Corporate Governance in India: Disciplining the Dominant Shareholder

The nascent debate on corporate governance in India has tended to draw heavily on the large Anglo-American literature on the subject. This paper argues however that the corporate governance problems in India are very different. The governance issue in the US or the UK is essentially that of disciplining the management who have ceased to be effectively accountable to the owners. The problem in the Indian corporate sector (be it the public sector, the multinationals or the Indian private sector) is that of disciplining the dominant shareholder and protecting the minority shareholders. Clearly, the problem of corporate governance abuses by the dominant shareholder can be solved only by forces outside the company itself. The paper discusses the role of two such forces the regulator and the capital market. Regulators face a difficult dilemma in that correction of governance abuses perpetrated by a dominant shareholder would often imply a micro-management of routine business decisions which lie beyond the regulators’ mandate or competence. The capital market on the other hand lacks the coercive power of the regulator, but it has the ability to make business judgements. The paper discusses the increasing power of the capital market to discipline the dominant shareholder by denying him access to the capital market. The newly unleashed forces of deregulation, disintermediation, institutionalization, globalization and tax reforms are making the minority shareholder more powerful and are forcing the companies to adopt healthier governance practices. These trends are expected to become even stronger in future. Regulators can facilitate the process by measures such as: enhancing the scope, frequency, quality and reliability of information disclosures; promoting an efficient market for corporate control; restructuring or privatizing the large public sector institutional investors; and reforming bankruptcy and related laws. In short, the key to better corporate governance in India today lies in a more efficient and vibrant capital market. Of course, things could change in future if Indian corporate structures also approach the Anglo-American pattern of near complete separation of management and ownership Corporate Governance in India: Disciplining the Dominant Shareholder Jayanth Rama Varma Reproduced with the permission of IIMB Management Review, the journal of the Indian Institute of Management, Bangalore , in which the paper was first published (OctoberDecember 1997, 9(4), 5-18).  IIMB Management Review(http://www.iimb.ernet.in/review). All rights reserved Issues of corporate governance have been hotly debated in the United States and Europe over the last decade or two. In India, these issues have come to the fore only in the last couple of years. Naturally, the debate in India has drawn heavily on the British and American literature on corporate governance. There has been a tendency to focus on the same issues and proffer the same solutions. For example, the corporate governance code proposed by the Confederation of Indian Industry (Bajaj, 1997) is modelled on the lines of the Cadbury Committee (Cadbury, 1992) in the United Kingdom. This paper argues however that the crucial issues in Indian corporate governance are very different from those in the US or the UK. Consequently, the corporate governance problems in India require very different solutions at this stage of our corporate development. The corporate governance literature in the US and the UK focuses on the role of the Board as a bridge between the owners and the management (see for example; Cadbury, 1992; Salmon, 1993; Ward, 1997). In an environment in which ownership and management have become widely separated, the owners are unable to exercise effective control over the management or the Board. The management becomes self perpetuating and the composition of the Board itself is largely influenced by the likes and dislikes of the Chief Executive Officer (CEO). Corporate governance reforms in the US and UK have focused on making the Board independent of the CEO. Many companies have set up a Nominations Committee of the Board to enable the Board to recruit independent and talented members. There is now increased recognition of the role that the Board could play in providing a strategic vision to the company. The Compensation Committee of the Board has been strengthened to exercise greater control over CEO compensation following widespread complaints that top management pay is disproportionate to performance. There is also a great deal of discussion in the literature on the role of the Board in firing non performing management and in managing the CEO succession. Perhaps the most powerful and well established of the Board committees is the Audit Committee. Apart from acting as a deterrent against financial improprieties and frauds, the Audit Committee also enables the Board to keep a pulse on the financial health of the company. Turning to the Indian scene, one finds increasing concern about improving the performance of the Board. This is doubtless an important issue, but a close analysis of the ground reality in India would force one to conclude that the Board is not really central to the corporate governance malaise in India. As elaborated at length in this paper, the central problem in Indian corporate governance is not a conflict between management and owners as in the US and the UK, but a conflict between the dominant shareholders and the minority shareholders. The Board cannot even in theory resolve this conflict. One can in principle visualize an effective Board which can discipline the management. At least in theory, management ©IIMB Management Review (http://www.iimb.ernet.in/review). All rights reserved. 