Evolution Of Corporate Governance In India & It's Influence On India's Capital Market
Prof. (Dr.) Uday Salunkhe, Prof. (Dr.) P.S. Rao, and Prof. Amitha Sehgal
Abstract In recent years the issue of corporate governance and the design of appropriate governance mechanisms have become important subjects of academic research and policy discourse in both developed and developing countries. The increasing importance of governance mechanisms comes in the wake of major corporate scandals in internationally renowned companies like Enron , Tyco and Worldcom as well as East Asian crisis in the early nineties and Satyam in India, with a large body of empirical and theoretical research highlighting the significant impact that an economy's corporate governance system can have on the profitability and growth of corporations.
Corporate governance is now increasingly being recognized as a crucial instrument to improve the efficiency of companies and to enhance the investment climate in a country. This paper traces the history of India's stock market
and the impact of corporate
governance norms on its evolution and growth. KEY WORDS: Capital markets, India's Economic Liberalisation, Corporate Governance.
1.1 Understanding the meaning of corporate governance Recent corporate scandals have focused attention on corporate governance for all the wrong reasons. There is a need to cut through all the 139
sensational corporate governance failures, like the case of Satyam, to understand what is the meaning of corporate governance. Shleifer and Vishny state that "Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment ." (1997, p.737). Corporate governance in the Indian context spells out clearly that ethics and values form the bases of corporate governance, while adherence to the legal framework is the minimum requirement. Confederation of Indian Industries (CII) - Desirable Corporate Governance Code (1998) defines it as "Corporate Governance deals with laws, procedures, practices and implicit rules that determine a company's ability to take informed managerial decisions vis-Ă -vis its claimants - in particular its shareholders, creditors, customers, the State and employees. There is a global consensus about the objective of 'good' corporate governance: maximizing long-term shareholder value." "Corporate Governance is an art of managing companies ethically and efficiently for enhancing stakeholders' value. The entire gamut of corporate governance system could be referred to as "corporate ethical and values system". (extracted from the Report of the Committee on the Companies Bill, 1997). The Narayana Murthy report, (2003) has a comprehensive definition : "Corporate governance is the acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal and corporate funds in the management of a company".
These definitions reflect the Indian ethos of corporate governance as articulated by Mahatma Gandhi in his writings. He believed that management is a trustee of shareholders capital and business is a trustee of all resources, including the environment. As trustees the primary goal of management is to protect the interest of the owners and also, not to exploit resources for short term profits. In India, the initiative on corporate governance was not a result of any major corporate scandal, like Enron, World Com, etc. It started as a selfregulatory move from the industry rather than the rule of law. The earliest developments in India began in 1991, after the report of the Cadbury Committee was released in the U.K. Industry groups held seminars and conferences to discuss the Cadbury report and its relevance to India. The Confederation of Indian Industries (CII) was the first to introduce a code on corporate governance in April 1998. Some companies did comply with the same in their annual reports of 1998-99. It was voluntary in nature. Over the years, the Government of India and the Securities and Exchange Board of India (SEBI) have constituted several committees to make recommendations. Recommendations of three landmark committee reports are milestones in the journey towards better governance. The Kumar Mangalam Birla Committee (1999), constituted by SEBI was instrumental in the addition of a new Clause 49 to the listing agreement with the Stock Exchanges. This was a landmark in the history of corporate governance in India. These recommendations, aimed at improving the standards of Corporate Governance, are divided into 19 mandatory and 6 non-mandatory recommendations. Its major contribution was in recommending the constitution of the Board of Directors (specifying the minimum number of independent directors and board procedures); the Audit Committee (including the mandatory
requirement of an audit committee); Disclosures (mandatory Management Discussion and Analysis section in Annual Reports + other disclosures). For the first time in the history of corporate India, specific corporate governance processes and disclosures were mandated under the listing agreement with the stock exchanges. This was followed by the Naresh Chandra Committee on Corporate Audit and Governance in 2002. The committee recommended best practices regarding the statutory relationship between auditors and companies and set the highest standards for the role of audit committees. For example, Clause 49 has incorporated the recommendation of the Birla Committee that the audit committee should have three non-executive directors as members with at least two independent directors, and the chairman of the committee should be an independent director. But the Naresh Chandra report set the benchmark higher. It recommended that all members of the audit committee should be independent directors, thereby plugging the loophole that could make it possible for a promoterdirector without an executive role in the company becoming a member of the audit committee. Progressive companies like Infosys follow the benchmark spelt out by the Chandra report and all the members of its audit committee are independent directors. The N.R.Narayana Murthy Committee (2003), raised the bar with greater emphasis on internal controls and risk management systems in companies. Several of its recommendations, concerning related party transactions and qualifications of audit committee members were accepted by SEBI and made mandatory under Clause 49. Interestingly, the committee made an important non-mandatory recommendation that companies must be encouraged to move towards a regime of unqualified financial statements (In many cases auditors taint financial statements with their disapproval/ 142
objection to some of the accounting practices). This recommendation has not yet been accepted. All these progressive developments in improving corporate governance have vastly improved the equity/capital market climate in India. The primary purpose of corporate governance norms is to ensure that managers protect the investment of the owners (scores of minority shareholders of the company's stock) and maximize their returns on such investment. Since the stock markets are the conduit through which these investments are made, the mechanics of the stock market and the principles of corporate governance are enmeshed in a continual cycle of codependency. The goal of this research paper is to understand the evolution of corporate governance in India, against the backdrop of the history of India's stock market, its corporate culture and the government attitude that strongly influenced the way business was conducted. It traces how corporate governance has evolved in India, from the time of India's independence till date. It also attempts to assess how new listing norms under Clause 49 issued by the Securities and Exchange Board of India and other regulatory reforms impact the functioning of the Indian stock markets. Several recent measures taken to reform liberalize the Indian business/ banking environment and simultaneously introduce sound corporate governance practices, have helped create robust stock markets, which in turn have raised the standards of corporate governance. 1.2 Early Developments In India Traditionally, dominant promoter groups and lax oversight by debt providers have been the underlying weakness of corporate governance in India.
