Jaimini Bhagwati: Dubious mergers and worse

The author discusses the many forms of fraud in Indian mergers

The parliamentary election season is in full swing with just a few weeks till the first polling date of April 7. Allegations about systemic and episodic wrongdoing are flying thick and fast as part of the electoral strategies of the parties in the fray. The individuals concerned hurl accusations with acerbic wit, and we are subjected to slanging matches on television. This article reflects on the issue of corruption and a form of recurring malfeasance in our capital markets that is inadequately investigated. Specifically, stock prices of listed companies invariably drop when they acquire substantial stakes in or buy out smaller, usually unlisted companies.

As far back as 1977, I was subjected to self-serving rationalisation about corruption by a prominent industrialist. His point was that too much fuss was made about the ills of corruption. According to him, when he bribed someone with executive or regulatory authority and got what he needed, it helped him expand business, raise employment and so on. Correspondingly, the person(s) who received bribes was better off. Additionally, the slush money that changed hands remained within the country and, therefore, this constant bleating about corruption was just incomprehensible to him.

Well, it can be argued that corruption is inevitable and even necessary in an economy constrained by innumerable, overlapping laws and regulations that are ambiguously drafted and epileptically enforced. In other words, it is just another cost of doing business in India where the central government, state governments and regulators are often engaged in never-ending legal battles with businesses both large and small and individuals. The obvious counterargument is that corruption eliminates or reduces the benefits of competition and usually results in sub-optimal, adverse and perverse outcomes.

The Economist of March 15-21, 2014, comments with commendable perspective, for a change, on crony capitalism and corruption in India. As is widely acknowledged, public sentiment against corruption spawned the movement led by Kisan Baburao Hazare, part of which has metamorphosed into a political party, namely the Aam Aadmi Party. Court judgments and the arrest of former minister A Raja were seen as heralding an environment gradually less tolerant of corruption. However, Mr Raja and others who have been charged on grounds of corruption are reported to be standing for the Lok Sabha. Election results, which are to be announced on May 16, should be an indication of the views of an increasingly aspiration-driven younger electorate's perceptions about transparency and honesty in public life.

At a day-to-day level, I was distressed to hear recently from a private sector friend that Indian businesses are almost always harassed when their reported profits go up. Rent seekers, including tax authorities, sniff around for pay-offs, failing which harassment is unleashed. There have to be more efficient ways of enforcing discipline in tax and utility payments than insisting on advance payment with refunds made only when authorities are satisfied that their claim has no merit. Since there is no penalty against the assessing authority for making mistakes, reimbursements can be held up indefinitely. After several rounds of reforms, including fitful or incomplete digitisation of land, property, tax, stamp duties and other records, we have moved from licence raj to inspector regulator raj.

Moving on from ad hominem commentaries about corruption, it would be useful to examine insider trading at best and outright theft at worst when it comes to mergers and acquisitions among Indian companies. In a 2012 paper titled "Stock Price Movement Around Merger Announcements - Insider Trading or Market Anticipation?", Pawan Jain and Mark Sanderman of the University of Memphis study the extent of insider trading around mergers. Their findings indicate that insider trading is often evident in the price movements of stocks prior to merger announcements.

Another, more insidious form of fraud in mergers is when majority owners of large companies enrich themselves by siphoning off funds from their firms through craftily engineered mergers. The first step is to float a 100 per cent privately held company that is de facto fully owned by the promoters of the listed parent company. The next stage is to show some profits for the smaller private company from consultancy services or other innocuous business activity. Then a proposal is made to fully acquire the unlisted company. For purposes of due diligence, an external "friendly" consultant is appointed to recommend why this acquisition is in the best interests of the parent company. Finally, the amount paid for the unlisted company is way above what would be warranted with arm's length valuation. The merger and valuation are, of course, duly approved by the board.

It could be claimed that such a chain of events related to mergers is highly unlikely since listed company boards are sufficiently independent to prevent such obvious scams. On the contrary, anecdotal evidence indicates that board members are not sufficiently independent or alert. It seems that board members, for the privilege of continuing on multiple boards, acquiesce in such over-valuations of privately held companies. And this is how sponsors of the principal company transfer retained earnings to themselves. It follows that there is inevitably a downturn in the share price of the larger listed company after the merger. It is curious that such regular reductions in the stock prices of parent companies after mergers have not attracted adequate attention of either the Securities and Exchange Board of India (Sebi) or the government.

Given the circumstances under which Indian regulators and corresponding government officials are appointed, it is a moot point if they are in a position to stand up to pressures to ignore or abet manipulation of markets. For example, The Hindu carried an item titled "When the hunter turns hunted" on March 17 - appropriately, on Holi, another of our festivals that celebrate the victory of good over evil. It is apparent from this news item that there have been serious differences between one set of Sebi officials and their successors and the government on issues related to probity in our capital markets. Further, our law enforcement agencies, including the Central Bureau of Investigation, should not undermine their credibility by shooting off trial balloons against those who are obviously not guilty of deliberate wrongdoing. To sum up, even as the electorate gives its verdict on who should represent us in the Lok Sabha, we need to make it difficult for inspectors, investigators, regulators and the government to engage in wilful harassment.

The writer, a former Indian high commissioner to the United Kingdom and finance professional at the ministry of finance and World Bank, is currently RBI chair professor at Icrier. These views are personal. j.bhagwati@gmail.com