In 1996-97, the issue that was most hotly debated was corporate governance. And of course, associated concerns like the role of non-executive directors, the fine line between law and ethics, came increasingly under the microscope. The Smart Inve-stor talked with Arvind Mahajan, director, A F Ferguson and Co to get the management consultant's perspective on those issues.
Q: What are the changes that Indian companies will have to make for corporate governance to succeed as a concept?
A: The major issue in making sure that corporate governance succeeds is by making sure that the institutional shareholders start playing their roles. Already, to some extent, many companies have got foreign institutional investors and the latter are playing a fairly important role in making sure that there is a certain amount of transparency, particularly for companies which need to continue to go to the international capital markets.
These companies have to be careful that their disclosures are correct and that their dealings are above board. Otherwise they cannot go again to the capital market. I am told that they share a lot of information with the FIIs, which they may or may not share with the non-institutional shareholder because of this aspect. But the key thing is that more than just the FIIs, it is the Indian financial institutions that have to play a role keeping in view their interests as shareholders rather than as government bodies which have lent money. And our FIs are no longer government bodies and have other shareholders too. So they will be under more pressure by their boards and shareholders to make sure that the decisions that they take are commercially oriented.
They have to check what is in their interests as shareholders, and have to decide whether they are actually getting value for their investments. The big concern at the moment is that perhaps they do not have enough nominees who can play this role, which is one of the reasons why, to some extent, some of them may need to categorise their holdings in certain ways "" maybe A, B, C, whatever "" and disinvest from those holdings where they do not see a future as an equity investor as opposed to as a lender.
This process is likely to happen first in companies where public and institutional holding are high. When the FI/FIIs sell out, the stock price will get dep-ressed. And market news that this institution is selling will depress price further. The firms have to be concerned about these matters and this will have an impact on corporate governance.
Q: Do you agree that there will be a conflict in the role of the nominee director of the Indian financial institution as a lender as opposed to that as a shareholder?
A: Yes, there should be a segregation of the role of the FI as a lender and as a shareholder. To some extent, there is probably a need within the organisation to re-organise these roles. Where there is a lender role, there is not much case for them to be on the board. There are should be enough mechanisms outside the system to exercise control for a lender. The lending appraisal system is more before you give a loan than after you give a loan. For a lender, there are other ways of exercising control by calling back loans, taking action legally, and so on. In the case of equity investors, the role is to make the company perform or divest. Because of this conflict, the FIs need to relook at all their holdings and nominee directors.
Q: What about the non-executive directors?
A: Non-executive directors are another group that, on many boards, has not played its role. This is because very often they are dependent on the management for their appointments. I think it will take a little more time in India before non-executive directors can start playing a more active role on company boards. The first area where an impact will be felt will be from the relatively progressive FIs and FIIs. In the longer term, there are issues of the non-executive directors and the formation of audit committees. Very few companies have these audit committees that interact with the finance department for the purpose of checking whether the accounts are in order, issues that the auditors have raised, what are the other factors that internal audit reports have thrown up.
This concept does exist in certain companies but we need to have more of it as an independent check on management. This process will be relatively slower and will happen because of outside pressure. But I think the key driver is going to be the liberalisation process and competition. If companies want to implement world-scale projects and resources cannot be generated locally, they will need to raise capital abroad where these standards have to be adhered. The pressure will be more on companies that need to raise debt or equ-ity abroad than on the relatively smaller ones or those that are more insular.
Q: Indian firms are often accused of siphoning off shareholders' funds. What steps can be taken to ensure that funds do not get siphoned out of a company by promoters?
A: With transparency of guidelines and equity analysis being done, we have a situation today which is very different from what it was like five years back. Many more research analysts are reporting on companies today. While some of them may be supporting the management, there are enough people around who are independent. Companies cannot get away with things they could in the past. The market will take action against companies which siphon off shareholders' funds. While there will be others like the enforcement directorates taking action against these companies, the biggest test will be the market. Today, when P/E ratios are down, those in which managements are such that people do not trust them, they are down disproportionately and the price is lower than the book value. Many profit earning companies are quoting below par. This reflects the fact that they can never go to the capital markets unless they clean up their acts. Earlier people felt that they could go to the capital market whenever they felt like.
Even if they did not complete the project on time, they could raise funds for another project and use it for the old project. This situation cannot exist anymore. People have become wary and the small investor is also not coming to the market. So, given the situation, managements themselves have to make sure that they woo the market.
Q: How do you view share buyback? How different is the US employee stock option plan from that in India?
A: Buyback should be allowed, particularly if you want to have a more permissive corporate controlled market. A corporate controlled market is another check on making sure that corporate governance takes place.
Companies which are inefficient or not using their resources productively will obviously be targets for acquisitions. The government is trying in a limited way to ensure that it does happen. Hostile takeovers have not taken place but will gradually take place.
A defense mechanism for companies to safeguard against hostile takeover, particularly if they have cash and are not able to deploy funds productively enough, is buying back of shares to ensure that they can get better earnings per share, which will be in the shareholders' interest. It also has linkages to the employee stock option plan (ESOP) aspect but even irrespective of this aspect, it would be useful for companies to buyback shares. It may be useful for capital restructuring too. A company may have a large capital base developed over a period of time which may not be in the interest of the company and shareholders over the long time. The company may not be able to give the kind of dividends that the shareholder expect.
As far as the ESOP is concerned, there are certain problems in India. A company cannot buyback shares and has to resort to other options. There are three possibilities. The first one is setting up a trust which will get shares from the company on a preferential basis and the trust will offer it to employees. But to give these shares, a special resolution with three-fourths majority is required. This is possible only in cases where management has a very strong control, like in Infosys. Most companies do not use this route because it is difficult.
The second option is another trust route but wherein the trust is given a loan from the company. But there are restrictions on the amount of loan the company can give. It can only go up to six months of the employees' salaries and so on. This will restrict the amount of loan the trust can give employees and the stocks they can buy. There are also restrictions in both the cases on the price at which these share warrants can be issued, which is the Sebi guideline of six monthly average price. So there is not much flexibility on the price.
The third option which many companies are following is the phantom share route. The company does not issue actual shares but runs a notional book. You take the value of the share at the time of issue and depending on the share price movement and the time of exercising the option, the difference is paid to the employee.
With the buyback of shares, the ESOP would become easier to implement. Internationally, there are no restrictions on the amount of loans that can be given and there is no need to make preferential allotment. The company can give a loan to the trust and this route is the most popular.
Q: Do you think the management is solely responsible for the irregularities in any company?
A: Yes. The primary accountability has to be with management. It may be that the irregularities are due to fraud and may not be that the top management is necessarily involved, but employees down the line are involved. Like in the case of SBI and Harshad Mehta, the irregularity was down the line. You can say the chairman is responsible and he is accountable to make sure that internal control systems are in place and if there are some weaknesses in the system, he has to make sure that a reasonable attempt is made to remove it.
If there are faults, then he has to take moral respondsibility in some cases. The key thing is that there will be irregularities down the line and you have to make sure that the management information systems and internal control systems are such that they pick them out. As long as there are mechanisms and corrective actions are taking place, the management is going in the right direction.