This has led to weak company boards, inept institutional activism and, therefore, poor protection of minority shareholders. Though India has not experienced large scale corporate scandals like those experienced by the U.S., this is more a result of a convergence of the interest of management and owners (both constituted by the dominant promoter-family/dominant government holding), rather than because of higher standards of corporate governance. But, in this context, it is crucial to understand how India's culture and political orientation were disincentives for higher governance standards. The idealism of socialism and equitable distribution of wealth formed the basis of a very high tax structure - both personal/corporate and also wealth tax. Companies had no incentive to show higher profits on their books and enhance shareholder value. Simultaneously such high taxes encouraged the growth of a strong parallel black economy. The private sector was denied access to the equity market at fair market valuations due to strict control of the pricing of public issues by the erstwhile Comptroller of Capital Issues. The combination of high taxes and low valuations left no incentive for good corporate governance. 1.3 The Corporate Governance Model While corporate governance in India is modeled on the lines of the Anglo-American system, (with an emphasis on shareholder protection), with definite elements inspired by the German-Japanese system, (with its emphasis on protecting all stakeholders); its chief concern has, through the decades, remained unique. 1.3.1. Theory of the Firm & the Agency Problem The fundamental basis of corporate governance is agency costs. Shareholders are the owners of the limited-liability company and are the 144
principals. The managers appointed by the shareholders, directly or indirectly are the agents. Shareholders surrender the management of the company to professional managers (agents), with the hope that they will protect their interests. Agency problems occur when the principal (shareholders) lacks the necessary power or information to monitor and control the agents (managers) and when objectives of the principal and the agents are not aligned. The extent of misalignment of objectives between the principal and agents measures the agency costs. The goal of corporate governance is to reduce this agency costs. This can be expressed diagrammatically as follows :
The impact of the agency problem differs depending upon the ownership structure and whether it gives shareholders direct control over management. In the Indian context we have five different structures and the impact of agency costs varies for each of them. 145
Highly Dispersed Shareholding and professional management (Very few in number. e.g.: L&T, ICICI Bank, Infosys).
Concentrated Ownership and management control rests with majority shareholders, mainly in family managed companies (The dominant structure. e.g.: Grasim, Hindalco, Reliance Industries, Wipro).
Public Sector with government ownership and professional management (Another dominant structure representing around 30 per cent of India's market capitalization. E.g.: State Bank of India, ONGC, BHEL).
Multinational Corporations (Hindustan Unilever, Colgate, Siemens).
Family Ownership but professional management. (Very few in number: Exide, Eicher).
The Anglo-American model, with widely dispersed shareholding in the United States fundamentally addresses the "Principal-Agency" conflict issue. It attempts to resolve the conflict of interest between management (agents) and shareholders (principals). While this conflict is a concern in India, the predominant issue in India is the conflict between "dominant" shareholder-promoter groups and minority shareholders. Illustrating this, is the Discussion Paper (February 8, 2008) by the Finance Ministry that seeks to revisit the provisions of the Securities Contract (Regulation) Rules (SCRR). The paper revolves around the need to increase the mandatory minimum public holding to 25 per cent, from the existing 10 per cent, in a limitedliability firm listed for public trading on the stock market. This would apply to Initial Public Offers (IPOs) as well as already traded companies. Also, it would equally apply to a government company and a private company. Interestingly, this is the first time that regulators propose to define "public"
in terms of its literal meaning of people at large. The Discussion Paper notes that since the word "public" has not been defined so far, it could mean "non-promoters" and include financial institutions, foreign institutional investors, mutual funds, employees, NRIs/OCBs, private corporate bodies, etc, thus making the floating stock insignificant. There are around 250 big and small listed companies with promoter holding of over 75 per cent each. The prominent among them are Wipro, Tata Consultancy Services, Jet Airways, DLF, Puravankara Projects, Akruti City, Omaxe, Plethico Pharmaceuticals, Sobha Developers, Mundra Port, BGR Energy, Blue Dart, Parsvnath Developers, and Bosch Chassis. The promoters, in most cases, currently hold over an 80 per cent stake in these companies. Table 1.11: Public Shareholding in select CompaniesA clear definition of
the word "public" will also restrict the growing dominance of Foreign Institutional Investors. 1
Source : Business Standard, February 8, 2008.
