Classic Accounting Fraud Resurfaces in Italy and India

In part 2 of this series, we discover the similarities between Ivar Kreuger's con games and the Unit Trust of India devastation. 

 

Unit Trust of India (UTI), the government-controlled fund manager, was a popular investment for millions of middle-income investors and retirees. But when it ran into financial problems, its managers worked some shady deals that led to further fraud and corruption and the loss of millions of rupees. Ivar Kreuger would have felt quite comfortable heading this pyramid scam. 

 

Although P.S. Subramanyam, the chairman of the Unit Trust of India (UTI), has received much criticism for his role in the firm's downfall, India doesn't really have a single individual that it can point to as being the equivalent of Ivar Kreuger, the "Swedish Match King" of the '20s and '30s or Calisto Tanzi, the founder of Italy's Parmalat. Instead, it has an entire board of directors that fulfilled the same roles as the Swedish and Italian fraudsters.1 

 

UTI, a statutory organization set up by a 1963 act of the Indian Parliament, was organized as a trust and operates as a nonprofit. Unlike other mutual funds whose asset management companies charge investment management fees, UTI distributes everything to its investors after deducting all expenses from its total income [Vyas and Joshi, 1998]. The initial contributors to the fund's capital were financial institutions and the Reserve Bank of India (the central bank of India). 

 

The most famous UTI product was the Unit Scheme 1964 (US-64), the first open-ended, non-assured income scheme ("scheme" here means a carefully arranged and systematic program) launched in India with investments mostly in debt. After 1979, the focus shifted from an income fund to a balanced fund when a significant amount from US-64's funds was invested in equities. The share of US-64's investments in equity more than doubled from 1990 to 1998. The US-64 never disclosed its Net Asset Value (NAV) and it was the only mutual fund for approximately 23 years because UTI began in a period when India was a closed economy. There are reports that suggest that the NAV was computed internally, but this NAV was never disclosed [Vyas and Joshi, 1998]. So the investors could buy units at a repurchase price that the UTI determined.2 

 

FIRST CRISIS 

This scheme could declare a dividend comfortably, year after year, because only a small part of US-64's funds was invested in equities until 1991-92 (less than 30 percent). US-64's problems began after 1993. First, there was an increase in the dividend paid out by US-64 from 19.5 percent in 1990-91 to 26 percent in 1991-92. This was US-64's sharpest increase in its history [Sindhwani, 1998]. Once the dividend was raised to these high levels, nobody at the top wanted to make the unpleasant decision of lowering it. 

 

In the early 1990s, India's stock market was booming because of the liberalization of the country's economy. Therefore, a strong equity market, combined with an aggressive dividend policy, pushed US-64's investments into equity. This appeared to be a wise decision until the 1994-1995 stock market crisis. Until then, large fusions of unit capital into its schemes enabled UTI to play the "bull" in the market. In addition, the entry of foreign institutional investors (FIIs) and the Global Depository Receipts (GDR)3 inflows in the stock market helped to keep the market up. This enabled UTI to continue paying a dividend of 26 percent every year. However, after 1994-1995, the dividends were being funded out of reserves - a Kreuger-like story. Table 1 provides a distribution of net income and the dividend payouts of US-64 in the 1990s. At that time, UTI couldn't exit from its equities because it was the most dominant player in the Indian stock market. If UTI tried to sell stock, the market would go down. 

At that time, UTI's chances were remote to find buyers for the stock it wanted to sell because of a stock market scam.4 Therefore, the firm floated new mutual funds, the proceeds of which were used to buy the equity assets of US-64. These new equity schemes raised huge amounts of money in their initial two years because US-64 was paying heavy dividends at the time. However, after that period, collections from those schemes were negligible. As a result, UTI could not resort to inter-scheme transfers to reduce equity and it was also faced with huge redemptions under its existing schemes.  