2 exercises only such powers as are delegated to it by the Board. But, how can one, even in theory, envisage a Board that can discipline the dominant shareholders from whom the Board derives all its powers? Some of the most glaring abuses of corporate governance in India have been defended on the principle of “shareholder democracy” since they have been sanctioned by resolutions of the general body of shareholders. The Board is indeed powerless to prevent such abuses. It is indeed self evident that the remedies against these abuses can lie only outside the company itself. It is useful at this point to take a closer look at corporate governance abuses by dominant shareholders in India. The problem of the dominant shareholder arises in three large categories of Indian companies. First are the public sector units (PSUs) where the government is the dominant (in fact, majority) shareholder and the general public holds a minority stake (often as little as 20%). Second are the multi national companies (MNCs) where the foreign parent is the dominant (in most cases, majority) shareholder. Third are the Indian business groups where the promoters (together with their friends and relatives) are the dominant shareholders with large minority stakes, government owned financial institutions hold a comparable stake, and the balance is held by the general public. The governance problems posed by the dominant shareholders in these three categories of companies are slightly different. Public Sector Units (PSUs) The governance structures of PSUs date back to the days when they were typically wholly owned by the government and were merely an extended arm of the state. These structures allowed the administrative departments in the concerned ministry to exercise virtually complete control over the functioning of these enterprises. It is now evident that these structures are incompatible with the efficient and successful operation of the PSUs in an increasingly competitive and deregulated economy. These issues are discussed extensively elsewhere in this volume (Vittal, 1997), and I shall not go into them again here. It is interesting however to observe how totally irrelevant the Board really is in the governance of the PSUs today. The Board has no role to play in any of the areas where US and UK reformers have sought to strengthen the Board. The Board has very little say in the selection of the CEO or in the composition of the Board. The government as the majority shareholder takes these decisions through the concerned ministry with the help of the Public Enterprises Selection Board. The Board cannot fire the CEO nor can it vary his compensation package. As far as audit is concerned, again the dominant role is that of the Comptroller and Auditor General (CAG). There is very little that an Audit Committee could add to what the CAG does. In many PSUs, the Board may still be powerful on paper because the delegation of financial and operating powers to the CEO is very limited. Many operating decisions have to be brought to the Board for decision making. This does not however make for an effective Board because it pushes the Board into “managing” rather than “directing”. As discussed elsewhere in this volume (Balasubramaniam, 1997), there is a clear difference between directing and managing, and the Board’s legitimate function is directing. The current governance structure allows the Board to play a highly obstructive role if it chooses by opposing the CEO on ©IIMB Management Review (http://www.iimb.ernet.in/review). All rights reserved. 3 operational matters. What it does not allow the Board to do is to play a meaningful strategic role since all strategic decisions are taken by the dominant shareholder through the concerned ministry. The more interesting issue which has not received much attention so far is the potential that exists for conflict between the dominant shareholder and the minority (public) shareholders. There was a well-known case a few years ago where a dispute of several billion rupees arose between two PSUs. One of these was wholly owned by the government while in the other there was a minuscule public shareholding. The government sided with the wholly owned forced PSU and forced the other PSU to pay up the disputed amount, and the impact on the earnings of the concerned PSU was quite substantial. The merits of the dispute apart, there is a serious corporate governance problem in the resolution of the dispute in this manner without either arms’ length negotiation or a resort to a judicial process. A minority shareholder could certainly have regarded it as a simple case of enrichment of the dominant shareholder at the expense of the minority shareholder. As government divestiture of minority stakes in PSUs gathers pace, conflicts of this kind would become more frequent and more serious. Multi National Corporations (MNCs) Government regulations have required most MNCs in India to operate through subsidiaries which are not 100% owned by the parent. In the 70s, the government enacted a law limiting foreign ownership in most industries to 40% while allowing 51% in a few high technology areas. This law was liberalized in the 90s and now 51% is permitted in most industries while 74% or even 100% ownership is allowed in some cases. These regulations have created severe corporate governance problems in several key areas as may be seen from the examples below. In the 70s, MNCs were forced to issue shares to the Indian public to comply with the law. The controls that then existed on pricing of public issues meant that these issues were at substantial discounts to the market price. In the 90s when the law permitted higher foreign ownership, these MNCs raised the foreign stake by issuing shares at very deep discounts to the market price. This obviously meant a large loss to the minority shareholders. One particular case where shares were issued to the parent at less than one-tenth the market price was analysed in detail by Barua and Varma (1993a and 1993b). They calculated that the net gain to the foreign parent after compensating for the loss that it suffered in the 70s (together with interest thereon at market rates of interest) amounted to over $200 million. This and other similar share issues by MNCs were made with the explicit consent of the shareholders in general meeting. The parent companies with their dominant shareholding were able to get the resolutions passed with impressive majorities. In fact when the government introduced regulations to prevent such preferential issues, the MNCs protested against what they called an assault on “shareholder democracy”. Another corporate governance problem arises where the foreign parent has two subsidiaries in India in one of which it holds a higher stake (say 100%) while in the other it holds a smaller stake (say 51%). The manner in which the MNC structures its business in India between these two subsidiaries is riddled with problems as far as the minority shareholder is concerned. ©IIMB Management Review (http://www.iimb.ernet.in/review). All rights reserved. 