Corporate Fraud Scandals Can Detonate Anywhere

January 12, 2009

When it comes to corporate fraud scandals, nowhere is safe.

Revelations of a $1 billion fraud at Indian IT firm Satyam Computer Services do not point to a higher systemic risk of accounting scandals in India, or even in emerging markets versus the developed economies, governance experts say.

With a global financial crisis ruthlessly exposing wrongdoing that would be easier to hide in less stormy conditions, more major frauds are likely to come to light this year. To predict where, traditional analysis of governance offers little help.

Most attempts to measure and compare corporate governance and regulatory quality among countries show standards far higher in richer countries than the developing world.

The World Bank’s annual World Governance Indicators rate U.S. regulatory quality at 90.8 out of 100. India is rated 46.1 — below South Korea (78.6), Malaysia (67.0) and Thailand (56.3) but above China (45.6), Indonesia (43.7) and Vietnam (35.9).

Assessing the integrity of accounting practices, the Economist Intelligence Unit gives India a rating of 2 on a scale of 0 to 4, where 0 is the best. That puts it above China, the Philippines and Vietnam, rated 3, and Indonesia, rated 4.

The apparent message from these rankings is that a corporate scandal in India was hardly unexpected, but that other emerging Asian economies are even more vulnerable — and investors in China and Indonesia have plenty of reasons to be worried.

Yet this is only part of the story. If cooking the books is more common in countries with poor governance rankings, nobody told the world’s corrupt executives. Scandals have been just as likely to erupt in supposed havens of corporate probity.

“Corporate governance in many emerging markets companies is actually better than in more developed markets. It has needed to be robust in order to attract capital,” said Christoph Avenarius, an emerging markets specialist at Credit Suisse.

The Enron, WorldCom and now Madoff debacles have shown how vulnerable the United States has been to corporate fraud. Germany has had a series of scandals too. South Korea, supposedly with among the best corporate governance in Asia, has a long history of murky behaviour by some of its chaebol conglomerates.

State Capture and Legal Corruption

To explain why conventional measures of governance and corruption fail to reflect the risk of corporate malfeasance, economists have been researching the concept of “state capture.”

The approach recognizes that while in developed countries outright bribery may be less prevalent, companies can sometimes benefit from “legal corruption” by achieving undue influence over regulation and policy-making. In such an environment, lax oversight and corporate scandals can be expected.

“Corruption ought to also encompass some acts that may be legal in a strict narrow sense, but where the rules of the game and the state laws, policies, regulations and institutions may have been shaped in part by undue influence of certain vested interests for their own private benefit,” said Daniel Kaufmann, a governance expert at the Brookings institute.

In a 2004 research paper, Kaufmann used World Economic Forum data to rank countries in terms of the prevalence of such “legal corruption” as well as traditional corruption measures.

A very different picture emerges.

The United States rates very poorly in terms of prevalence of legal corruption — about the same level as India and South Korea, and well below China, which scores relatively well.

Putting together estimates of legal and illegal corruption, Kaufmann derives a “corporate ethics index” which can go some way to predicting the countries more vulnerable to abuses. Of 104 countries ranked, India is 57th, Thailand 70th, Pakistan 88th, and in the bottom two places are Bangladesh and the Philippines.

Killed by the Cure

Analysts say that while Indonesia remains susceptible to vested interests capturing state policy, the fact the government acted last year to prevent too many rules being bent in favour of the struggling business empire of Aburizal Bakrie, formerly the nation’s wealthiest man, shows governance may be improving.

China’s relatively lax corporate oversight is a concern in Asia, analysts say, and the country has had its share of scandals. But the harsh penalties for executives convicted of abuses — including, sometimes, death — make China less vulnerable than its corporate governance ratings might suggest.

Analysts say the risks may be greatest in Thailand and the Philippines, where both legal and illegal corruption is common.

While lax governance is already reflected in share prices in these markets, a corporate scandal can still dent investor confidence in a country. And a further risk, analysts say, is that countries hit by scandals may over-regulate in response.

In its survey of the top political risks for 2009, the Eurasia Group identified over-zealous regulation as a key issue.

“There’s a real risk that all these politicians are going to over-regulate — that they’ll create obstacles to the free flow of capital that will weigh on foreign investment and global growth for years to come,” said Ian Bremmer, Eurasia Group’s president.

Governance experts agree that too much regulation is as dangerous as too little. “In fact a politically expedient rush to over-regulate typically results in more corruption, and in a further deterioration of the investment climate,” Kaufmann said.

He said the best way to ensure better corporate behaviour was not necessarily to introduce more regulations, but to do as much as possible to promote transparency — and that transparency could be the most powerful weapon against corporate fraud.

“As the expression goes,” he said, “sunshine is the best disinfectant.”

(Editing by John Chalmers)

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