Monday, November 26, 2007

Quiz for Students: Fraud Analysis

--------------- Original Message ---------------- 
Subject: Fraud Analysis
Date: Mon, November 26, 2007 10:51 pm

How would you approach this disclosure?

Text follows:

Hexaware Technologies Ltd on November 26, 2007 reported that its Board of Directors has appointed a special committee to conduct an internal investigation and make recommendations for changes to its foreign exchange management practices. This action is due to certain actively concealed and potentially fraudulent foreign exchange Option transactions conducted by one Hexaware official. The Hexaware official, who exercised unauthorised fiduciary powers, has been immediately suspended, pending Investigation. Hexaware plans to provision between US$ 20-25 million to cover any potential exposure as a result of these transactions.

The series of forex transactions in question were initiated over the last few months. These transactions were unauthorised and outside the Company's normal hedging program. The information regarding these transactions was intentionally withheld from the senior management and the Board of Directors and was not included in internal reports. The first transaction came to light on November 22, 2007. Preliminary investigations conducted
over Friday, Saturday and Sunday led to uncovering of more such transactions.

"The need for provisioning is because or direct actions of one individual which were actively concealed," said Rusi Brij, Vice Chairman and CEO.

A meeting of the Board of Directors was called on November 26, 2007, where it was decided to appoint a Special Committee comprising the following independent directors, to conduct a thorough investigation into the transactions:

- Mr. Shailesh Haribhakti, Chairman of the Audit Committee
- Ms. Preeti Mehta, Partner, Kanga & Co.
- Mr. L S, Sarma, Member of Audit Committee

"As immediate steps, an embargo has been placed on all Option deals; future forex deals will necessarily have to be transacted jointly by two signatories out of the designated four from amongst the top management; the Company's authorised dealers are being informed about this procedure and the internal auditors (KPMG) are being asked to conduct a thorough audit of the function. The Company will continue to maintain the normal hedging strategy to protect against the rupee appreciation," said Shailesh Haribhakti, Chairman of the Audit Committee.

The Company will take all measures and actions as advised by the Special Committee of the Board of Directors, Statutory Auditors (Deloitte) and Legal Advisers, to mitigate the impact or the transactions and prevent recurrence of similar situations in the future.

"The Company's business remains robust and its future growth trajectory unaffected. Our order book, as of September 30, 2007, stands at over US$300 million. We will continue to build on that," added Rusi Brij.


Anonymous said...

Couple of comments Prof.:

The downside is that the internal control systems in place at the company are obviously not commensurate with the size of the company... et al. Keeping in mind the axiom that there is seldom one cockroach in the kitchen, this could well be one of several issues that might surface in time.

On the upside, the management seems to be shareholder friendly inasmuch as they seem to be doing the right things including promptly setting up an investigation with credible people on the committee, being upfront with disclosure about the problem than behaving like an ostrich and hoping it will go away.

Lastly, there seems to be a psychological angle to this too. The management is trying to reassure shareholders that the guidance stands. Whether this is a face saving measure (which is untenable) or the genuine situation on the ground, only time will tell. If it is the latter, I would certainly place a higher degree of trust on management comments that may come out in the future.

Vishal Mittal said...

Hi Sanjay,

I had a brief look at the company -Looks interesting.

- At CMP of Rs. 82, the market cap is Rs. 1180 cr.
- 9 month FY07 PAT is Rs. 88 cr (Dec ending), so full year PAT should be around Rs. 114 cr (before exceptional items), hence current P/E would be 10.
- The share price has fallen from Rs. 120 level on 1st Oct to Rs. 80 currently – eroding the market cap by Rs. 600 cr.
- The fall in last 1 week around the forex announcement was temporary – share fell from Rs. 88 to 74 and recovered to Rs. 82 – so no major fall
- Mgmt estimated one off loss of USD 20 – 25 m (Rs. 80-100 cr)
- If we take the fall from October beginning to incorporate any impact of insider selling, the fall in market cap vz. estimated loss is high (5 times)
- But this could be due to Rupee impact also – Infosys also fell by 20% from Oct beginning

- PAT growth is flat – because of business refocusing and obviously rupee impact
- Uncertainty regarding exact impact of the fraud (current mgmt estimate could be high or low)
- In Oct release, management had talked about a cover of USD 400 at Rs. 41 – no clarity on the same as of now
- Three fourth of the FY07 PAT will go because of this forex loss – could impact future plans

