Getting the right architecture for corporate governance

Financial Express, 13 January 2009

Good corporate governance involves ensuring that each share gets the same benefits. There are three zones of interest.

Zone I: Big promoter holding

In Zone I, the promoter owns a lot. When the promoter owns 90%, he gets 90% of the true profit of the company anyway. He can only grab 10% more by stealing from the outside shareholders. For this reason, even in countries with weak institutions, corporate governance works out okay for such companies. This is an easy incremental step for family businesses or PSUs: a little outside capital is brought in but basically nothing changes.

Zone II: Promoter can't be sacked

The difficulties are worst in Zone II, where a promoter who owns 51% can make a grab for (say) 80% of the cash produced by the business. Such theft presents acute problems because with 51% of shares, the promoter cannot be displaced. For this reason, outside shareholders are least willing to pay a good price for such companies. The growth of these companies is impeded by expensive equity capital.

Zone III: Low promoter holding

In good countries, companies with a low promoter ownership - such as 5% to 15% - work the best. These are the dispersed shareholding companies which dominate Anglo-Saxon capitalism. In India, we're used to intermingling the words `CEO' and `owner'. But in Zone III, the CEO is not the owner. He is an employee brought in by the owners to run the company. He serves at the pleasure of the shareholders.

In this Zone III, the low ownership of the CEO should make him vulnerable to being sacked, thus deterring theft. This would help attract large quantities of cheap equity capital from the public and thus enable high growth. At the same time, such companies avoid the inefficiencies which go with family run companies particularly over long horizons. In good countries, Zone III companies have the best chance of becoming meritocracies. The DNA of a young employee does not disqualify him for the CEO's job, which improves his drive.

By and large, India is doing okay in Zone I and Zone II. In Zone I, not much needs to be done. In Zone II, paying low valuations is really the only defence. Even in good countries, it is difficult to prevent stealing by a promoter who can't be sacked. The real story of corporate governance lies in Zone III, and that is where India is weakest. In March 2001, the family had 25.5% of Satyam. This had dropped below 20% in September 2003 and below 10% in June 2006. The Satyam episode hence puts a spotlight on India's difficulties with the critical Zone III.

From the viewpoint of economic development, this is the most important zone. Zone III firms are best able to attract outside equity capital and thus become big. The best growth path for a family business is to graduate to Zone III and harness the energies of professional management. Family businesses that fail to do this by the 3rd generation tend to get enfeebled. The country needs to create the institutional environment that fosters efficiency in Zone III, for that is where a growing proportion of GDP is produced.

How can corporate governance in Zone III work?

The incentive for theft in Zone III is the greatest: there is a great temptation for a CEO who owns 8% of a company to make a grab for 100% of the cashflow. To gain intuition into the solution for Zone III governance, envison a company with a 100% shareholder "P" who is not the CEO. Imagine how "P" would set about recruiting the CEO, "A", who has 0% shares. Visualise how "P" would regularly take stock of the progress of the business, exercise judgment on strategy, identify and criticise flaws of execution, block theft, pay bonuses, and sack "A" when performance is inadequate. That arrangement is the role model for what Zone III governance should aspire to be.

Good governance in Zone III is achieved by having a board of directors which performs the role of "P". Individual shareholders are too dispersed and generally do not have either the competence or the interest for governance. So the institutional shareholders must recruit the board of directors. This board must recruit the top management team, supervise them, and award their compensation packages. When the CEO misbehaves or malperforms, the board must sack the CEO.

There is an interesting analogy in shifting from the CEO-as-dictator seen in Zone I and Zone II to this proper configuration of Zone III corporate governance: it is much like the reduction in power of the head of state that goes with shifting from dictatorship to democracy. It is much like setting up the array of checks and balances which is the essence of democracy.

A key hurdle: shares owned by PSUs

One generation ago, when this discussion came up, everyone in the room dropped into a tacit silence. At the time, the institutional shareholders were all PSUs. Giving institutional investors the job of appointing a board of directors and thus the CEO was tantamount to nationalisation of (say) Tata Steel, which nobody wanted. For this reason, the culture of institutional shareholders always blindly voting with the promoter was established. This was not pretty, but at the time the alternative (of government meddling in private companies) was worse.

But now, things have changed. The government has significantly stepped back from meddling in finance. Effectively, IDBI and IFCI died, and ICICI was privatised. Now, LIC and UTI are the only big PSU shareholders left. A wealth of private institutional investors, including FIIs, have sprung up. It is now safe for India to move towards a proper configuration for corporate governance of Zone III companies.

These connections have not been widely recognised: Making progress on the core of India's development problem requires proper corporate governance for Zone III companies, which (in turn) requires getting the government out of controlling financial firms.

New work required on organisational capability of institutional investors and their coordination mechanisms

Exercising corporate governance functions is a new idea for most institutional investors in India. At present, they do not have the staff or skill to do this. But as Satyam has reminded them, they have the interest. It is dangerous for an Aberdeen that has a large investment in Satyam to not go that last mile of taking interest in setting up a proper board of directors.

This requires work on two fronts: Institutional investors have to setup staff that is focused on their governance functions, and informal or formal mechanisms have to be setup through which coalitions of institutional investors come together to perform governance functions of the companies that they own. A proposal from 2002 on making progress with PSU banks hinges on institutional investors creating value by exercising governance functions.

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