 

Investors wanted to exit from US-64 when they heard that it was paying dividends out of its reserves. During the first few days of October 1998, UTI faced redemptions worth Rupees (Rs.) 5-6 billion (about USD $1.2 billion), which was more than the total redemptions in the first three months of 1998. The redemption requests drew huge media attention when UTI told the public about its US-64 problems. For 34 years, UTI's US-64 was the main investment for more than 20 million middle-class investors; the investor community never before had the opportunity to know how the fund performed [Rajeshwar, 1998]. These revelations shocked investors. 

 

Many media stories dissected UTI problems and how to fix them [Nemivant, 1999; Chandra Sekhar, 2001; and Rajeshwar, 1998]. Academics and practitioners offered suggestions such as reducing investments in equity and freezing the sale and purchase of additional units in US-64 until the fund returned to a healthy position. There were some articles that suggested that the Indian government should step in and bail out UTI. In the midst of this uncertainty, however, common middle-class investors were suffering the most. They didn't know what to do because they had always enjoyed a healthy rate of UTI dividends. As with Kreuger & Toll, the fraud involved the firm paying dividends out of the proceeds from new sales; the resulting collapse of the pyramid scheme hurt thousands. 

 

BAILOUT PLAN 

Finally, there was some good news for UTI and the Indian mutual fund industry. The Indian government stepped in and bailed out UTI (but at a cost of approximately Rs. 33 billion (about USD $6.6 billion) for the taxpayers [Nemivant, 1999]. At the time, UTI accounted for 65 percent of the total sales mobilization and 81 percent of the total investible funds. 

 

In addition, the government set up the Deepak Parekh Committee that recommended to UTI 19 restructuring measures. (Parekh was the chairman of a large and hugely successful Indian financial institution, Housing Development Finance Corporation.) UTI adopted nine of the recommendations by 2001. The initial results of the government bailout recommendations were positive. The UTI performance in 1998-99 was much better than the previous year; its sales rose by 18 percent. However, investible funds remained the same as the year before. [Chandra Sekhar, 2001]. 

 

For the most part, UTI seemed to be on the right path. Sales were rising even though the redemptions also continued at almost the same pace. However, the media questioned its investment decisions, and there were unconfirmed reports that UTI had used its power to sway the stock market at the behest of the government [Jayakar, 2001]. 

 

SECOND CRISIS 

On July 2, 2001, media and investors decried UTI's decision that day to stop repurchasing units of US-64 for six months. The next day, the Finance Ministry forced Chairman Subramanyam to quit. (The later analysis of this decision revealed that the problems in US-64 were similar to the previous crisis of 1998, only more pronounced.) 

 

The US-64 fund was on a tight deadline to align its repurchase price to the NAV by May 2002.5 In May 2001, the fund paid out a dividend of 10 percent and its repurchase price was Rs. 14.25 per unit. Many investors probably assumed this was their last chance to get out of the fund with their money intact and they weren't wrong [Viswanathan, 2001]. Equities still comprised 72 percent of US-64's portfolio and the stock market had fallen by a further 25 percent since 1998. Therefore, assuming that US-64 earned 12 percent returns on its debt portfolio, its NAV should have fallen by 15 percent.6 In May, the fund was paying out dividends and redeeming units at a purchase price of Rs. 14.25 (which was worth Rs. 11.37). Therefore, the NAV for remaining units was bound to fall further. In addition, UTI was required to align its repurchase price to the NAV by the end of the year. So there were huge redemptions in May 2001 (approximately Rs. 20 billion) from many large investors (mainly corporate), who had figured out the impact of overpriced buyouts. The fund was also forced to remain in its investments due to a "bear" market. So, US-64's only option was to freeze its repurchases.  
The foremost reason for the 2001 crisis was corruption among the UTI's top officials. Chairman Subramanyam made many inexplicable decisions. He randomly shuffled the top executives from one department to another and placed many of them in sensitive positions. For example, he reassigned the head of credit rating and replaced him with someone who had almost no experience. Then private sector mutual funds lured away the dissatisfied professional fund managers that UTI recruited after the last crisis. It was speculated that the random shuffling of employees at UTI and placement of inexperienced staff at sensitive positions were done so that Subramanyam could make important investment decisions by himself. Also, it was speculated that many companies in which UTI had invested had given gifts to Subramanyam and other members of the board.  