4 There have been allegations in some cases that the most profitable brands and businesses have been transferred from the long established 51% subsidiary to the newly formed 100% subsidiary at artificially low prices. This implies a large loss to the minority shareholders of the 51% subsidiary who have after all contributed to in equal measure to the investments that were made in the past to build up these businesses to their current dominant position. Yet another problem is the payments that parent companies increasingly demand for all the services that they provide to their subsidiaries. One well-known example involves a company where the parent has recently started collecting royalties for the use of a brand. In this case, India is actually the principal market for this brand and the Indian company had assiduously cultivated the brand through decades of advertising paid for in part by the minority shareholders. Minority shareholders could only watch in dismay as the royalties knocked off a sizeable chunk of the earnings of the company. Indian Business Groups The situation in this category of companies is more complex than in the PSUs and the MNCs where there are clearly defined dominant shareholders. In the Indian business groups, the concept of dominant shareholders is more amorphous for two reasons. First, the promoters’ shareholding is spread across several friends and relatives as well as corporate entities. It is sometimes difficult to establish the total effective holding of this group. Second, the aggregate holding of all these entities taken together is typically well below a majority stake. In many cases, the promoter may not even be the largest single shareholder. What makes the promoters the dominant shareholders is that a large chunk of the shares is held by state owned financial institutions which have historically played a passive role. So passive have they been that in the few cases where they did become involved in corporate governance issues, they were widely seen as acting at the behest of their political masters and not in pursuance of their financial interests. So long as the financial institutions play a passive role, the promoters are effectively dominant shareholders and are able to get general body approval for all their actions. This allows the promoters to play all the games that dominant shareholders play in PSUs and MNCs structuring of businesses and transfer of assets between group companies, preferential allotments of shares to the dominant shareholder, payments for “services” to closely held group companies and so on. But there are a number of new games too. Over several decades of the command economy, a large parallel black economy has developed in India where transactions are carried out in cash and are not recorded in the books of accounts. Some industries were at one stage so strongly permeated by the black economy that it was almost impossible to carry on business without using black money. Though there have been several honourable exceptions, many Indian business groups have succumbed to the lure of black money. The literature on black money views it primarily as a means of cheating the government of its legitimate dues. But the fact that it is not accounted for in the company’s books means that it is also cheating the minority shareholders. Quite often when a company makes losses in its books, the true picture of the business is much healthier because of the ©IIMB Management Review (http://www.iimb.ernet.in/review). All rights reserved. 5 profits pouring in in the form of black money. It is a standard joke among bankers in India that there are many financially sick companies but no financially sick promoters. The situation in some of these business groups is strongly reminiscent of what the father of economics, Adam Smith, wrote over two centuries ago about the rampant corruption in the East India Company: “Frequently, a man of great fortune, sometimes even a man of small fortune is willing to purchase a thousand pounds share in India stock merely for the influence which he expects to acquire by a vote in the court of proprietors. It gives him a share, though not in the plunder, yet in the appointment of the plunderers of India ... Provided he can enjoy this influence for a few years, and thereby provide for a certain number of his friends, he cares little about the dividend, or even the value of the stock upon which his vote is founded” (Smith, 1776, Book V, Chapter I, Part III, Article 1st). Tax reforms coupled with economic liberalization have tilted the balance away from black money transactions. This is partly because tax rates are now lower, and partly because increasing scale economies make it more difficult to operate with the informal organizational structures and financial arrangements that black money entails. It is to be hoped that tax reforms, deregulation and competition would gradually reduce the role of black money to the point where it is confined to isolated cases of corruption. Another important corporate governance issue is that of mergers and restructuring of companies in the same group. There have been several instances where the valuation of two group companies for the purpose of merger has been perceived to be biased in favour of one of the companies. It has been alleged that in many of these cases, the promoters had secretly built up large positions in this company as a cheap means of acquiring shares of the merged company. The amorphous nature of the promoter group makes it very difficult to verify these allegations. Mergers are subject to approval by shareholder bodies of both companies as well as judicial review. But shareholder democracy is an empty defence against the dominant shareholder. The Regulatory Dilemma Regulators face a number of difficulties in tackling the problem of corporate governance abuses by the dominant shareholders. In many cases, it is difficult to decide how far the regulator should go in interfering with the normal course of corporate functioning. Some of these problems are highlighted below. Shareholder Democracy A much talked about regulatory dilemma is that of balancing the rights of minority shareholders against the principle of shareholder democracy. On closer examination, this regulatory dilemma is not as serious as it might appear at first sight. In many ways, the very term shareholder democracy represents a misguided analogy between political governance and ©IIMB Management Review (http://www.iimb.ernet.in/review). All rights reserved. 