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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

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