- Added highest incremental manpower in Q3, so management should be having positive views on business
- Employees have stock option at Rs. 109, General Atlantic converted at Rs. 142
- Company was considering buyback when the share was at Rs. 120 – 130 levels, though it has got defered, but may not be far away.
- As per release, the Order Book is at USD 300 mn (Rs. 1200 cr) vz. FY07 expected revenue at ~ Rs. 1000 cr – period of order book needs to be checked. Also, in Oct release, management had talked about a order book of USD 150 mn so that seems to have been doubled in Q4 ?!
- Rupee may not appreciate so sharply going forward

A mid size IT company with decent management – think trailing P/E should be like 13-14. In my opinion, it can give good returns with limited downside. It does not seem like a no brainer, but can be a part of a diversified portfolio.

Peeyush said...

More than anything about the company itself, I feel a lot of the companies active in forex markets become suspect after this. More so because of the advent of a lot of structured products in forex markets. I would be slightly cautious against companies which reported high other income in the previous quarters, since that might be due to some products which give higher upfront gain, at the cost of spread out losses in future. Some of the companies seem to be plainly speculating in the forex market. Hexaware was the first one to report. The next few quarters may see some more.

Sanjay Bakshi said...

Anonymous, is it a co-incidence that when I talked about this transaction in the class the other day, I used the same Buffett words which you posted? :-)

Those words were "There is never just one cockroach in the kitchen."

When studying market over-reactions, one has to compare the probable, post-tax impact of the worst-case scenario on a present-value basis with the decline in the market cap attributable to the market cap decline because of an adverse development.

Of these two factors, the second one - the decline in market cap attributable to forex trade losses, can be estimated. However, the first factor, in the absence of information cannot be reasonably estimated in my view.

In the last few days, two of my ex-students, both working with forex departments of banks have written to me about "hidden skeletons in the cupboards" of many Indian companies which took large, leveraged positions in the forex markets, and lost. That kind of reinforces the view that there are more cockroaches in the kitchen waiting to be found out...

Many years ago, ITC's stock fell much more than what was warranted by a lost battle with the government over unpaid and disputed excise duties. In that situation, the maximum loss that ITC would have to bear on a post-tax, present-value basis could be estimated. Moreover, that loss was much lesser than the decline in its market cap, so there was a compelling opportunity there.

The Hexaware case is not similar to that of the ITC case, in my view.

Hexaware may be a cheap stock for other reasons. However, the over-reaction hypothesis is not applicable here imho.

Rana Pratap said...


Do not agree with the worst case scenario to be applied religiously to every over reaction situation, the only way that you can come out with a worst case is if the loss can be quantified or if liquidation value/fair value of the business can be ascertained

Think of it in this way, there is a lot of empirical evidence that the market over reacts a LOT to dramatic and vivid events - fraud anyone?

Now, I am playing odds here, and I am playing in a sample set where a liquidation floor does not really exist and I am talking steep declines here, 17% for a very prominent IT company in a single day is steep by any standards

Now you add management incentives, how dramatic the event was, the possibility of a buyback, management's love for it's equity, well, it HAS to love it's equity, every IT company has to, for a lot of reasons, plus esops issued on the same day as the buyback announcement, plus my return expectations

If I mix up everything, I do not see how buying on the day of the over reaction and selling off a day or two later will not land me a 10-15% return.

Now to directly tangle with the professori, you talk about odds, how many situations similar to this, with a certain element of uniqueness and uncertainty are you likely to encounter in a given year, now if the answer is minuscule, the chances of the market losing it's wits are VERY big. Now does the party on the other side have an information advantage over me - NO, does the party on the other side have a behavioral advantage over me - NO, Now how many times can I bet out of 10 times where I will suffer a small loss of capital, maybe 1, 2 or 3 - Point to be noted that I am not talking about forex related events but UNIQUE over reactions, everybody knows what earnings disappointments are, but this is to paraphrase the famous ketchup ad - "different"

Now, if I bought on the day of the over reaction with a time frame of 1 or 2 days, how likely is it that somebody will get to know the true losses, errr...the management till now does not know the true losses, the positions are being unwound, so if nobody is likely to have an informational edge in the next 1 or 2 days and I know that this event is unique and dramatic enough why would I not play the psychology

This is a long and "spread all over logic" mail but I am trying to present a different point of view, my point is that I am willing to go into situations where stuff cannot be quantified accurately for short durations of time where nobody is likely to have an informational advantage over me, it may work, it may not work, but what is important is an ability to take calculated risk.

