This issue of ISBInsight provides a perspective on the corporate governance agenda in India in the wake of the new Companies Act that became law after the President’s assent on August 29, 2013. This article places our authors’ contributions in the context of international developments and research in the area.
Several themes emerge from these articles. Mirza Baig (“Redefining India’s Governance Landscape”) explains how with the new provisions, Indian laws measure up to the best in the world. In particular, the Act strengthens the provisions regarding independent directors, as Asish Bhattacharyya also points out (“The Corporate Affairs Perspective”). And yet, as Baig points out, India is still considered below par in terms of the culture, as opposed to the legal framework, for corporate governance. Improving this perception is key not only to enhancing India’s attractiveness as a destination for foreign capital, but also to increasing competitiveness and growth by ensuring that capital and resources are allocated to their most productive uses.
Enforcement Matters
The key is enforcement. The Act takes a step in this direction by increasing the penalties for violations of the provisions. For example, if the auditor violates the provisions of the Act, he may in some cases be fined up to Rs 25 lakhs or imprisonment up to one year, or both. This is timely because despite Clause 49, the Securities and Exchange Board of India (SEBI) recently found that more than 1100 companies were non-compliant with their listing agreements and over 900 with corporate governance rules (Laskar and BS, 2013). Until now it was just a violation of the firm’s contract with the Exchange; the new Act makes it a violation of the statute, and provides for enhanced penalties.
Enhanced penalties too will remain only on paper unless regulators sniff out the violators and prosecute them. This requires a well-trained cadre of regulators who are able to strike the right balance between enforcement versus regulatory overreach that stifles action. It is heartening to note that training regulators is one of the mandates of the Indian Institute for Corporate Affairs (IICA) (see interview with Asish Bhattacharyya).
Another matter of overreach that stifles, currently the criminal liabilities of independent directors make many competent individuals unwilling to take up independent directorships in companies because they might have to go to jail for violations by their companies, of which they neither knew anything nor even could have known. In one well-known case, there was an arrest warrant out for Nimesh Kampani because one of the companies where he was an external director defaulted on their public deposits, even though the default occurred after he had resigned from the directorship. The Act establishes an important principle that independent directors are not liable except if they knew of the violation or ought to have known from normal Board processes. However, jurisprudence is yet to evolve on this matter, so there will be uncertainty in the meanwhile. Moreover, there are many other laws that hold all directors liable, without drawing a distinction between executive directors and independent directors.
In another welcome move in matters of enforcement, the Act sets up the National Financial Reporting Authority (NFRA). Until now the Indian auditing profession was self-regulated, i.e., regulated by the Institute of Chartered Accountants of India (ICAI). Worldwide, self-regulation of the accounting profession is on its way out. The United States (US) set up the independent Public Company Accounting Oversight Board (PCAOB) over ten years ago, and the European Union (EU) has a requirement of independent regulation as well.1 As the EU does not recognise self-regulation, until now Indian companies cross-listed in an EU member country have to get themselves separately audited by an auditor from a jurisdiction that is approved by the European Council (EC) as equivalent. This will change after the NFRA is approved by the EC as a regulator that is an equivalent of those in the EU member states.
Another matter of overreach that stifles, currently the criminal liabilities of independent directors make many competent individuals unwilling to take up independent directorships in companies because they might have to go to jail for violations by their companies, of which they neither knew anything nor even could have known.
Private Enforcement
In addition to regulatory enforcement, there is private enforcement. The Act brings some changes in this regard as well, by enabling class-action lawsuits. The US has had securities lawsuits for many years, and research shows that despite the potential for misuse by lawyers for their own gain, on the whole it has the favourable effect of keeping managers prompt and honest in their disclosures (Ali and Kallapur, 2001). Several other countries have introduced class action lawsuits recently, such as Canada in 2006 (Kolers and Konyukhova, 2013), and South Korea in 2007 (Lee and Park,2009).While 35 class action lawsuits have commenced in Canada, the first class action lawsuit was brought in Korea in 2009; and to date there have been very few. There is no incentive for individual shareholders to bring class-action lawsuits because the cost falls entirely on them while the benefits go to all shareholders in the class. Significantly, the ban on champerty and maintenance, i.e., third-party financing of lawsuits in return for a percentage of the recovery, was relaxed in Canada for class actions. The prospect of large recoveries give third parties an incentive to take the risk of financing the lawsuit. The US has third-party financing in the form of contingent fees for lawyers-who effectively finance the costs of the lawsuits by charging no upfront fees, and winning up to one-third of the recovery. Without legal changes allowing for some form of third party financing, the provision on class actions will remain on paper only.
Finally there is private enforcement through contractual and market processes. As Baig points out, SEBI has nudged institutional investors to play a more active role, but they have not been forthcoming. Let us hope that as investors become more aware of their own clout they will play a more active role in their own self-interest.
