Credibility Crisis

Financial scandal at outsourcing company rattles a developing
countryproclaimed a New York Times headline on January 7, the same day Satyam
chairman B Ramalinga Raju admitted to years of fraudulent and inflated
accounting in the company.

It did not take even a full day for the description to change. The emerging
IT superpower, the country with unlimited talent pool, and the center of the
flat world, was reduced to what it was two decades backjust a developing
country.

That gives you a fair idea of what to expect from the Western media in the
days to come. In earlier occasions, even isolated DNC (do not call) violations
by Indian call center agents have been played up to paint the entire Indian
industry as incompetent. This is a far more serious issue and a genuine cause
for concern. Not the least because Satyam, the fourth-largest IT outsourcing
company from India has, among its clients, some of the largest corporates in the
US, Europe, and Australia. If something severe happens to the company, they will
be directly affected. Unlike small security lapses and DNC violations, this is
not extrapolation of isolated incidents to conclude that clients and their
customers might be hit. It is a very real possibility.

There is no doubt that this is a huge black mark for Indian IT, says
Akshaya Bhargava, CEO of London-based Butterfield Fulcrum Group, a hedge fund
administration firm and a veteran of the services industry, who has been
associated with the Indian outsourcing industry in various capacities. Bhargava,
however, clarifies that this type of outright fraud could happen anywhere in the
world, pointing to examples of Enron, Madoff and Parmalat.

In fact, that probably explains why the Western media has not engaged so much
in India-bashing in its coverage of the Satyam story, which we have seen in the
past, in reaction to far more trivial incidents. But then, it is not motivated
media reports but confidence of customers in their suppliers that determines the
extent of business. That confidence may not have been completely shaken yet, but
it surely is not what it was before January 7.

Credibility Hit

It may be still early to definitively say how exactly the Indian IT industry
will be impacted because of the Satyam incident and to what extent. But all who
Dataquest spoke to seemed to agree that the credibility of the industry has been
hit, even though the consensus was lacking on the exact implications.

Yes, the Satyam incident will affect the credibility of the Indian IT
firms, says Avinash Vashistha, founder and CEO of sourcing advisory firm,
Tholons.

The buying process for major services contracts has a lot of qualitative
factors involved, not just quantitative parameters. Something like this will
clearly impact the credibility, adds Jens Butler, principal analyst, IT
services and sourcing, Asia Pacific with research firm, Ovum.

The sentiment is echoed by Forrester analysts Sudin Apte and John C McCarthy,
For years, clients have praised Indian firms as transparent and forthcoming in
addition to applauding their quality, client service, and software delivery
process superiority. The recent Satyam events, including the chairmans
resignation, bring that well-cultivated image into question, they said in a
statement.

Predictably, that kind of skepticism is challenged by Nasscom president Som
Mittal. We must not overlook the fact that even with Satyam, it was real
business, real clients, and real employees. It is just about a few people
getting together to manipulate the numbers. How does that challenge the entire
industrys quality of delivery and process excellence?

That raises an important question, the answer to which is still not known at
the time of writing thisdid Satyam intermingle its accounts, in some way, with
services and billings to clients? If not, it is simply a question of the ethics
of a few people. The investors still need to worry. But it does not really
impact the customers business in any way. But if it did that, it would be a far
bigger issue than what we are seeing it as today.

Even now, Mittal does not completely dismiss the fact that the Satyam episode
has raised some questions of credibility of the industry. The industry has to
re-establish the confidence among customers, regulators and investors, he
admits.

Will the Top Three be Exceptions?

While there is a broad agreement that the Satyam scandal has created a
credibility issue for the industry, the opinion, however, is divided on whether
the impact will be secular on everyone. Some say that the top three IT services
firmsTCS, Infosys and Wipro, will not be impacted negatively, in fact, they may
even gain because of this. Others say there is no reason to believe that the
clients will distinguish between large companies and small companies.

