Weak governance, both corporate and civil can erode investor confi dence and prevent India from achieving its vast economic potential, argues Mirza Baig, Managing Director, Hikma Governance Consulting. In this article, he analyses the implications of recent regulatory reforms on India’s governance regime, and observes that despite their good intentions, reforms alone are unlikely to succeed in transforming corporate behaviour without sustained commitment from key stakeholders.
Amidst the despondency over tempered economic growth rates, widening balance of payment deficits and the turbulence in the currency markets, it is natural that regulators, market participants and the media become consumed with short-term efforts to kick-start the ailing Indian economy. There is a degree of inevitability that the market will continue to react to new economic data or statements from policymakers with often exaggerated valuation swings. However, it is important for the market to not lose sight of the long-term fundamentals that have made India such an exciting destination for capital over the last two decades.
Weak governance, both corporate and civil can erode investor confidence and prevent India from achieving its vast economic potential, argues Mirza Baig, Managing Director, Hikma Governance Consulting. In this article, he analyses the implications of recent regulatory reforms on India’s governance regime, and observes that despite their good intentions, reforms alone are unlikely to succeed in transforming corporate behaviour without sustained commitment from key stakeholders.
Amidst the despondency over tempered economic growth rates, widening balance of payment deficits and the turbulence in the currency markets, it is natural that regulators, market participants and the media become consumed with short-term efforts to kick-start the ailing Indian economy. There is a degree of inevitability that the market will continue to react to new economic data or statements from policymakers with often exaggerated valuation swings. However, it is important for the market to not lose sight of the long-term fundamentals that have made India such an exciting destination for capital over the last two decades.
The Indian growth story has essentially been built upon the existence of a large volume of high- quality companies; an exceptional entrepreneurial culture and highly skilled and educated workforce; significant untapped consumer markets and positive demographic trends; the presence of substantial reserves of natural resources and critically, a high level of commitment from regulators to establish a progressive and efficient capital market.
International recognition of these economic realities has helped fuel a 25-fold increase in annual inflows from foreign institutional investors since 1997,1 as investors chased top-line growth opportunities unattainable in more mature markets.
Despite the immediate financial challenges facing the country, the core elements of the Indian investment case remain principally unchanged.
Nevertheless, it is widely acknowledged that, even during the boom years, India has fallen some way short of realising its enormous potential. While this can be attributed to myriad factors, a number of concerns would top most international investors’ list of grievances. These include:
- Widespread and endemic corruption;
- Questionable behaviour of controlling shareholders;
- Weaknesses in the controls and auditing regime;
- Ineffective enforcement of rules and inadequate investor protection;
- Bottlenecks in the development of vital infrastructure; and
- Inconsistent government policies, which have served to dampen the investment climate.
In effect, the Indian economy has been held back by fundamental weaknesses in civil and corporate governance, which in turn has led investors to apply a market- and company-level discount.
Therefore, even though short-term policies to control market liquidity and support the rupee will continue to grab headlines, the future of India as an Asian and global powerhouse will ultimately be determined by its willingness and commitment to the fundamental reform of its governance regime.
In effect, the Indian economy has been held back by fundamental weaknesses in civil and corporate governance, which in turn has led investors to apply a market- and company-level discount. Therefore, even though short-term policies to control market liquidity and support the rupee will continue to grab headlines, the future of India as an Asian and global powerhouse will ultimately be determined by its willingness and commitment to the fundamental reform of its governance regime.
Regulators Lead The Way
The Securities Board of India (SEBI) recently celebrated its 25th anniversary, a period in which it introduced both ground-breaking and iterative policies that have been instrumental in raising the standards of corporate governance across the country. The most significant of these contributions was the inclusion of Clause 49 within the listing rules, which outlined the corporate governance standards, structures and practices expected of listed entities.
However, a combination of local and international corporate incidents and crises over the last few years has served to highlight significant gaps and failings in the existing governance regime. In the aftermath of the Satyam scandal, regulators responded with a series of initiatives including the publication of the Ministry of Corporate Affairs’ (MCA) Voluntary Principles and the Godrej Committee’s Guiding Principles. Although these measures were well intended, the outcome has been a disjointed set of voluntary principles that have done little to impact corporate behaviour or rebuild investor confidence.
Nonetheless, 2013 marked two key developments that have the potential to transform the governance landscape of the country. Firstly, SEBI outlined proposals early in the year to bring about much needed reform of Clause 49, and secondly, the new Companies Act finally received presidential assent in August.
Key Provisions of the Companies Act 2013
The much-awaited Companies Bill was first introduced in parliament in 2008, and after several revisions, has now replaced the 1956 Act. The Act seeks to address a wide range of issues to make the formation and operation of Indian companies more efficient, while at the same time improving their long-term sustainability and attractiveness to outside capital. Among these, some provisions have special significance for corporate governance.