A case in point is the IT industry. Promoter and promoter group stakes in India's top five IT services exporters TCS, Infosys, Wipro, Satyam and HCL Technologies have come down between FY2005 and FY2007, even as these companies chart an aggressive roadmap to expand global footprint. Over the last three years, these companies witnessed a decline in their promoter group holding, and some of them saw the Foreign Institutional Investor (FII) holdings going up. The decline was steep - in excess of five percentage points in case of Infosys and Satyam, while it was a little over three percentage points in case of TCS, Wipro and HCL. The decline in Infosys is due to the company's sponsored secondary ADS (American Depository Shares) offers during these years, wherein promoters diluted their holdings to a certain extent. Infosys' two sponsored secondary ADS offerings - in May 2005 and November 2006 - saw its overseas float increase to 19 per cent. Table1.22 : Falling Stake of promoters (in per cent) March 2005
Though the non-promoters holding is about 48%, the public held only 15.26% and the institutional holdings by (FIIs, MFs, FIs) accounted for 20.67%. There is not much significant difference in the shareholding pattern of companies in different sectors. About 80% of shares in companies in infrastructure sector are held by Indian promoters. The German/Japanese model of corporate governance allows for a close relationship between banks/financial institutions and companies. It is also characterized by large cross-holdings between companies. 2
Source : Kulkarni V. and Chatterjee, M.B., Hindu Business Line August 11, 2007
Similarly, in the years prior to 1991, Indian companies had limited access to the equity markets and were largely dependent on banks and Financial Institutions (FIs) for their funds (see Table 3). Table 1.3 : Pattern of Sources of Funds for Indian Corporate Percent of total Item
1995-96 to 1999- 2000-01 to 2004-
1. Internal Sources
2. External Sources of which:
a. Equity capital
ii. From Banks
b. Borrowings of which:
iii. From FIs c. Trade dues & other current liabilities Total
Note: Data pertain to a sample of non -government non -financial public limited companies.
3 Source : Article on "Finances of Public Limited Companies", RBI Bulletin (various issues) But unlike in Japan/Germany, where banks play a critical role, as creditors, in the corporate governance of companies, in India, though banks/ FIs had large debt exposures to the Indian corporate sector, (and with a conversion clause in the loan agreement the debt was often converted into an equity holding) several studies have shown that they did not exercise close monitoring of the corporate governance standards in these companies. An analysis of the above table clearly shows that the proportion of funds from internal sources started increasing from 1995-96 onwards, after economic reforms started and after wealth tax was abolished. Wealth tax was payable on dividend income post tax, which was insufficient to pay the onerous wealth tax, leading to a dilution of management holding in order simply to pay it. Its abolition, therefore, gave every incentive to promoter management to retain profits in companies instead of siphoning it out. 149
It is observed that in the Indian context, the external market exercises a limited force on corporate governance (since the floating stock in the secondary market is limited). Nor is the internal force of a strong Board (since management and Board members are, very often, from the same dominant promoter group) always effective in protecting the principles of sound corporate governance. Despite globalization, and an increase in foreign institutional investment in Indian companies, institutional activism is also weak and yet to emerge as a strong counter force. Institutional investors, both domestic and foreign, are more prone to vote with their feet, by exiting the stock, than to influence a change in management behavior. The onus of protecting the interest of minority shareholders and other stakeholders, thereby ensuring high standards of corporate governance, falls primarily on the market regulator, Securities and Exchange Board of India, Reserve Bank of India, the Department of Company Affairs, Government of India, the media, both print and electronic, and the stock exchanges. 1.4 A Historical Perspective: Early Years After India's Independence On gaining independence in 1947, India's first Prime Minister, Jawaharalal Nehru, emphasized the need for the country to build heavy industry (steel, cement, capital goods) and the primacy of the role of the public sector in it. The corporate sector had inherited a managing agency structure that was stacked in favor of managing agents. The first managing agency in India was British. It was established in 1809. Carr, Tagore & Company is known as the first equal partnership between European and Indian businesses and it also initiated the managing agency system in India. From then on, for over a century, growth of joint stock companies and
managing agencies was simultaneous and it was dominated by the power and influence of the managing agencies. In 1850, an Act was passed for the registration of companies with limited liability. It marked a turning point in the history of Indian business. Agency houses formed new joint stock companies, to attract savings from a large pool of investors. The managing agents controlled these companies through inter-locking of directorship and inter corporate investments. Several malpractices and speculative trends emerged on the Bombay and Ahmedabad stock exchanges. This system dominated Indian business till independence. It was formally abolished in 1969. Indian business families continued the controlling streak that the managing agency system had put into place. In 1950-51, for example, 9 leading Indian industrial families held 600 directorships, with only two families, viz. Dalmia and Singhania holding 200 of them. One hundred individuals were found to hold 1700 directorships, 30 of them holding 860 directorships and the top 10 held 400 directorships. The practice of multiple directorships continued to plague Indian corporate boards. The Bhabha Committee (1953-54) recommended as upper limit of 20 directorships. This was incorporated in the Companies Act, 1956. Ram Jethmalani, the law minister in the Union Government (1996-2000), specified the maximum number of directorships to be 15, the limit that continues till date. Dr. JJ Irani Report on Amendments to the Company's Act (2005), has also recommended 15 as the maximum number of directorships. In 1964, the Monopolies Inquiry Commission (MIC) was appointed to look into the concentration of ownership in industry. MIC concluded that the overall concentration of industrial power had increased since 1950.