Evaluating Change
With such a comprehensive piece of legislation, it is inevitable that some provisions will be of questionable value.
Auditor rotation is a new idea – the Act requires auditors to be mandatorily changed after a maximum of 10 years (five years if the auditor is a sole proprietorship). The EU seems to be on the verge of enacting similar requirements, but the maximum limit is 14 – 25 years. The US has considered it but appears to have decided against it (Crump, 2013; Lynch, 2013). Whether mandatory rotation will help or hurt is an open question. Academic studies have shown that auditors need a significant amount of client-specific knowledge to do a good audit, so audit quality improves with tenure.
Worldwide, there is little experience with mandatory rotation. Only Italy, Brazil, and Korea have actually implemented mandatory rotation. Korea instituted it effective 2006 and abandoned it effective 2011. In a study by Bae, Kallapur, and Rho (2013), my co-authors and I fail to find evidence of any benefits of mandatory rotation in Korea, and in fact find that auditors have a tendency to slack off towards the end of their tenure.
However, each country is different. In particular, India has one of the toughest regimes to replace an auditor-a special resolution is required as well as central government permission. If the net result of these provisions is to prevent companies from changing their initial auditor even when that auditor is no longer the best suited one for the company, rotation could have a favourable effect. So whether it will hurt or benefit in India is an open question that will only be satisfactorily answered by the future experience.
The Act establishes an important principle that independent directors are not liable except if they knew of the violation or ought to have known from normal Board processes. However, jurisprudence is yet to evolve on this matter, so there will be uncertainty in the meanwhile.
Redefining the Company?
Nawshir Mirza (“An Upheaval in Corporate Purpose”) traces the history of shareholder rights, and draws attention to Section 166 which imposes a requirement that directors balance the interests of different stakeholders. He brings up a fundamental issue: to whom does the corporation belong? Who can quarrel with the idea of keeping all stakeholders’ interests in mind? Is that not part of the social responsibility of companies in today’s world?
Research in the area leaves no doubt in my mind that the requirement will hurt corporate performance. First, Nawshir points out an important issue: there is no method to measure total value created for all stakeholders. In the absence of a measure, not only is it difficult for directors to implement the requirement, but it also affects corporate performance and efficiency. If the surplus created is to be distributed among all stakeholders (which is what balancing entails) then the stock market value will not measure value creation reliably because the markets will be uncertain about how much of that value will go to stockholders. (This is what market value measures).
Research published by a former ISB visiting scholar (and faculty member at Indiana University) Nandini Gupta (2005) shows that the performance of public enterprises in India improved after partial privatisation resulted in their being listed on the stock exchange. Listing generated a measure of value to shareholders, which in turn helped assess efficiency and value creation. Even though the government continued to own a majority of the shares, and there was no stated change in objectives, the existence of a barometer of value resulted in an increase in performance and efficiency.
Second, one might be tempted to believe that all non-government business entities are owned by the contributors of capital; hence the term capitalism. Ownership here refers to two things that usually go hand in hand-who gets the residual returns after everyone else has been paid their dues, and who has a say in how the business is managed. In the case of the stockholder-owned corporation, stockholders are entitled to the residual returns, and they elect the board of directors.
Despite the usual perception, there is in fact a wide diversity of ownership. On the one hand, there are entities with no owners of residual returns – the non-profits. Then there are producer-owned entities (producer cooperatives such as Amul), consumer cooperatives, and labour-owned entities ranging from small individual drivers of bank-financed taxis to large consulting firms. One factor that determines who owns a corporation is who is able to safeguard their rights through contracts. Contracting can be affected by uncertainty and asymmetric information. In the normal case because of uncertain future returns, it is impossible for the company to contract for any specific amount of return to the contributors of capital, and hence they end up owning the firm.
Ownership is just a type of contract, albeit an open- ended one. In this view, a firm is often referred to as a nexus of contracts, according to the conceptualisation introduced by Jensen and Meckling (1976). Non- profits exist in higher education, for example, because the nature of the product is such that it is difficult to specify quality exactly in advance, making contracting with the consumer (student) difficult. In such cases, a stockholder-owned corporation might have the incentive to skimp on quality in order to reduce costs and generate higher profits for the stockholder. This incentive is eliminated by the fact that non-profits must plough back their surpluses into the entity and cannot distribute any profits to any stakeholder. (Another common misconception is that non-profits capital, and hence they end up owning the firm. Ownership is just a type of contract, albeit an open- ended one. In this view, a firm is often referred to as a nexus of contracts, according to the conceptualisation introduced by Jensen and Meckling (1976). Non- profits exist in higher education, for example, because the nature of the product is such that it is difficult to specify quality exactly in advance, making contracting with the consumer (student) difficult. In such cases, a stockholder-owned corporation might have the incentive to skimp on quality in order to reduce costs and generate higher profits for the stockholder. This incentive is eliminated by the fact that non-profits must plough back their surpluses into the entity and cannot distribute any profits to any stakeholder. (Another common misconception is that non-profits are not allowed to generate profits and must price their products below cost-the fact is that non-profits are allowed to generate surpluses but not distribute them).