1. Board Composition: Prescribed companies will be required to have at least one-third of the board made up of independent directors, establish audit, remuneration and nomination committees and appoint at least one female director.
Comment: One of the greatest criticisms leveled at Indian companies is the dominance of controlling shareholders. Although this can often result in successful businesses as promoters pursue long-term value accretive strategies, occasionally promoters’ agendas may be at odds with the interests of minorities.
Consequently, the introduction of requirements governing the composition, structure and roles and responsibilities of the board is a welcome addition to the Act.
While matters related to board independence have existed in the Listing Rules for some time, the requirement to appoint a female director was one of the most hotly debated inclusions in the Act. However, rather than focusing exclusively on gender, it is more appropriate to frame the discussion in the context of board diversity more generally (gender, ethnicity, nationality, professional experience, etc).
High-performing and effective boards are needed to oversee and challenge executive management and tackle “group-think”. This requires effective chairing as well as a strong, diverse and balanced board. Therefore, boards should seek to appoint directors whose individual expertise and contribution to the collective diversity of skills and perspectives on the board will add value to the development and execution of corporate strategy by enhancing the quality of board debate.
To ensure that compliance with the regulation extends beyond tokenism, companies and other stakeholders must undertake measures to widen and deepen the talent pool such that directors add to board diversity strengthen rather than weaken boards. It is imperative that the diversity agenda be reflected at all levels within an organisation, and that companies begin investing in developing a pipeline of future leaders that reflect the diversity of their businesses and operations.
2. Auditor Rotation: The tenure of a company’s auditor is to be limited to a maximum period of ten years where the auditor is a company and five if the auditor is an individual. Auditors will also be prohibited from providing non-audit services to audit clients.
Comment: A series of accounting-related scandals across global markets has weakened investor confidence in the integrity of financial statements. This has resulted in an extensive review of the structure of the accounting industry and the manner in which it delivers services to clients. In particular, there has been an increasing focus on the impact that tenure and the provision of lucrative consultancy services may have on auditor independence. Conventional wisdom now appears to be gravitating towards the necessity of mandatory rotation and restricting consultancy services provided by auditors (although few jurisdictions have taken such a bold position as India). However, while limiting these potential conflicts of interest will intuitively have a positive impact on audit quality, evidence from jurisdictions where mandatory rotation of audit firms have been prescribed has shown mixed and inconclusive results (Bae, Kallapur and Rho, 2013). Therefore, the optimal period for auditor rotation should be kept under review to ensure the ultimate objective of enhancing audit quality is achieved.
To ensure that compliance with the regulation extends beyond tokenism, companies and other stakeholders must undertake measures to widen and deepen the talent pool such that directors that add to board diversity strengthen rather than weaken boards. It is imperative that the diversity agenda be reflected at all levels within an organisation, and that companies begin investing in developing a pipeline of future leaders that reflect the diversity of their businesses and operations.
3. Corporate Social Responsibility (CSR):
Prescribed companies will be required to set up board-level CSR Committees and will be obligated to spend at least 2% of average net profits on CSR- related projects on a “comply or explain” basis.
Comment: The CSR spending requirement included in the Act unsurprisingly proved to be one of its more controversial provisions. Framed as a mechanism to address the widening social and economic gap between the “haves and the have- nots”, the MCA outlined nine broad areas that would qualify as social spending, including eradicating hunger, improving environmental sustainability and enhancing vocational skills.
Although CSR has a long history in India, companies have traditionally been careful to separate philanthropic spending from any form of business consideration in the fear of being perceived as duplicitous. However, this mind-set is outdated, unsustainable and will fail to achieve the intended outcome of the provision. The implementation of the new law is an opportune moment for companies and the soon-to-be-constituted board CSR committees to fundamentally rethink their approach towards CSR such that it is no longer considered a social tax but rather a business-driven investment in society.
This necessitates a more holistic understanding of business and its inherent interdependency on the market, society and environment in which it operates. Companies must begin to acknowledge that their long-term sustainability will be determined by the health and wealth of the country’s human and natural capital. A debate of this nature should result in a more strategic outlook towards CSR spending and ensure programmes are dictated by the future needs of the business and its primary stakeholders. Through the alignment of business and social objectives, India will be better placed to tackle the most critical social challenges facing the country.
Companies must begin to acknowledge that their long- term sustainability will be determined by the health and wealth of the country’s human and natural capital. A debate of this nature should result in a more strategic outlook towards CSR spending and ensure programmes are dictated by the future needs of the business and its primary stakeholders.