Professor RK Hazari Committee Report (1966) and Dutt Committee or the Industrial Licensing Policy Inquiry Committee (1969), laid the framework for the passing of the Monopolies and Restrictive Trade Practices (MRTP) Act in 1970. This restricted the size and scope of private enterprise. In 1977 it became mandatory for the All India Financial Institutions to put the convertibility clause and nominee directors' appointment clause in their loan agreements. After the second phase of bank nationalizations (the first was in 1969) in 1980, all major banks and all large financial institutions were in the public sector. The stage was set for the Government to have a firm grip on, and a substantial stake in, both the industrial sector and the financial sector. Government kept out of stock markets; up until the advent of the National Stock Exchange (NSE) in 1992, it was the Bombay Stock Exchange (BSE), a 130 year old exchange, which was the major exchange for companies to list their shares on. The BSE was governed by brokers as a self regulatory organization. There were other, minor, regional exchanges which have died, or are dying, a natural death. 1.4.1. Role of Private Sector The private sector had a small role to play in industrial development and had to rely, largely, on financial institutions for their funding requirement. Although India boasts of having one of the oldest stock exchanges in the world, its equity market had yet to mature for several reasons. Primarily, the offer price for new issuances was not market determined but was based on a formula determined by a Government functionary called the Controller of Capital Issues (CCI). It used an average of the past three years high/low stock prices, the book value and the earning value of its stream of profits capitalized at an assumed rate, to determine at what price
stock could be issued. In essence, historical, rather than prospective, earnings were the determinants. Thus the private sector was denied access to the equity market except at prices so low that there was no incentive for good corporate governance. It had to rely on debt funding from the six All India financial institutions for project finance, and from public sector banks for its working capital finance. Both came with a price tag. Bank loans for working capital were expensive whereas the rupee loans from all India financial institutions carried with them an option to convert a fifth of the loan into equity at very attractive prices. Hence in the context of how financial markets were then structured, and in the prevailing ethos of domination of the public sector, good corporate governance was of the least importance for management. There was no reward for good governance. Industrial enterprise was licensed and simply obtaining a license to manufacture anything was almost enough to assure a profit. Licensing restrained domestic competition and high tariff walls ensured that there was no foreign competition either. In short, the interest of shareholders became subservient to the interest of lenders, which were in the public sector and which permitted, even encouraged, a high leverage. A debt: equity ratio of 3:1 (or more) was fairly common, and high profit margins for producers, due to a lack of competition, allowed such high leverage. The interest of the customer became subservient to the fiscal interest of a Government that got a good chunk of its revenue from high import duties. Corporate governance thus did not necessitate finding ways to enhance shareholder value nor did it involve customer care. The reasons were simple. Shareholder value was, in fact, sought to be contained, because not only
were income tax rates were very high (going up to 97 per cent) but there was also a wealth tax payable on such holdings. Dividend income, after paying tax, did not leave enough for the wealth tax, resulting in a dilution of holding by promoter groups. Simultaneously, because of the option to convert rupee loans, the share of the six all India financial institutions was increasing. This, of course, alarmed the private industrial groups. The biggest tax breaks were on capital investments including depreciation and allowances for setting shop in 'backward areas' where Government wanted industrial development and job growth and gave fiscal benefits to achieve it. This, of course, led to a scramble for licenses to invest and applications to finance the projects to the monopolistic all India institutions. Rupee loans from domestic financial institutions came, of course, with a Damocles sword of conversion option into equity. This structure of financing of industry led to several consequences. Poor quality of goods to consumers for one, and mediocre returns to equity investors, for another. There was a time when the wait for a telephone connection (a monopoly of MTNL in metros and BSNL outside of them; both Government companies) or of scooters (a near monopoly of private sector Bajaj Auto) was of several years. The quality of service or product was awful but given the absence of any alternative supply source, Indian consumers accepted these with stoicism, in conformity with the Hindu philosophy of 'karma'. Corporate governance was thus restricted to producing more since this assured a profit irrespective of quality. Investors were content with investing in debt instruments of the Government of India, which yielded decent returns after factoring in inflation. Investor queries to management at annual meetings of shareholders tended to focus more on why dividend was not increased or
