Common Law Countries

VIKALPA * VOLUME 36 * NO 3 * JULY - SEPTEMBER 2011 9

R E S E A R C H

includes research articles that

focus on the analysis and

resolution of managerial and

academic issues based on

analytical and empirical or case

research

Executive

Summary

Tunneling vs Agency Effect: A

Case Study of Enron and Satyam

Srinivas Shirur

KEY WORDS

Self-dealing Problem

Enron

Satyam

Bankruptcy

Unsystematic Risk

Common Law Countries

This is a comparative study of Enron and Satyam corporate frauds. An attempt has

been made to arrive at some generalizations about the key reasons for the differences

between agency and tunneling problems. Agency effect and tunneling phenomena

focus on the divergence in the interests of managers, promoters, and minority shareholders,

which are the key reasons for corporate fraud. There is a clear difference

between the fraud committed due to tunneling and agency effect. The article highlights

this feature through the case study of Enron and Satyam. The difference between

tunneling and agency effect has important implications for corporate finance. Corporate

finance is based on the assumptions of separation of ownership and management

and also perpectual continuity of corporation. If these two assumptions are dropped,

then many of the widely accepted theories may not hold.

The article concludes that the legal framework, nature of financial system, and level of

economic development are the key factors which determine the level of agency effect

and tunneling problem. Solutions to corporate governance problems are quite different

in India as compared to the US or Europe. Hence, it would be inappropriate to copy

American legislations like Sarbanes Oxley Act in India. Effective prevention of destructive

self-dealing activities is necessary for development of vibrant capital market,

whereby small investors will be confident to invest in the Indian market, since they

will perceive risk premium to be low.

The key policy prescriptions are as follows:

* Effective delivery of justice is as important as enacting investor-friendly laws.

* Creation of subsidiary companies by the parent company and large financial transactions

with banks should be viewed with suspicion. On the part of the shareholders,

they should be suspicious of any self-dealing transactions. Since the time of

Harshad Mehta, when stock brokers, promoters of the company, and bankers connived

to cheat small investors, enforcement agencies view even large banking transactions

with suspicion.

* Small investors and institutional investors should play a proactive role to seek

information and reject any decisions which reduce their value of shares. Proactive

participation of outside shareholders in the corporate affairs of the company, especially

in the selection of board of directors and approval of resolutions, are the key

remedies to prevent such cases.

* There should be an effective control of black money.

* Certain clues like promoters setting up too many subsidiaries, frequent changes

and resignations in board of directors, consistent decrease in promoter stake or

increasing liquidation of equity options, are clear signs of fraud taking place. Regulatory

authorities should work on such clues and operate in such a way that there

is least chance of regulatory arbitrage.

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There is an urgent need to distinguish between companies

controlled by managers and those controlled

by promoters. Many academicians consider

agency cost and tunneling as two sides of the same

coin with the same impact on shareholders. The present

study tries to clarify this misconception. Agency cost is

prevalent in companies controlled by managers. In contrast,

tunneling is a problem faced by promoter-driven

companies. Understanding the key difference between the

two concepts is central to the future analysis of various

topics in corporate finance. This analysis is done with

the help of a comparative case study of Enron and Satyam.

Both the financial scams took place in the first decade of

the 21st century and will have wider implications than

has been understood till now.

According to La Porta, et al (1998), India and the US belong

to the common law countries which have fairly good

disclosure norms and investor protection laws.