How One Fund Dealt with the Satyam Scandal

 Lazard Emerging Markets (LZEMX), which combined with similar emerging-markets portfolios run by Lazard Asset Management was one of the largest shareholders of scandal-plagued  Satyam Computer Services (SAY), sold its entire stake in the India-based firm in mid-January. Discussions with Lazard Asset Management make clear that it wasn't an easy decision--and that shortly before the fund sold its shares in Satyam, it had been adding to that stake.

A Lazard Asset Management spokesman said that the factor persuading its managers to sell was the announcement by Satyam's auditor, an affiliate of PricewaterhouseCoopers, that it no longer had confidence in its audit. He said that the positions owned by Lazard's emerging-markets portfolios, consisting of both local shares and ADRs, had amounted to more than 7% of Satyam's stock.

Satyam, which had appeared briefly in the headlines several weeks earlier during a short-lived takeover controversy, created a worldwide sensation in early January 2009 when its then-chairman announced that he had vastly overstated the company's financial results and current cash position. Upon that announcement, the company's already-battered share price plunged even further. The stock has now dropped more than 90% over the past 12 months.

In the portfolio of Lazard Emerging Markets--a mutual fund available to retail and institutional investors--Satyam was a 1.5% position at the end of September 2008. The year-end portfolio, reflecting the toll taken by the decline in Satyam's stock price rather than any share sales by Lazard, shows a 1.3% stake. Lead manager James M. Donald said that the fund then bought a bit more in early January 2009. He said that the position at one point was in the range of 1.7% to 2%.

The decision to add more Satyam shares in early January might raise eyebrows, for this move took place only a few weeks after an ill-conceived attempt by Satyam to buy other companies owned by members of the chairman's family. The proposal to take over those companies sent Satyam's share price tumbling and was quickly canceled. Several board members then resigned.

Why buy more shares after that debacle? Donald explained that he felt Satyam had learned from the incident, as indicated by its quick reversal of course and the subsequent resignation of the directors. He added that he assumed that the departed directors had backed the chairman's takeover plan, and that with them out of the way--and with investors having registered their dismay over this shareholder-unfriendly action--the company was unlikely to go astray again.

Given that background, the decision to then sell all of its shares in mid-January 2009 marked quite a turnabout for Lazard Emerging Markets. In fact, on Jan. 12, just a few days before selling, Donald had told Morningstar that he was hanging on to the fund's Satyam position, even after the much-greater controversy that had erupted after the chairman's confession of fraud on Jan. 7. Donald explained that one of the fund's comanagers had journeyed to India immediately after the chairman made public his scheme. After hearing that comanager's reports from his meetings with a variety of officials, Donald felt that with the extensive involvement of the Indian authorities, Satyam had a good chance of recovering even given the fraudulent accounts, and if such rehabilitation succeeded, the payoff to shareholders would be huge.

At that same time that he made that comment to Morningstar, Donald also said that he was not convinced that the chairman's statements concerning his alleged fraud were true, explaining that many aspects of the story simply didn't add up. (Donald may well have been on the mark. A week later, media reports indicated that the Indian investigators digging into the scandal had themselves begun to have doubts about the chairman's confession.) The Lazard spokesman, speaking after Lazard sold its shares, said Donald's opinion on that score remained the same. He added that Lazard is still considering all options, including legal action against Satyam, even though it is no longer a shareholder.

It's worth noting that Lazard Emerging Markets is one of the better emerging-markets funds. It uses a flexible, value-oriented strategy and is not a notably aggressive risk-taker. In that sense it is surprising that this fund got caught up more than most others in the Satyam affair.

Some observers have noted, though, that when a high-ranking executive of a company is himself falsifying numbers, it can be very difficult for outsiders to detect. Donald said that in his and his colleagues' seven or eight years of owning Satyam, they had always found the executives to be forthcoming, with no hint of problematic aspects either in their statements or behavior or in the company's financial reports. He added that Lazard systematically had done what it calls its own "accounting validation" on Satyam's financials, and the few discrepancies that came up were minor and concerned matters such as depreciation of buildings, not the areas that eventually turned out to have been falsified.

However, even if it might be tough to blame fund management for failing to uncover the fraud, that's not the case for its decision to boost its Satyam stake in early January. It's not just in hindsight that Satyam's aborted takeover plan could be seen as a sign of problems hitherto unknown. After all, many investors dumped the stock upon news of the takeovers; the stock price plummeted on the day of that announcement. Donald himself was taken aback by the takeover plan. In fact, Donald said that in order to drive their concerns home, he and his comanagers had sent a letter to Satyam's directors on Dec. 23, asking them to pledge not to buy any unrelated companies in the future and requesting the company declare a special dividend or stock buyback to demonstrate commitment to shareholders.

As noted above, Donald bought more shares in January only because he thought the company had, in effect, learned its lesson from the uproar that the plan had created.

His reasoning is understandable to a certain degree. Nevertheless, it's clear that at that point, with an ethically questionable takeover having been proposed out of nowhere, followed by the sudden resignation of several board members, Satyam had become a much riskier holding, with much greater levels of uncertainty, than it had been before.

Donald said that the collapse of Satyam's stock price cost the fund about 1.6 or 1.7 percentage points in returns in total. One consolation for Lazard Emerging Markets shareholders is that even with this setback, the fund has posted one of the better showings among emerging-markets funds over the 12 months through Jan. 21 (although that did mean a 50% loss). In short, the Satyam affair has dented the fund's returns and has been far from management's finest hour. But it has not derailed the fund. That said, it will be interesting to see how this experience affects the way that Donald and his colleagues evaluate companies in the future.