why bonus shares were not issued, than on the nature of business or the quality of management. Corporate governance was, largely, cozy meetings of closed groups of associates. Director fees were governed by the Centre and were not conducive to encouraging an independent spirit of inquiry. The structure also led to poor productivity and lack of innovation, there was simply no incentive to do either to survive, in the absence of competition. The equity market, though old, had not created enough excitement to the number of investors willing to take its risk. This excitement came about in 1973 when a minister, George Fernandes, gave transnational companies operating in India an ultimatum. Either offer 40% of your shares to domestic investors or quit. Two companies, IBM and Coca Cola chose to quit (only to return later); the rest diluted and so created community interest in their prosperity. Because the offer price of these issues (these companies were called FERA companies since they were covered by the Foreign Exchange Regulation Act) was controlled by the CCI formula, resulting in a low price, allotment of shares in them was a safe and splendid investment. The FERA dilution gave a major impetus to equity investment and thousands of new investors were attracted to stock markets. But Government policies still stilted in favour of "public good" and macroeconomic considerations, rather than encouraging private competition. One such policy introduced during the aftermath of the Bangladesh war (1971) to curb inflation, was introduced by the then Prime Minister, Indira Gandhi, was control on dividend, by the introduction of Companies Dividends Restriction Ordinance in 1974, further dampening the development of the capital market. The structure of a protected market providing enough margin to sustain a highly leveraged industrial sector at high financing cost, broke down in
1991. India went into a financial crisis, with enough foreign exchange to support just two weeks of imports. Manmohan Singh, as Finance Minister, supported by the taciturn Narasimha Rao as Prime Minister, saw the writing on the wall. He ushered in economic liberalisation. Import tariffs were slashed and licensing requirements greatly reduced. This ensured competition from both imported goods as well as domestically produced ones. In order to protect Indian industry from an onslaught of imports and to give them time to prepare themselves, he did two things. One was a sharp devaluation of the rupee. The other was to bring down import duty in steps. He then did a third thing, which was to open capital markets to foreign investors. 1.4.2
Even as the economic reforms ushered a transformation in India's corporate sector, investors had to carry the baggage of poor governance and lax regulation, into the next phase of India's economic history. The first jolt was the Harshad Mehta securities scam in 1992, involving several banks. (Harshad Mehta was an aggressive bull operator in the Bombay Stock Exchange). The stock market crashed by 40 per cent, in the two months after April, 1991 when the media exposed the story, with a loss of around Rs.1,00,000 crores. This was followed by several cases in 1993 when transnational companies, seeing the "India growth story", started consolidating their ownership by issuing equity allotments to their respective controlling groups at steep discount to their market price. In this preferential allotment scam alone investors lost roughly Rs.5000 crore. The third scandal was the disappearance of companies during 1993-94. Between July 1993 and September 1994, the stock market index shot up by
120 per cent. During this boom, 3,911 companies that raised over Rs.25,000 crore vanished or did not set up their projects. The case of vanishing companies continues to persist. The issue is monitored by the Department of Company Affairs and not by SEBI or the stock exchanges, and there are regulatory shortcomings that have failed to plug this issue. Recently, a high powered Central Coordination and Monitoring Committee, co-chaired by the Secretary, Department of Company Affairs and Chairman, SEBI was set up to monitor action taken against vanishing companies. It was decided to set up seven task forces at Mumbai, Delhi, Chennai, Kolkata, Ahmedabad, Bangalore and Hyderabad with Regional Directors/Registrar of Companies of the respective regions as convenor, and regional offices of SEBI and stock exchanges as members. Their main task would be identifying companies which have disappeared, or have misutilised funds mobilized from investors, and to suggest appropriate action as per the Companies Act or SEBI Act. Another scam involved the plantation companies in 1995-96. It saw around Rs.50,000 crore of retail investor money disappear. Ketan Pareikh, a major bull broker, propelled the information technology, communications and entertainment stocks to dazzling heights from 1999 onwards till the crash in 2001, when his speculative trades were exposed and the market crashed 177 points. Prior to 1991, the only mutual fund then was in the public sector, in the form of the Unit Trust of India (UTI), one of the six all India financial institutions. Its governance was, by virtue of Government ownership, at its sole discretion. Its flagship scheme was the US 64 scheme, which ended up, several years later, in deep trouble, because of bad governance. US 64 (a mutual fund product launched by UTI) started, like all open ended mutual funds, as an open ended scheme, with redemptions and purchases
linked to net asset value (NAV). NAV linked redemptions impose their own discipline on investing; if investors do not like the performance, they exit. It was a regular income scheme (it had to invest around 80 per cent in debt instruments) but it changed its investment portfolio and by the late 1990s, 70 per cent of its portfolio was in equity. The crash of the stock market in 2001 saw its portfolio value crashing. US 64's position became untenable, and the fund announced that it would drop its repurchase price to Rs 10, to the consternation of those who had bought units at Rs. 16 in the recent past. Investor confidence was shaken and the Government bailed out UTI, taking over (at reduced liability) the assets and liabilities of US 64and segregating and spinning off the other assets. The UTI episode shook the confidence of the small investors. There was an urgent need felt to reform India's capital markets. Though the Securities and Exchange Board of India was established in 1988, it was empowered as a capital market regulator in 1992 (post-Harshad Mehta scam), with the passing of an Ordinance, giving it statutory status and powers. Since then, SEBI had taken several steps to reform the market. But after the UTI episode it had to tackle a confidence-crisis that hit the equity market on a war footing. 1.5 Reforms in India's Capital Markets Among the first steps taken by the government was to repeal Capital Issues (Control) Act, 1947, in 1992 paving the way for market forces in the determination of pricing of issues and allocation of resources for competing uses. Companies were free to price their issues according to what investors perceived to be their value, looking to the future, rather than on the basis of an antiquated formula, which peered into the past. The next major step was the abolition of wealth tax on shares in 1992-93.