The Importance of Clause 49
While the Companies Act has understandably dominated regulatory discussions, SEBI’s proposed revisions to the listing standards is likely to be of greater significance in defining the future shape of corporate governance in the country. The proposals sought to develop a coherent and progressive governance framework, mixing voluntary “comply or explain” standards with minimum mandatory requirements for listed companies. The document drew on experiences and best practices from markets around the world and included mechanisms to empower minorities with respect to board elections and related party transactions, improve the effectiveness and independence of boards, strengthen enforcement and shareholders’ legal rights, and hold institutional investors to account for the manner in which they discharge their fiduciary duties as stewards of capital.
SEBI is yet to finalise the revisions to Clause 49 following the public consultation, and while the tone, issues addressed and inventiveness of some of the proposals were refreshing, there was a sense of disappointment that the proposals did not go far enough, particularly with respect to the tightening of controls over related party transactions. Nevertheless, despite reservations over some of the details, the steps taken by Indian regulators demonstrates their long-term commitment to raising the standards of corporate governance in the market and their desire to help restore India’s standing as a destination of choice for international capital.
Cautious Optimism?
As the reform agenda continues to gather momentum, the question that arises is whether this is sufficient for investors to feel optimistic about the future. To answer this question, it is important to understand what good governance really means in practice. Putting aside the numerous codes and papers detailing every aspect and component of an effective governance regime, in reality, good governance boils down to the presence of competent, responsible, transparent and accountable boards and companies that seek to maximise long-term value for shareholders and serve the interests of their primary stakeholders. In effect, good governance is about behaviour rather than just form and structure.
While the development of the right structures, policies and procedures are essential pillars of an effective governance culture, one does not necessarily follow the other. Rather, what is equally and arguably more important to consider is the manner in which companies embed the spirit of good governance within their boards and businesses more generally.
By way of illustration, regulation has not only stipulated the requirement for independent directors but also provided detailed criteria of their qualifications and valid compensation structures. Nevertheless, this in itself does not guarantee a culture of scrutiny and challenge on the board, as non-executives may be discouraged, disempowered, or even lack the competence to question the will of the promoter or executive team. In such a scenario, even a majority independent board would serve as little more than window dressing.
Perhaps a more vivid example of where a compliance-driven approach has resulted in limited behavioural change is SEBI’s 2010 directive that Indian mutual funds publish their voting policies and records. The SEBI initiative was designed to encourage investors to become the primary safeguard against corporate malpractice. However, according to a recent study by InGovern (2013), three years after the enactment of the regulation, institutional investors, on average, voted against only 1.5% of management proposals, preferring instead to vote for or simply abstain due to a perceived conflict of interest.
While SEBI has recently resorted to public shaming and vague threats to force mutual funds into action, real change will only occur through a combination of investment managers appreciating the positive impact of active ownership on investment returns coupled with pressure from clients. The moment that the investment mandate selection process includes requirements for proxy voting and governance engagement, investment managers will begin to view the development of in-house governance capabilities as a business imperative.
Ultimately, the success of the MCA- and SEBI- sponsored reforms will be judged by their impact on corporate behaviour. The market will look to recent high-profile cases of fraud, power struggles between promoters and value destroying strategies adopted by controlling shareholders, and question whether the proposed changes will limit the likelihood of similar incidents occurring again in the future. Unfortunately, as things currently stand, this is unlikely to be the case.
While the development of the right structures, policies and procedures are essential pillars of an effective governance culture, one does not necessarily follow the other. Rather, what is equally and arguably more important to consider is the manner in which companies embed the spirit of good governance within their boards and businesses more generally.
The Path to Enlightened Reform
Top-down initiatives are important components in developing a framework for good governance but these will have a limited impact on the governance culture within a market unless complemented by a wider strategy of reform. Any such strategy should take into consideration each of the key stakeholders, which together constitute the governance ecosystem of the country. These will include regulatory bodies, companies, investors, lenders, the business media, employees, customers and civil society groups.
It is important to recognise that the motivations of each of these economically and socially diverse groups of stakeholders may well differ significantly. Consequently, there is a risk that their respective objectives and desired outcomes become misaligned or even conflicted, which can result in the relegation of corporate governance to the realm of veneer or box-ticking.
To overcome this hurdle, it is essential that these distinct groupings be brought together for an open and honest debate on the importance and value of good governance. This should seek to address the following critical issues:
- Understand the different expectations of stakeholders with respect to the building of long-term sustainable businesses.
- Outline why and how the establishment of a robust and progressive governance culture and regime would help facilitate the achievement of this objective.
- Agree on the role that each stakeholder must play in strengthening the governance framework of the country.
- Develop a mechanism to facilitate ongoing dialogue and build a roadmap for change.
This multi-stakeholder approach will require a significant investment of time and resources. Nevertheless, real change can only occur after achieving broad consensus among market participants on the value of good governance in form and substance.
