A new frontier for regulators

Corporate India is changing. For one, the number of companies without an identified promoter has been steadily going up. This is linked but not entirely on account of the growing number of unicorns and start-ups that now occupy a disproportionate amount of space on our telephone screens. Two, while institutional investors still own roughly the same amount of equity that they did a few years ago, they are now far more vocal. But not all change is external to a firm.

A soon-to-be released OECD-Sebi publication on “Company groups in India” notes that “on average, Indian listed companies have more than tripled the number of subsidiaries over the past 15 years and as of March 2020, listed companies in the NIFTY 50 index have an average of approximately 50 subsidiaries/step-down subsidiaries.” This together with the growth in company groups will impact our corporate landscape and regulations. (Personal disclosure— I have been associated with this report).

Like most countries, India too does not have an overarching definition of “group”. In the absence of a definition, what helps regulators is that the most prevalent group structure is a cross-shareholding, with the pyramidal or hierarchical structures being the more prevalent forms. Consequently, as in most other jurisdictions, Indian regulators too define a “group” based on a set of conditions, using “associate company”, “subsidiary”, or “holding company”. Criteria like control over the board composition, voting rights, or significant influence, either directly or together with its subsidiaries and associates, help in identifying a group company. Further it is the branding that burnishes the group identity.  

The strength of group structures is also what raises challenges for the regulator. With cross-shareholding structures, companies own each other’s stock. Cross-shareholding helps minimise business risk as it brings about cooperation and integration between enterprises, including easier access to resources, personnel, and capital. This is particularly so in early stages of a company’s growth. The flip side is that such structures cause an imbalance in the corporate governance structure. The to-and-fro of funds might exaggerate the real solvency of an enterprise. In economic and business downturns, this risks creating a domino effect, where the financial failure of one company can lead to the financial failure of the other. In India, between 60 and 70 of the NSE 500 companies have been in cross-shareholding relationships over the last decade.

The pyramid structure has some of the same benefits. It allows a shareholder to achieve control over a number of firms through a small outlay: A shareholder that directly owns 50 per cent of a firm, which in turn owns 50 per cent of another firm, achieves control of 50 per cent of the voting rights though its economic ownership is only 25 per cent. Governance commentators further point out that with such structures, the controlling shareholders can distort the benefits by diverting cash flows from firms in which they have a smaller stake to those where it is larger.

For companies, despite the several benefits of carrying out business activities through affiliated yet legally distinct companies, there are associated costs like conglomerate or “holdco” discounts, leakages on account of dividends, implying that the capital allocation decisions rarely have straight-line risk-rewards.

The bigger question is, where will the opportunity be assigned? While this is at times straightforward — determined by regulations (think of a financial conglomerate comprising a bank, an insurance company, a mutual fund and a securities business all through separate legal entities). Or geography (take the case of a telecom company with operations in India and Africa). But often, in the case of, say family businesses, or a multinational which decides to pursue an opportunity through a wholly-owned subsidiary rather than the listed entity, there is no defensible answer. This is by far the biggest risk. In this area, multinational corporations need as much oversight as domestic firms.  
 

Given the pyramidical or the cross-holding structures, regulatory focus is on related-party transactions. This has been an area of focus for Sebi for close to a decade (I remember attending a Sebi-OECD roundtable as far back as 2012). Sebi has been measured in its regulatory approach. The emphasis has been on disclosures and strengthening the hand of the independent directors through the audit committee. And while initially the thrust of its regulations was on the company itself, increasingly it is company groups, with the parent having to nominate a director on its material subsidiary, the auditors reviewing the material subsidiaries accounts, and setting up a company group governance structure.  More recently, Sebi has asked for greater oversight over subsidiaries — through which money is often re-routed.

Going forward, attention will be on the flow of information within the group — though it may be argued that this is covered by the insider trading regulations, and compensation. Companies could be made to disclose cross-holding relationships — as in Japan. Also, the compensation from all group entities and subsidiaries may need to be tabled.

We can expect that company structures to continue to prevail even as company groups come under greater regulatory focus. But if well harnessed with internal —and not just regulatory guardrails— a company group can be of immense value. Take the Tata group. Today, the group employs 750,000 people, and operates in more than 100 countries across six continents. Held together by the Tata name that reflects the groups’ ownership and shared values, the brand is reported to be valued at $20 billion, the most valuable in India. 

The writer is with Institutional Investor Advisory Services India Limited. Twitter: @AmitTandon_in