Tax rates were reduced from a peak 97 per cent to 56 per cent in 1991 and 30% in 1997. Due to recent imposition of a surcharge and cess, it is almost 34% today. Indian companies experienced the euphoria of market pricing and market driven valuations for their company. Book building was introduced to improve the transparency in pricing of the scripts and determine proper market price for shares. The primary market saw a boom. Simultaneously, the secondary market was given a lift up when trading infrastructure in the stock exchanges was modernized by replacing the open outcry system with on-line screen based electronic trading. This improved the liquidity in the Indian capital market and led to better price discovery. The trading and settlement cycles were initially shortened from 14 days to 7 days. Subsequently, to enhance the efficiency of the secondary market, rolling settlement was introduced on a T+5 basis. With effect from April 1, 2002, the settlement cycle for all listed securities was shortened to T+3 and further to T+2 from April 1, 2003. Shortening of settlement cycles helped in reducing risks associated with unsettled trades due to market fluctuations. The establishment of National Securities Depository Ltd. (NSDL) in 1996 and Central Depository Services (India) Ltd. (CSDL) in 1999 has enabled paperless trading in the exchanges. Trading in derivatives such as stock index futures, stock index options and futures and options in individual stocks was introduced to provide hedging options to the investors and to improve 'price discovery'mechanism in the market. The Investor Protection Fund (IPF) has also been set up by the stock exchanges. The exchanges maintain an IPF to take care of investor claims. Another significant reform has been a recent move towards corporatisation and demutualisation of stock exchanges. The Bombay Stock Exchange was
corporatised and demutualised in 2005. Setting up of credit rating agencies, CRISIL, ICRA was significant but it has not made a significant contribution to the retail market for corporate debt instruments. The recent failure of a few large Initial Public Offers (IPOs) issues and disappointing performance of some IPOs on listing, has prompted regulators to suggest a mandatory rating for all new IPOs. The recommendation has not yet been implemented. The setting up of the National Stock Exchange of India Ltd. (NSE) as an electronic trading platform set a benchmark of operating efficiency for other stock exchanges. Table 1.45 : Comparision of BSE and NSE Bombay Stock Exchange Ltd
National Stock Exchange of
Market Turnover (Rs.
* Rupees (Rs.) is the Indian currency and Rs. 1 is approximately equal to $40 (average). 5
Source : Bombay Stock Exchange and National Stock Exchange.
Foreign Institutional Investors (FIIs) allowed since the mid-1990s, brought 160
with them better disclosure and corporate governance standards. Foreign institutions were willing and able to pay a higher multiple for earnings and they were also willing to pay for good corporate governance standards. At present, around 1000 FIIs are registered with SEBI. To attract retail investors into the equity market the mutual fund industry was thrown open to the private sector and today one private fund, Reliance, has overtaken UTI in terms of assets under management, with others close behind. Since 1980, after the second round of bank nationalization, the Reserve Bank of India had not issued any private bank license. In a major move to increase the efficiency of intermediation in the financial markets, the policy was reversed and private sector banks were set up. Some of the more enlightened all India financial institutions converted themselves into commercial banks. ICICI was the first of the three lending institutions to do so, and has now become the most valuable private sector bank in the country. Interestingly, ICICI was, ab initio, a listed company, with an independent board accountable to public shareholders, which, perhaps, explains its greater ability to transform. The next to transform from developmental finance to commercial banking was IDBI. The last, IFCI, was closest to Delhi and hence most suitable for misdirected lending under political pressure; it nearly became a sick institution. Thus, even within financial institutions there were different governance standards. The advent of foreign institutional investors, the growth of the mutual fund industry and the freedom to price issues gave a huge impetus to good corporate governance. Institutional players were willing and able to pay more than individual investors, so promoters found that their wealth was multiplying in value. There was now no wealth tax, hence an incentive to
increase shareholder value. Price/earnings multiples were higher and, they discovered, every rupee retained in the books of the company rather than taken away through financial jugglery, enhanced their wealth far more. Increasing shareholder value thus became a mantra and improved corporate governance standards the means to achieve it. 1.6 Outcomes of Equity Market Reforms and Proactive Corporate Governance Processes. 1.6.1.
Impact on the Companies
Freedom to price issues and access to capital markets provided to first generation entrepreneurs, set in motion a chain of events. Whereas earlier only the already established houses had the wherewithal and the contacts to obtain licenses to manufacture products and the connections with state owned financial institutions to finance their projects, the field was now open to anyone. Thus sprang first generation entrepreneurs, such as Infosys Technologies, led by the well known N. R. Narayan Murthy, which ventured into software services. This, a field where the biggest assets walked out the door every evening, was not a venture traditional lenders, which lent against asset backed securities, would have earlier considered fundable. The equity market was also unsure of his venture and the IPO had to be rescued by their investment bankers. Under Murthy's leadership, Infosys raised the bar for good governance. In one of its earlier analyst meetings, Murthy confessed that GE, its largest customer accounting for a major share of turnover, had walked out on them because Infosys refused to cut prices to get more business. More than the event, it was the honesty and the chutzpah of the disclosure that impressed analysts. The stock price never looked back and gave superlative returns to early shareholders. Shareholders were willing to pay a higher price for well-governed companies with good disclosures.
On the flip side, corporate management realized that good governance yielded commensurate returns. Another first generation entrepreneur was Dhirubhai Ambani, who founded Reliance Industries, now a FORTUNE 500 company. He was astute enough to appreciate the value of the equity market and clever enough to reward his shareholders so well that they subscribed to each new offering of the group. He financed his ventures through frequent tapping of capital markets, ensuring that he left enough on the table for his investors to want more. The group is now split between his two sons, with both growing sizeably. n telecom, a new entrepreneur, Sunil Mittal set up Bharti Airtel, one of the best performing stocks. Mittals forte was finding strategic and financial investors with staying power, and building and maintaining relationships with them. Corporate governance has a cause-and-effect relationship with investor expectations. As the market became institutionalised with the advent of mutual funds, investor expectations of governance standards increased. Simultaneously, institutional investors were willing and able to pay more for companies with better governance. Companies have now set up different committees for investor relations, compensation, audit and others, with independent board members sitting on each. Sometimes these committees are independent and effective, sometimes not. Infosys Technologies is considered the benchmark of good corporate governance; its CEO was recently fined by its audit committee for neglect inadvertently failing to disclose certain transactions within the 24 hour time set for such disclosure. The committee asked him to pay the fine as a donation to his favourite charity. Annexure 1.2 compares the top 10 companies based on their market
capitalization in 1992, a year after the economic reforms started; 2001, around 10 years after the reforms were initiated; 2007, when the markets were witnessing a boom and in 2008, after the sub prime problem in the U.S and the subsequent volatile international capital market, as also a slow down in the world economies. The analysis is revealing. The top positions in 1992 were dominated by private companies in steel, engineering, cement, FMCG, and capital goods. In 2001, IT and telecommunications enjoyed the top slots and public sector companies in oil and finance industries began making inroads into the capital market. A comparison between 2007 and 2008 reveals that well-governed companies Bharti Airtel, TCS, Reliance Industries continue to find a place among the top 10 companies despite the turbulence in the market while several government controlled companies in the metals, mining & commodities industries, enjoying a near monopoly position in their industries, are now placed among the top 10. 1.6.2.
