Tunneling vs agency effect: A case study of enron and satyam

Abstract

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.