September 17, 2009
Indian Economy|Governance & Politics
A Feudal Capitalism
By Nitin Desai
This column has been provoked by a current dispute between two publicly listed companies that has been linked to a family arrangement for partitioning the management control of these companies. My purpose in referring to this dispute is to suggest that messy situations like this one can only be avoided if we can establish an efficient eco-system for the prudential management of publicly listed companies in India that ensures transparency and allows all shareholders, the controlling group as well as the others, to assert their interests.
This requires two things. First we must ensure that those who control the management of publicly listed corporations live in some fear of shareholder wrath and loss of management control to a competing claimant. Second we need a firewall between policy making, which is the legitimate responsibility of the political executive, and the implementation of policy which must be left to truly independent regulatory authorities. Neither of these conditions holds at present. This column is about the first of these requirements.
It is well known that most listed corporations in India are managed by the promoter-owners rather than by independent managers chosen by the board of directors who represent the shareholder interest. If we take the companies in the BSE 200 (as of December 2007) and exclude the 28 companies that are in the public sector where the shareholding of the controlling group (the Government) necessarily exceeds 50 %, the picture on the holdings of the controlling group is as follows:
- There is no controlling group in 12 companies and these include ITC, IDFC, HDFC and ICICI Bank which have acquired a reputation for professionalism.
- Another 12 companies have a controlling group shareholding between 0 and 25% and this group is a mixture of professionally run and family controlled enterprises, including for instance both Infosys and Satyam.
- The remaining 148 companies in which the controlling group’s shareholding exceeds 25% (and for 79 of these, exceeds 50%) are mostly family controlled, except for some MNCs.
Why is this a problem? One could argue that the owner-manager’s incentives will be congruent with those of shareholders to a greater extent than those of the hired professional. But ownership may also involve other interests, to put it politely, which are not aligned with those of the shareholders. The main downside of family control over management is that the shareholders often get caught in the cross fire of family disputes. We have seen how several such disputes are settled by family agreements in which the non-promoter shareholders play virtually no role. SEBI’s takeover regulations smoothen the path for such family arrangements by exempting share transfers within the controlling group from the other provisions to regulate changes in management control.
The real question is whether this feudal form of management by inheritance is workable in a competitive economy or whether we need a more robust ecosystem for ensuring that capital is managed by those who are most competent to use it. This requires two things-effective oversight by a board that can replace top management when it fails to perform and a market for corporate control that through takeovers and mergers makes management incumbency contestable.
Our model of oversight relies heavily on independent directors and auditors. When ownership and management are separated, this may well work. In the UK, after the voluntary implementation of the Cadbury recommendations, forced replacement of top management increased. But in our context, where the managers are also the principal, often the majority shareholders, this fails because the promoter-manager plays a decisive role in choosing both.
The Finance Ministry has called for an increase in non-promoter shareholdings. It is not clear how this can be enforced. In any case, individuals are seldom in a position to exercise due diligence on corporate managements. Many invest in the stock market through intermediaries and are not even aware of where their money is placed. This places a special obligation on these intermediaries to oversee corporate management. This does happen and it is believed that the Satyam case came out in the open because of the vigilance of some institutional investors. This needs to be systematized and intermediaries should be required to disclose their due diligence procedures with regard to corporate governance.
Oversight by the board may be a necessary but is not a sufficient condition for preventing abuse of corporate power. For that we must let the market for corporate control operate efficiently. There is a price for corporate control and that price is the premium that an investor is willing to pay if his purchase of shares gets him into a situation of management control. The takeover regulations that we have are biased in favour of incumbent managements. For instance our regulations on creeping acquisitions are so lax that controlling groups can increase their stake without too much difficulty. In fact many of them have done so and promoter holdings have increased in the post-liberalisation period without the promoters having to pay the premium for management control. Hostile takeovers will be rare in India because of the large promoter holdings. But the threat is helpful in ensuring sound management of assets and the proposed reexamination of the provisions should be used to ensure transparency at least.
The vestiges of feudalism in the case of the public sector companies do not come from any form of management by inheritance. It is the opposite. The close control maintained by the political masters, who, in a coalition environment can act with impunity, leads to “off-with-his-head” uncertainty not just for poor performance but for less salubrious reasons. Divestment and the need to maintain an attractive share price will bring a measure of market discipline. But that requires that the political executive steps back and leaves more to the boards and professional management, holding them accountable for performance. As a first step the line ministry responsible for policy should no longer be the controlling ministry for the PSEs in the sector. All PSEs should be placed in three or four competing holding companies under the Ministry of Finance, which is perhaps the one Ministry which has too many other things to do to micro-manage these companies.
The agenda sketched here is barely a beginning in moving Indian capitalism out of its feudal phase into a more democratic environment of effective shareholder control.