisiting the regulatory agencies should be taken to examine the adequacy of each institution and the relative mix of policy, operational systems, and manpower in these agencies. Second, as a part of this e ffort it has to be recognised that a guard cannot be posted at every bank, brokerage firm or a manufacturing company. In a ddition, the adequacy of self-regulation should be assessed. It is too important a matter to be left either to the politicians or the professionals. Third, the regulatory agencies should become proactive without becoming too intrusive or progressively interventionist. The latter approaches border on harassment and should be minimised. Arms length continues to be a valid principle. It also permits investigative a udit. Fourth, the regulatory agencies have to be empowered, as is the case with medicines to approve each new financial instrument – before its operational debut. Fifth, risk assessment should continue to be a part of the individual investor’s kit. Any effort at nationalising risk assessment it would only increase the moral hazard.

A prudent first step is to engage in mapping the issues rather than luxuriate in the view that the crisis is elsewhere and that we are well fortified against it. Both views are misplaced.


1 For a discussion of these aspects see Premchand (1995), Effective Government Accounting (Washington DC: International Monetary Fund).

2 For a detailed account of this whole affair, see Levy and Scott-Clark (2007), Deception: Pakistan, the United States, and the Secret Trade in Nuclear Weapons (New York: Walker & Company).

3 A former member of the board of directors told this writer that Ramalinga Raju inculcated such a strong sense of discipline that any telephone call made to the ambulance service is picked up at the first ring. The experience has been confirmed by many who availed the service.


Chandler, Jr D Alfred (1977): The Visible Hand: The Managerial Revolution in American Business (Cambridge (MS): The Bellknap Press of Harvard University Press).

Chernow, Ron (2009): “Madoff and His Models” in The New Yorker, 23 March, pp 28-33

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may 16, 2009 vol xliv no 20

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