 

Inexperienced managers made stupid costly decisions. The UTI corporate governance probably was similar to the United States during the Great Depression when Kreuger made his pyramid scheme famous. 

 

RELIEF PLAN AND ANOTHER CRISIS 

After UTI's clean-up acts, it announced a relief plan for the middle-class investors of US-64. The fund announced that it would allow all investors to redeem up to 3,000 units each from Aug. 1, 2001 to May 31, 2003. For those units, it said the repurchase price would be the higher of either the NAV of the fund at the time of redemption or the specified price for that month. The minimum guaranteed price began at Rs. 10 per unit for August and increased by 10 paise (one-tenth of a Rupee) per month to a maximum of Rs. 12 in May 2003 (Sachdev, 2001). The media viewed this as an interesting scheme because UTI had bought some time from its investors for a turnaround in its performance. However, an investor, who held more than 3,000 units in US-64, had no option but to wait until January 2002 for an exit opportunity. 

 

The government later bailed out UTI in yet another crisis. UTI was split into two entities: UTI-I and UTI-II (now UTI Mutual Fund). UTI-I retained control over all present UTI assured- return schemes, namely US-64 and the remaining MIPs. The government would retain control over UTI-I to manage the obligations of assured return schemes. (After all of these schemes are paid off, the government will shut down UTI-I.) 

 

The cost of this bailout plan to the government was estimated at approximately Rs. 145.41 billion. The government said this package would settle UTI's problems once and for all. 

 

In the meantime, UTIMF (UTI-II) rode on the stock market boom and launched a number of schemes. With more than Rs. 200 billion in assets under management, UTIMF was still the largest mutual fund in India and so was able to tap the retail investor market. Its new image and new professional management attracted retail investors and UTIMF continued to flourish. The stock market boom in 2004 allowed UTIMF to return Rs. 35 billion back to the government. In addition, the value of the securities in the portfolio of SUS-99 and US-64 doubled in less than nine months. This helped the Indian government recover the money it lost in the fiasco [Adjania, 2004(a)]. 

 

COMPARING UTI TO KREUGER & TOLL 

As with Parmalat, we can make a number of comparisons between UTI and Kreuger & Toll: 

• Both advocated secrecy in financial dealings. 
• Both resulted in losses for middle-class investors. 
• Both led to widespread publicity in the popular media. 
• Both led to widespread government investigations and interventions. 
• Both suffered from improper actions by the head of the company. 
• Both used proceeds from the sales of other funds to pay large dividends. 
• Both were impacted by downturns in the economy and stock market that accelerated the collapse of the pyramid scheme. 
• Neither had independent internal auditors.

 

HISTORY ISN'T DEAD 

Five books were published and even a movie (Warner Brothers' "Match King") came out in 1932 on Ivar Kreuger's life. More than 300 articles on the fraud appeared in The New York Times, and newspapers of all sizes covered the scandal. Kreuger's downfall led to tragedy for thousands, many of them small investors. Congress acted quickly. The transcripts of committee investigations filled hundreds of pages, and the result was the Securities Act of 1933 [Flesher and Flesher, 1986]. In India, the UTI devastation was similar; its units were widely held and small investors suffered. The media widely publicized the problems and investors had to look to the government for protection. 

 

In the Parmalat debacle, the Italian government also acted quickly. The Cabinet approved a new law that protected Parmalat employees by hastening bankruptcy proceedings and giving large companies a better chance to restructure operations. Although the similarities are most obvious between Kreuger and Parmalat, all three companies share the commonalities of failing to report accurate figures to investors, paying dividends out of capital, and decrying the need for extensive audits. 