I wanted to also write what I would have done if the losses were 3-4 times what they were found out to be, but my hand is tired enough

luv and kisses

Sanjay Bakshi said...

Rana, a few observations:

You write " I do not see how buying on the day of the over reaction and selling off a day or two later will not land me a 10-15% return."

You also write, "Now, if I bought on the day of the over reaction with a time frame of 1 or 2 days, how likely is it that somebody will get to know the true losses."

You also write, "I am willing to go into situations where stuff cannot be quantified accurately for short durations of time where nobody is likely to have an informational advantage over me, it may work, it may not work, but what is important is an ability to take calculated risk."

How do you know that a decline in the stock price on the day the negative news hits the markets is an overreaction? Indeed, the very term "overreaction" must, by definition, be computed/estimated by comparing what was warranted with what actually happened.

So, unless you can estimate the loss, how can you even come to the conclusion that there is in fact an overreaction?

How can you take calculated risks, without doing any calculations (except that of observing a a significant price decline)?

The correct anchor is always value, not price.

Merely because the price has fallen does not necessarily make it an over-reaction. Was the sudden one-day decline in prices of "Harshad Mehta Stocks" or "Ketan Parikh Stocks" when those scams hit the market an over-reaction? Was the one-day drop in the stock price of Enron just after its accounting fraud was made public an over-reaction?

All over-reactions may be preceded by sudden price drops, but that does not mean that all sudden drops in price are necessarily over-reactions waiting to be exploited.

I would rather go with Graham, who said, "you are neither right nor wrong because you disagree with the crowd. You are right because your data is right and because your reasoning is right."

Any blind contrarian strategy carries unacceptable risks in my view.

Rana Pratap said...

The points you put are very valid

My point was I will not quantify the risk.

You wrote this - "comparing what was warranted with what actually happened"

Now the reserve was made for 25 mn dollars, think about management's point of view, if you are the CEO and I come and tell you on the weekend that there is a fraud in the forex transactions, am I likely to over reserve ( and thus, play safe so that while my company's reputation has come under a cloud I do not compound the problem by doing something dumb which could lead to a second blow ) or under reserve ( and leave my company open to another debacle if the losses are more than the reserve )

"how can you even come to the conclusion that there is in fact an overreaction" - a 17% decline when the management was ready for a share buyback at 110

"So, unless you can estimate the loss, how can you even come to the conclusion that there is in fact an overreaction" - Here I would put forward my point about not needing to quantify the risk accurately, this is a hard to identify ambiguous situation, whatever I do I cannot quantify the risk, but my competition has a over reaction problem plus people have a risk coefficient of 2 plus people get unduly spooked by bad news

You must understand, I am not playing against the event, I am playing against the people on the other side

The points about Enron and the other bubble stocks aren't related to what I am talking about

My point is I do not need to calculate value, just make sure that my time frame is short and figure out the management's actions and decide what I would do if the price really collapsed

The company was carrying 280 crores of cash, how much would the losses have to be for the company to be completely decimated - More than 200 crores would be the point where this company would have struggled

There is one event where Mr Buffett actually displays this type of thinking - the reinsurance of the California Earthquake Authority -

He later wrote that he did NOT know the true odds of having to make a payout because of an adverse event and he said that neither would computer models tell anything accurately

And as far as calculated risks without doing any calculations is concerned - well, I did try calculating stuff, it just was not hard numbers, and hard numbers could not have helped in this situation

And you quoted Graham - there is NO data to analyze here, how am I ever going to quantify the event

The idea was not to pick a fight, just present a different point of view

Luv and kisses

Sanjay Bakshi said...


Your views are most welcome - we don't have to agree on this - but I very much appreciate your posts. Remember its the difference of opinions which create market prices in the first place!


Rana Pratap said...


Diversity is good from evolution's point of view and all that jazz :) :)

We both agree to disagree, maybe in the future you'll allow me to send you a description of an event in real time where no meaningful quantification can be performed but it offers an opportunity of excess returns