By the same logic, contracting with unions had become difficult because of distrust between managers acting in stockholder interest and the employees at United Airlines; yet it was necessary to save the airline from bankruptcy. In 1994, in a widely hailed move, the firm ended up being majority-owned by its employees.
Research shows that the performance of public enterprises in India improved after partial privatisation resulted in their being listed on the stock exchange. Listing generated a measure of value to shareholders, which in turn helped assess efficiency and value creation. Even though the government continued to own a majority of the shares, and there was no stated change in objectives, the existence of a barometer of value resulted in an increase in performance and efficiency.
Too Many Stakeholders?
Research by Hansmann (1996) however, has shown that there is another less appreciated but equally important factor: the owners need to have homogeneous interests. Otherwise decision-making becomes difficult. Shareholders have homogenous interests in maximising long-term profitability. In other cases, problems arise even when there is a single group of owners if it is not homogenous. This is shown by the subsequent history of United Airlines. United Airlines’ owners included two groups of employees- pilots and machinists-whose interests were not similar. A dispute arose as to which union should make how much concession and even before losses in the wake of 9/11 put it into bankruptcy, employee ownership of United had ended (Zuckerman, 2001).
Alert readers will point out that large consulting firms such as McKinsey continue to be successfully owned by employees. Employee ownership works because the consultant partners are a relatively homogenous group. Audit firms too continue to be employee owned, but they have had strains between audit and consulting partners who have divergent interests. In one case, it led to an acrimonious divorce-between Arthur Andersen the audit firm and Accenture which used to be Andersen Consulting.
Considering that ownership by (that is managing the corporation in the interests of) even a single stakeholder group such as employees, if not homogeneous in its interests, ultimately collapses, there is no hope for the survival of a firm whose top managing body is tasked with balancing the divergent interests of a wide group of stakeholders.
In conclusion, the right regulation in corporate governance requires a strong evidentiary base. Since the context of international studies and international experience would not exactly match India’s, understanding the local context through empirical research is critical for the best regulatory and policy- making results.
ENDNOTE
1 Directive 2006/43/EC of the European Parliament and of the Council of 17 May 2006.
FURTHER READING
Ali, A and Sanjay Kallapur (2001). “Securities Price Consequences of the Private Securities Litigation Reform Act of 1995 and Related Events”, The Accounting Review, 76(3): 431–460.
Bae, Gil S, Sanjay Kallapur and Joon Hwa Rho (2013). “Departing and Incoming Auditor Incentives, and Auditor-Client Misalignment under Mandatory Auditor Rotation: Evidence from Korea”, Working Paper, Indian School of Business. Accessed 18 December 2013: http://papers.ssrn.com/abstract=2281127
Crump, Richard (2013). “Audit Reforms Are a Great Compromise: No One Is Happy”, Accountancy Age, April 26. Accessed 18 December 2013:http://www.accountancyage.com/aa/blog- post/2264413/audit-reforms-are-a-great-compromise-no-one-is- happy
Gupta, Nandini (2005). “Partial Privatisation and Firm Performance”, Journal of Finance, 60 (2): 987–1015.
Hansmann, Henry (1996). The Ownership of Enterprise, Cambridge, Massachusetts: Harvard University Press). Jensen, MC and William Meckling (1976).
“Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”, Journal of Financial Economics, 3(5): 305– 360. Kolers, Eliot N and Maria Konyukhova (2013).
“A Judicial Approach to the Blurring Geographic Boundaries of Litigation”, LExpert US Guide – Litigation. Accessed 11 December 2013: http://www.lexpert.ca/USGuide-Litigation/featured-articles/ securities-class-actions-in-canada-10
Laskar, Anirudh and Sunil BS (2013). “Sebi Orders Closer Scrutiny of Corporate Disclosures”, LiveMint, November 18 ,2013 Lee, Inhak and Park, Jun-Ki (2009).
“Securities Class Action Landmark”, AsiaLaw. Accessed December 11, 2013: http://www.asialaw.com/Article/2330632/Issue/71637/ Securities-class-action-landmark.html
Lynch, Sarah N (2013). “House Panel OKs Bill to Prohibit Mandatory Auditor Rotation”, Reuters, June 19, 2013. Accessed 18 December, 2013: http://www.reuters.com/article/2013/06/19/us- house-sec-bills-idUSBRE95I1NS20130619
Zuckerman, Laurence (2001). “Management: Employee-Ownership Experiment Unravels at United”, New York Times, March 14 , 2001.