 

Secrecy of financial information was valued over transparency at all three companies, dividend policy was emphasized as the only thing investors needed to know, and the result was new security laws (or in the case of UTI, a requirement that all mutual funds must be subject to existing securities laws). These were primarily accounting frauds that mislead investors; and even though the Parmalat case is still in limbo, little money was actually stolen from the three companies. In other words, the frauds helped the companies stay in business longer than would have been possible without the frauds. 

 

Who says history is dead? Whether you're talking about Ivar Kreuger of 1932, the Indian UTI episode of the 1990s, or Parmalat of 2004, the story is the same. Apparently novelist William Faulkner was correct when he wrote in "Requiem for a Nun": "The past is never dead. It's not even past." When are investors going to learn from it? When will the world of international capitalism learn to protect itself from CEOs and boards whose pomposity and egos hide the activities of fraudsters? 

 

Gaurav Kumar, Ph.D., CPA, is an assistant professor of accounting at the University of Arkansas - Little Rock.   

 

Dale L. Flesher, Ph.D., CFE, CPA, CIA, is an Arthur Andersen Alumni Professor of Accountancy at the University of Mississippi.   

  

 

References (for part 2) 

 

Adajania, K.E., June 1, 2004 (a), "Payback Time," Outlook Money.  

 

October 16, 2006 (b), "UTI MF Champion Again," Outlook Money.  

 

Chandra Sekhar, Y., February 2001, "Losing the Race," Chartered Financial Analyst.  

 

Dutta, A., July 2001, "Where Trust's Gone," India Infoline.  

 

Edmondson, Gail, and Laura Cohn, January 12, 2004, "How Parmalat Went Sour," Business Week Online.  

 

Flesher, D.L., Flesher, T.K., 1986, "Ivar Kreuger's Contribution to U.S. Financial Reporting," The Accounting Review, 61 (3).  

 

Jayakar, R., May 6, 2001, "The Rot in UTI," Business Today.  

 

Muthukumar, K., January 16, 2003, "UTI: Second Coming," Outlook Money.  

 

Nemivant, T.R., August 1999, "Setting Things Right?," Chartered Financial Analyst.  

 

Rajeshwar, C., November 1998, "Credibility in Question," Chartered Financial Analyst.  

 

Sachdev, S., July 25, 2001, "For US-64, Is There Life After Profligacy?," Outlook Money.  

 

Shaplen, Robert, 1960. Kreuger: Genius and Swindler, New York: Knopf.  

 

Sindhwani, S., October 18, 1998, "A Second Look at the Problems of US-64," The Economic Times.  

 

Singh, Kavaljit, February 9, 2004, "Parmalat's Fall: Europe's Enron," ZNet Economy.  

 

Sylvers, April 17, 2004, "New Audit Details Fall of Parmalat," New York Times.  

 

Viswanathan, V., August, 2001, "Missed Chances and Inexplicable Decisions," Business World.  

 

 

1 Because UTI was a government organization, it wasn't headed by a single individual. Therefore, it was never proved that P.S. Subramanyam was alone responsible for UTI's demise. Subramanyam was asked to resign immediately after the second UTI crisis. However, neither Subramanyam nor any members of the board were prosecuted.  

 

2 Because the UTI never disclosed the NAV for US-64, the popular press in India termed NAV as "not available value" or "next available value." [Vyas and Joshi, 1998 and Sindhwani, 1998]  

 

3 When the Indian companies listed their shares on the U.S. market, they were issued through a depository bank in the United States and therefore were called GDRs or global depository receipts.  

 

4 This was a scam perpetrated by an Indian broker, Harshad Mehta, who borrowed heavily from banks and invested in the stock market. His contacts at banks never revealed that the money he borrowed from the bank was invested in the stock market. As long as the market was booming, nobody bothered to find out, but when it started falling, this scam became public knowledge. More information is available at http://en.wikipedia.org/wiki/Harshad_Mehta  

 

5 According to the recommendations of the Deepak Parekh Committee Report.  

 

6 The previous known NAV of US-64 was Rs. 13.40. Therefore, the NAV in 2001 should have been Rs. 11.37.  

 

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