Investors, so far, have believed that the large companies will be exceptions.
On the day the news broke, Satyam fell 78% in the Bombay Stock Exchange. While
the 30-share Sensex slid by 7%, Infosys held steady. Since then, even some
customer movements have endorsed this belief. World Bank, which banned Satyam as
a supplier, said that it awarded part of the contract that it canceled with
Satyam to TCS. Infosys too claimed in the recent earning conference that many of
its common clients with Satyam have already approached it to see if it can take
up the existing Satyam work.

Forrester clearly foresees this possibility as what it calls the polarization
of offshore suppliers. Offshore providers that are either family-owned or part
of large industry conglomerates, will face more financial scrutiny. With these
smaller firms facing the brunt of extra checking, top Indian providers like
Infosys will continue to take market share, it says in its statement.

Vashistha of Tholons has similar views. The top three will be exceptions
because of their stronger relationships and strong perceptions. I feel they will
tend to benefit in terms of getting additional business because of the higher
level of trust clients would place on them. It will be difficult to establish
the credibility of smaller firms, he says.

Not everyone is so optimistic about the large companies, though.

The Satyam story represents a breakdown in trust and has set the entire
Indian IT industry back. Everyone, including the top three, will just have to
work much harder to convince customers, says Bhargava, who headed Infosys BPO
as its CEO before moving out as a partner of UK-based private equity firm 3i, as
head of its BPO investments.

Says Butler of Ovum, Looking at what has occurred since then (referring
obviously to the banning of Wipro as a supplier by the World Bank), I do not
think the top three will be exempt.

The Wipro revelation, coming just a few days after the Satyam news broke, has
created a major question of credibility. Though nowhere comparable to Satyams
fraudulent accounting, there are three reasons why it has snowballed into a
major issue. First, of course, is the reason why World Bank says it banned Wipro:
providing benefits to its staff, which according to the Bank was improper. The
media has since reported that it is common practice to use benefits for
executives in client companies to further sales interests, prompting many
analysts to comment that the creativity is not limited to accounting alone.

Second is the fact that the announcement came only when World Bank decided to
make it public. Wipros logic that it had no major impact on revenues may be a
rational explanation, but not everyone is convinced that not making something
like this public is good ethics.

Third is that it has come at a time when the entire IT community globally and
the entire India is shocked by the Satyam revelations. Many had taken solace in
the fact that Indias largest IT companies are above all questions. Wipro,
especially, is known for its strong values.

We still do not have a clearer answer to the question, but the events of the
next few weeks may answer at least this question fairly decisively.

Long Term Impact? Not Really

While there is a clear agreement that the event has badly affected the
credibility of the Indian IT industry, there is an equally strong, if a little
uncanny, agreement that the impact that it would make on the sector will not be
very long-lasting.

This is because of a combination of reasons. First and foremost, events like
these have an immense shock value which makes them look earth shattering in the
immediate aftermath. Over a period of time, people take decisions based on
reason. So, while it would make potential clients a little more vigilant, the
business may not be affected too much in the long run. Says Peter Brudenall,
partner, Global Technology and Outsourcing Practice at London-based law firm,
Hunton & Williams, which advises its clients on legal issues in offshoring and
outsourcing: It is too early to say that the Satyam issue has any broader
impact on the Indian outsourcing community.

Two, many have been pleasantly surprised by the swiftness the government has
shown in trying to solve the issue. The government moved fast to take control of
the situation and appointed a three member board. If the government continues
to handle it as well as they have done and the board is seen to be taking strong
and positive actions, there is nothing to fear: the company will pull through
and the industry will not be tarnished, says Ganesh Natarajan, chairman of
Nasscom. Also, what makes people hopeful is that the Indian IT industry has
successfully met many challenges earlier and most believe that even though there
will be some changes in the way business is done, the industry will steer
through the crisis. When asked to compare it with the anti-offshoring campaign
in the 2004 US presidential electionsthe last major non-economic crisis the
industry as a whole facedmost said the two situations are not comparable.

Normal political/economic events and fraud are quite different from each
other. However, the Indian IT industry has overcome many challenges and is a
resilient group. I am confident that the industry will move on from this, says
Bhargava. Vashistha of Tholons. He feels it is a comparatively easier challenge
to tackle than the anti-offshoring campaign, while Butler of Ovum says it is a
lot tougher.