6 corporate governance. Unlike political governance, corporate governance is primarily contractual in nature, and corporate governance is at bottom a matter of enforcing the spirit of this contractual relationship. It is important to bear in mind that the relation between the company and its shareholders and the relation between the shareholders inter-se is primarily contractual in nature. The memorandum and articles of association of the company constitute the core of this contract and the corporate law provides the framework within which the contracts operate. The essence of this contractual relationship is that each shareholder is entitled to a share in the profits and assets of the company in proportion to his shareholding. Flowing from this is the fact that the Board and the management of the company have a fiduciary responsibility towards each and every shareholder and not just towards the majority or dominant shareholder. Shareholder democracy is not the essence of the corporate form of business at all. Shares are first and foremost ownership rights rights to profits and assets. In some cases (non voting shares for example) that is all there is to it. In other cases, shares also carry some secondary rights including the control rights rights to appoint the Board and approve certain major decisions. The term shareholder democracy focuses on the secondary and less important part of shareholder rights. Corporate governance ought to be concerned more about ownership rights. If a shareholder’s ownership rights have been trampled upon, it is no answer to say that his control rights have been fully respected. The dilemma of micro-management Corporate governance abuses perpetrated by a dominant shareholder pose another and far more difficult regulatory dilemma. Regulatory intervention would often imply a micromanagement of routine business decisions. In a competitive world, highly complex business decisions have to be taken quickly and smoothly. Subjecting a large number of these decisions to the process of regulatory review would make a travesty of a free economy. In the name of ensuring that corporate decisions are taken in the best interests of the company as a whole (rather than just the dominant shareholder), the regulator would end up running the company by remote control. The company would then effectively become an extended arm of the state. Regulatory intervention must perforce be confined to a few clearly defined prohibitions and restrictions that require minimal exercise of regulatory discretion. This approach carries with it the danger that broad prohibitions would also stand in the way of many legitimate business transactions. Some examples of these issues are discussed later in this paper. Regulatory Response: Company Law The primary protection to minority shareholders is laid down in the companies law. Some of these provisions are the regulatory equivalent of an atom bomb they are drastic remedies suitable only for the gravest cases of misgovernance. ©IIMB Management Review (http://www.iimb.ernet.in/review). All rights reserved. 7 Protection of minority shareholders Company law provides that a company can be wound up if the Court is of the opinion that it is just and equitable to do so. This is, of course, the ultimate resort for a shareholder to enforce his ownership rights. Rather than let the value of his shareholding be frittered away by the enrichment of the dominant shareholder, he approaches the court to wind up the company and give him his share of the assets of the company. In most realistic situations, this is hardly a meaningful remedy as the break-up value of a company when it is wound up is far less than its value as a “going concern”. It is well known that winding up and other bankruptcy procedures usually lead only to the enrichment of the lawyers and other intermediaries involved. Company law also provides for another remedy if the minority shareholders can show that the company’s affairs are being conducted in a manner prejudicial to the interests of the company or its shareholders to such an extent as to make it just and equitable to wind it up. Instead of approaching the Court, they can approach the Company Law Board (now proposed to be renamed as the Company Law Tribunal). The Company Law Tribunal which is a quasi-judicial body can make suitable orders if it is satisfied that it is just and equitable to wind up the company on these grounds, but that such winding up would unfairly prejudice the members. In particular, the Tribunal may regulate the conduct of the company’s affairs in future, order the buyout of the minority shareholders by the other shareholders or by the company itself, set aside or modify certain contracts entered into by the company, or appoint a receiver. The Tribunal could also provide for some directors of the company to be appointed by the Central Government, or by proportional representation. The Tribunal normally entertains such complaints only from a group of shareholders who are at least one hundred in number or constitute 10% of the shareholders by number or by value. The powers given to the Company Law Tribunal are perhaps more effective remedies than the power of winding up which is vested in the Courts, though one may wonder whether these powers are too sweeping. However their scope is limited to very extreme cases of misgovernance where it is just and equitable to wind up a company.