Corruption as Investment Risk
While these consensus building initiatives should seek to systematically address the full spectrum of governance-related themes and challenges, the subject that requires the greatest and most immediate attention is tackling corporate and civil corruption, which remains the single greatest investment risk in the country. Corruption has had catastrophic consequences on the economy including the misallocation of capital, the imposition of substantive risk premiums, and the delaying of critical infrastructure development. The impact of corporate corruption in India has been exacerbated due to a perception of complicity with officials at varying levels of government, raising questions over the political will to genuinely address the problem. This has been reflected in Transparency International’s Corruption Perception Index where India has seen its ranking plummet from 72 in 2007 to 94 in 2012. In a December 6, 2012 article in The Hindu, P S Bawa, Chair of Transparency International India said, “Corruption is a hydra-headed monster and governments have to make efforts to tackle it from all sides. This can only happen if all stakeholders work together.”
The granting of statutory powers to the Serious Fraud Investigation Office (SFIO) under the Companies Act is an important and welcome first step, provided the SFIO has adequate resources, authority and political backing to deliver results. However, given the deep-rooted nature of the problem, the efforts of a single enforcement agency will be ineffective unless the objectives of the SFIO are mirrored in corporate and civil society. This requires a commitment from companies, investors, employees, customers and the media to adopt a zero tolerance approach to corruption in any form. While the details of how to embed such a culture and empower stakeholders to act merits an article in its own right, any discussion on governance reform in India would be incomplete without acknowledging that the eradication of corruption should rank among its highest priorities.
Ultimately, the success of the MCA- and SEBI- sponsored reforms will be judged by their impact on corporate behaviour. The market will look to recent high-profile cases of fraud, power struggles between promoters and value destroying strategies adopted by controlling shareholders, and question whether the proposed changes will limit the likelihood of similar incidents occurring again in the future.
Finally, it is vital that India does not embark on this journey of reform in a vacuum and that it heed the lessons from regional markets that are competing for capital. The Asian Corporate Governance Association (ACGA) undertakes the most comprehensive and robust assessment of governance practices across 11 Asian markets (CLSA, 2012). India ranked seventh in its most recent study. The intention behind the benchmark was not to encourage markets to obsess over individual rankings, but for countries to benefit from evaluating their strengths and weaknesses relative to their regional peers. By way of example, an assessment of Singapore’s approach towards regulatory enforcement, coupled with an appreciation of the excellent work of the Minority Shareholder Watchdog Group in Malaysia, could help India refine its thinking and approach towards issues that have traditionally been challenging and problematic for the country. (Singapore and Malaysia ranked first and fourth respectively in the benchmark).
It would be naive to suggest that India merely mimic the practices of its higher-ranked neighbours. However, an honest assessment of the practices, initiatives and successes of other markets will provide invaluable lessons as India charts its own course towards a more enlightened path of reform.
Conclusion
Transforming the governance landscape and culture of a country the size and complexity of India will require a herculean effort by those committed to the process. Therefore, investors must be realistic in their expectations of the speed and penetration of reforms. In such circumstances, the most crucial factor to consider is the commitment from key stakeholders to change and the development of a clear strategy and roadmap.
The positive steps taken by regulators coupled with increased scrutiny of corporate actions by the media and local governance focused institutions are promising signs for the future. However, until this is combined with a genuine commitment from companies, investors and related stakeholders towards raising the standards of corporate governance in the country, India will struggle to realise its goal of establishing a truly leading regional and global capital market. The jury is still out on this count.
END NOTE
1 The estimate here is taken from the Foreign Institutional Investor (FII) data from Equity Master. In 1997, these inflows amounted to Rs 50,423 million; in 2012 they were Rs 1,290,154 million. Retrieved December 2013: http://www.equitymaster.com/india-markets/fiis/ index.asp?utm_source=submenu
FURTHER READING
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, Fox School of Business, Temple University, Philadelphia. Available at SSRN: http://ssrn.com/abstract=2281127
The Hindu (2012). “India Placed 94th out of 176 countries in corruption: Transparency International,” The Hindu, December 6.
InGovern Research Services (2013). Mutual Fund Voting Pattern 2013 Analysis, Special Report. Retrieved November 2013: http://www.ingovern.com/wp-content/uploads/2013/08/Mutual- Funds-Voting-Patterns-2013-Analysis.pdf
Transparency International (2012). “Corruption Perceptions Index”. Retrieved November 2013: http://cpi.transparency.org/cpi2012/ results/
Credit Lyonnais Securities Asia (CLSA) (2012). “CG Watch 2012: Corporate Governance in Asia”, ACGA, Hong Kong. Retrieved December 2013: http://www.acga-asia.org/loadfile.cfm?SITE_ FILE_ID=658