But even those who believe that the credibility is hit badly, believe that it
will affect only in the short run. Butler says it would affect new contracts in
the three to six months period. Agrees Bhargava of Butterfield Fulcrum, In the
long run, I dont see much impact. Agrees Vashistha of Tholons, I think the
client concern will be short-term. Nasscoms Mittal, of course, is equally
optimistic.

One reason, and that is left unsaid by all, is that despite everything there
is no credible large alternatives to India. Isolated events like this result in
drastic decisions when the cost of switching is low. So, it is not surprising to
find that most of the clients considering switching from Satyam are looking at
another Indian alternative. It would have been different had it happened
probably ten years earlier.

What Should Clients Do?

At the time of writing this, most Satyam clients are still in the
wait-and-watch mode. That was expected, as no one was prepared for something
like this. Very little is heard from other clients and potential clients. While
agreeing that the event by itself will not impact long-term outsourcing
potential to India, it is sure that the India offshoring strategy would not be
the same again.

Two clear changes are imminent: more derisking and a greater due diligence,
leading to tighter contracts.

If I were a large client, I would institute a policy of always having at
least two Indian IT vendors and split the business between them as a derisking
measure, says Bhargava.

We have already seen an increased focus on risk management over the past 18
months. This event, coupled with the recession, will only increase the firms
focus on this area as a key responsibility of the vendor management office, add
Apte and McCarthy of Forrester.

Derisking strategies apart, most agree that the level of due diligence should
and will increase as a fallout of the Satyam scandal. This may lead to tighter
contracts.

Companies should ensure that contractual relationships with Indian, and
other, outsourcing vendors enable appropriate get out clauses as well as
sufficient levels of access to information, intellectual property and know-how,
says Brudenall of Hunton & Williams. He suggests several measures including
looking at obtaining financial guarantees from the vendor if the contract needs
to be terminated. The current spectacle ought to remind us all of the risks
inherent in any significant long-term relationship and the importance of
constructing protections not only against ordinary risks, but also against the
lightning bolts which strike less often, but with devastating consequences, he
adds. Agrees Bhargava, Customer diligence will increase and contractual exit
provisions will become tighter. The sentiment is shared by Ovums Butler,
expect the risk/ethical factor of vendor selection to gain an even greater
weightage as a decision criterion.

What Changes for the Industry?

The change in client strategy would have implications for the industry. The
derisking strategies may not affect smaller vendors too much, as they were
anyway used to split contracts. In fact, if anything, more clients many now look
at splitting the contracts, leading to an increase in the base of suppliers that
they shortlist. This will help good but smaller vendors. However, this may also
mean that the selling India phase that everyone seemed to agree had had a
logical end, would be back.

But what will hit most is the fact that thanks to added levels of scrutiny
during due diligence, the sales cycles will be longer. That may affect the
pipeline, not a great situation in a recessionary phase. But as most observers
agree, it may not impact much in the long run.

Of course, corporate governance is back on the agenda. In earlier years, we
at Nasscom used to focus a lot on corporate governance issues but we thought
that had stabilized. This incident brings the entire issue back to the forefront
again.

Smaller companies who may not have given enough attention to this aspect will
have to tighten their belt, as an incident like this would result in governance
being there on the marketing presentation. That requires some tangible measures.
Expect some proactive measures to obtain certifications in client markets. The
same way, Indian companies took to CMM and COPC in earlier years, we may see
some rush for some external endorsements in corporate governance. And that will,
of course, cost time, money and energy. There is very little choice.

Says Mittal, What happened at Satyam is a black and white issuea violation
of law. That must and will be tackled by regulators. Governance is more a gray
issue. The differentiation will have to happen in this gray area.

So, call it the next phase of Indian outsourcing: the proactive governance
phase. We have seen capability, quality, and innovation being the buzzwords in
the past. It is time for governance to take over.

Shyamanuja Das

shyamanujad@cybermedia.co.in