Impact on the Equity Markets
One of the most significant ratios to measure the impact of reforms on the equity market is stock market capitalization to GDP ratio. Graph. : 1.1 :
6 Source : Currency & Finance, RBI, 2005-2006 164
Graph : 1.27 : Market Capitaliation as percent of GDP in select economies (As at end-2005) UK Singapore Hongkong
Aust rali a US Japan
K oreaThailand Indi a Brazil Philipines Argentina Mexico
Source : Currency & Finance, RBI, 2005-200
During the recent boom in 2007, the market cap/GDP ratio in India jumped up to 173 per cent, and it was feared that the market is overheated. The turnover ratio (TOR) is measured by dividing the total value of shares traded on a country's stock exchange by stock market capitalization. It is a measure of trading activity or liquidity in the stock markets. The value traded ratio (VTR), is the total value of domestic stocks traded on domestic exchanges as a share of GDP. This ratio measures trading relative to the size of the economy. As is evident in the following table both TOR and VTR have significantly improved since 1990-91, when the economic liberalization process began. Between 1996-97 and 2000-01, the ratios reached high levels, largely because of the rise in stock prices due to the boom in information technology stocks.
Table 1.5 : Liquidity in the Stock Market in India
(Per cent) Value Traded Year 1
Turnover Ratio 3
The National Stock Exchange was a leader in the trading of single stock futures in 2006, according to the World Federation of Stock Exchanges. It was at the fourth place in the trading of index futures.
Table 1.68 : Top Five Equity Derivative Exchanges in the world - 2006
A. Single Stock Futures Contracts No. of Exchange
National Stock Exchange, India
Jakarta Stock Exchange, Indonesia
BME Spanish Exchange
B. Stock Index Futures Contracts No. Exchange
Chicago Mercantile Exchange
National Stock Exchange, India
Korea Stock Exchange
Source : World Federation of Exchanges. 8
Source : Currency & Finance, RBI, 2005-200
As per the SEBI-NCAER Survey of Indian Investors, 2003, there has been asubstantial reduction in transaction cost in the Indian securities market, which declined from a level of more than 4.75 per cent in 1994 to 0.60 percent in 1999, close to the global best level of 0.45 per cent. Further, the Indian equity market had the third lowest transaction cost after the US and Hong Kong. Despite the positive impact of the reforms, households continue to have a limited investment in the equity markets, including the mutual funds market. (See table 1.7).
Table 1.79 : Share of Various Instruments in Gross Financial Savings of the Household Sector in India (Per cent) Period
Bank and non -
@: Includes investment in shares and debentures of credit/non-credit
Note : Gross financial savings data for the year 2004 are on new base, i.e.,-05
Source :Handbook of Statistics on the Indian Economy, 2005-06, RBI.
An important question is how far are do the reforms in the capital market benefit the Indian retail investors. In fact, the India growth story has attracted foreign institutional investors (FIIs) in a big way, with global majors like CLSA, HSBC, Blackstone, Fidelity, Goldman Sachs, Citigroup, Morgan Stanley, UBS, T Rowe Price International, among others, entering the capital market. Several sovereign pension funds like, the Netherlands' ABP (Algemeen Burgerlijk Pensioenfonds), Norway's The Government Pension Fund - Global (Statens pensjonsfond - Utland) and Denmark's Lonmodtagernes Dyrtidsfond (LD Pensions) have invested over $1.2 billion (nearly Rs. 5,000 crore) in India.
This has increased the buoyancy as also the volatility in the stock markets. With a net cumulative investments of around $65 billion, FIIs account for around 25 per cent of the floating stocks in the Indian stock markets. Till recently, Indian pension funds were disallowed investment in Indian equities. After three years of delays and discussions on Project OASIS (Old Age Social and Income Security) Report tabled by SA Dave in 2001, the Pension Fund Regulatory & Development Authority Ordinance was passed in 2004. It allows investment of pension funds up to 5 per cent in to equities and another 10 per cent in to equity linked mutual funds. Around 95 per cent of government backed pension funds are locked in low-yielding government paper. This denies Indian pension funds the right to reap the benefits of economic reforms and the great 'India shining' story. India needs a market driven corporate governance culture with greater participation from Indian retail investors, either directly or through mutual funds; entry of government pension funds into the equity market in a really competitive mode, with checks, balances and transparency in line with the Norwegian sovereign fund's high standards of corporate governance and a close, alert regulatory oversight to ensure compliance with the welldrafted codes and clauses. The Indian equity market presents an opportunity for a real transformation to the Indian landscape. If India misses this opportunity, the Indian growth story would benefit foreign pension funds and high net worth investors/ promoter-families more than the Indian on the street. This is not much different from the British Empire days when India's wealth enriched the coffers of the British, and the wealthy Indian business community. 1.10 Summing Up a) 169
Historically Indian companies had no incentive to show higher profits
on their books and enhance shareholder value. This was on account of a very high tax structure - both personal/corporate and also wealth tax. b)
The private sector was also denied access to the equity market at fair market valuations due to strict control of the pricing of public issues by the erstwhile Comptroller of Capital Issues. The combination of high taxes and low valuations left no incentive for good corporate governance.
The early beginnings of corporate governance was an outcome of the repealing of the Capital Issues (Control) Act, 1947, in 1992 paving the way for market forces in the determination of pricing of issues and allocation of resources for competing uses. Tax rates were reduced from a peak 97 per cent to 56 per cent in 1991 and 30% in 1997. Due to recent imposition of a surcharge and cess, it is almost 34% today.
Indian companies experienced the euphoria of market pricing and market driven valuations for their company. Corporate management realized that good governance yielded commensurate returns.
Though India has not experienced large scale corporate scandals like those experienced by the U.S., this is more a result of a convergence of the interest of management and owners (both constituted by the dominant promoter-family/dominant government holding), rather than because of higher standards of corporate governance.
The predominant issue in India is the conflict between "dominant" shareholder-promoter groups and minority shareholders. There are around 250 big and small listed companies with promoter holding of over 75 per cent each. The prominent among them are Wipro, Tata Consultancy Services, Jet Airways, DLF, Puravankara Projects, Akruti City, Omaxe, Plethico Pharmaceuticals, Sobha Developers, Mundra
Port, BGR Energy, Blue Dart, Parsvnath Developers, and Bosch Chassis. The promoters, in most cases, currently hold over an 80 per cent stake in these companies. g)
Unlike in Japan/Germany, where banks play a critical role, as creditors, in the corporate governance of companies, in India, though banks/ FIs had large debt exposures to the Indian corporate sector, (and with a conversion clause in the loan agreement the debt was often converted into an equity holding) several studies have shown that they did not exercise close monitoring of the corporate governance standards in these companies.
It is observed that in the Indian context, the external market exercises a limited force on corporate governance (since the floating stock in the secondary market is limited). Nor is the internal force of a strong Board (since management and Board members are, very often, from the same dominant promoter group) always effective in protecting the principles of sound corporate governance.
Despite globalization, and an increase in foreign institutional investment in Indian companies, institutional activism is also weak and yet to emerge as a strong counter force. Institutional investors, both domestic and foreign, are more prone to vote with their feet, by exiting the stock, than to influence a change in management behavior. i)
India needs a market driven corporate governance culture with greater participation from Indian retail investors, either directly or through mutual funds; entry of government pension funds into the equity market in a really competitive mode, with checks, balances and transparency in line with the Norwegian sovereign fund's high standards of corporate governance and a close, alert regulatory oversight to ensure compliance with the well-drafted codes and
clauses. Corporate governance goes beyond crises, committees and compliances. j)
The corporate board reflects the spirit of corporate governance of a company. To understand the corporate governance of a country it is imperative to understand the framework of its corporate boards. Table 1.1COMPARISON ON OF TOP MARKET CAPITALIZATION COMPANIES SINCE ECONOMIC LIBERALIZATION
RELIANCE INDUSTRIES LTD.
HIND LEVER LTD.
LARSEN & TOUBRO LTD.
CENTURY TEXTILES & INDS.
GRASIM INDUSTRIES LTD.
HIND UNILEVER LTD.
RELIANCE INDUSTRIES LTD.
INFOSYS TECHNOLOGIES LTD
Oil & Petroleum
INDIAN OIL CORPORATION LTD
Oil & Petroleum
STATE BANK OF INDIA
RELIANCE INDUSTRIES LTD.
Oil & Petroleum
BHARTI AIRTEL LTD
INFOSYS TECHNOLOGIES LTD
TATA CONSULTANCY SERVICES
ICICI BANK LTD
RELIANCE INDUSTRIES LTD.
Minerals & Mining
Mineral & Metal
Minerals & Mining
TATA CONSULTANCY SERVICES
Ow nership Private
Type of Industry Steel
Company TISCO LTD.
Authorâ€™s Profile Prof. Dr. Uday Salunke Director - Welingkar Institute of Management is a mechanical engineer with a management degree in 'Operations', and a Doctorate in 'Turnaround Strategies'. He has 12 years of experience in the corporate world including Mahindra & Mahindra, ISPL and other companies before joining Welingkar in 1995 as faculty for Production Management. Subsequently his inherent passion, commitment and dedication toward the institute led to his appointment as Director in 2000. Dr. Salunkhe has been invited as visiting fellow at the Harvard Business School, USA and European University, Germany. He has also delivered seminars at the Asian Institute of Management, Manila and has been awarded "The Young Achievers Award-2003" in the field of Academics by the Indo American Society recently.
Published on Feb 15, 2011
Published on Feb 15, 2011
This article gives an in depth analysis on Evolution Of Corporate Governance In India & It's Influence On India's Capital Market. It has b...