Corporate Governance in India - Still a Half Hearted Measure?

With the end of November of 2008 came India’s own 9/11; and with the dawn of January 2009 was born India’s own Enron (or WorldCom if you wish). While the two events are not comparable at all, they do have one common causal factor – the failure of governance and administration at the helm. Both tragedies have impacted the unsuspecting and the innocent the most, but those who are accountable and responsible are yet to take stand in the courts of justice.

In the particular case of Satyam, an expectation of legal proceedings commencing this early might be premature; however, it is probably high time that corporate governance reforms are implemented in India. Given that Clause 49 of SEBI’s[1] listing agreement already calls for measures akin to the Sarbanes Oxley (SOX) act of the US, is there any further room for regulatory improvement? A brief analysis underscores a few avenues where further amendments, to increase the corporate governance and transparency standards, are possible.

To begin with, independent corporate governance assessment (CGA) and its disclosure should be made mandatory for all listed firms.[2] While this might seem an extreme reaction, it will have an impact; as desiring at least presentable public disclosures, firms would be forced to improve internal controls. All assessments being widely available will potentially promote competition, thereby improving governance standards on the whole. And most importantly, increased transparency and control will have a positive impact on the share price. Historical and current data support this share price increase argument. The mere announcement of the introduction of Clause 49[3], in May 1999, caused large cap companies’ share prices to increase by c. 10% over a 2-week window.[4] Infosys, the most revered company for its corporate governance, by both CRISIL and CARE[5], gained 1.33% from 7th January 2009 (the day Satyam CEO disclosed the fraud) to 9th January 2009 (the next trading session). In the same time period, Satyam shares lost 50% of their value while the NIFTY Index lost c. 1.62%[6]. In fact even the introduction of SOX in the US in 2002, caused an upward swing in the share price movement. Thus CGA is not just a cost centric exercise alone but can translate into significant tangible gains for an organisation.

With majority control being held by insiders, earnings management is a highly probable event. While not totally illegal, the practice leads to deficient disclosures and ambiguity in financial statements. In order to align interests of the promoters (typically also the senior management of the company) with the wider shareholder base, there needs to be minimal earnings management. To successfully implement this, the audit committee must have on board at least one independent director with financial expertise. Clause 49 requires that the audit committee has one independent director and one financial expert. However, it does not make it mandatory for both characteristics to be represented by the same member. A study conducted by Carcello, Hollingsworth, Klein and Neal in 2006[7] concludes that the inclusion of an independent director on the audit committee with in depth financial knowledge and experience is the most efficient in extenuating earnings management. The study also highlights that this is in particular true for firms with weaker corporate governance standards. Given that most Indian firms are family owned mid sized companied, maybe the Clause 49 requirement should be amended to require an independent financial expert being a member of the audit committee. Additional experts and/or independent directors will only strengthen the team.

It is interesting to note at this point that the Satyam board, which had many a reputable name from the industry as members, could not identify a fraud of this magnitude right under their noses. There are questions surrounding the monitoring of the Satyam audit committee. Here Khanna and Black’s study, Indian Corporate Governance an Overview, provides an interesting input. Apparently less than 70% of the 293 Indian corporates they sampled, have bylaws governing the audit committees. The reality and implementation of these bylaws is further questionable. Clause 49 probably needs to further detail the working of the audit committee and its reporting. A more focussed watch and detailed analysis might cost Indian companies a little extra, as independent directors begin to demand higher remuneration for their time and efforts. However, that will be money well spent and hopefully will lead to improved corporate performance and a more credible shareholder base.

Corporate performance also depends on the investments, fund raisings, capital utilisation resolutions passed by a CFO’s office. These key financial decisions impact the balance sheet of the company; shaping the return on capital. The 2008 derivatives’ scandal in India, which caused multi million dollar losses for the small and mid-cap companies, illustrated how unknowing CFOs took decisions to the detriment of the shareholders. In the absence of knowledge and expertise, an investment made by an individual without the board approval, puts the company’s balance sheet even in greater danger. In numerous cases, the derivatives investments made by SMEs were not approved by the company boards. Thus the board, under Clause 49, probably needs to be empowered to regularise the dealings of the CFO’s office.

Away from the company, one avenue that requires new legislation is that of generally accepted accounting principals. The Institute of Chartered Accountants of India (ICAI) has made proactive efforts in bringing international accounting standards to India; to integrate local policies with the global practices. To this extent, ICAI has even adopted 15 International Accounting Standards (IAS) out of the 33 IAS. However, due to the absence of prescribed statutory obligations, accounting standards in India still remain inadequate and non-uniform; dependent on the interpretation of the company auditor. Take the case of FCCB issuance in the country. While most securities issued will redeem at a premium to the issue price, there is no requirement for companies to account for the accretion of the bonds. This has the potential of creating significant liability mismatch upon maturity of the bonds. In the absence of a market norm, every company follows an accounting standard different from its peers. In some instances, the company follows one standard that has a partial impact on the balance sheet and then ignores another standard only to protect the financial statements from being further impacted.[8] There needs to be a concerted effort by ICAI and the law-makers to limit the alternate interpretation of accounting standards.

Corporate governance is not only about finance and economics. However, since most global corporate governance scandals revolve around these two issues, maybe the capitalistic society needs to address these two aspects before any other pillar supporting corporate governance is touched for refurbishment.


[1] SEBI: Securities and Exchange Board of India
[2] Currently only 50 of the 4,700 listed firms have undertaken the CGA exercise. Of these 50, only 19 have disclosed these assessments. Source: www.livemint.com
[3] Clause 49 of SEBI’s listing agreement
[4] Source: Black, Khanna; Can Corporate Governance Reforms Increase Firms’ Market Value: Evidence from India
[5] Source: www.livemint.com
[6] Source of statistics: www.nse-india.com
[7] Audit Committee Financial Expertise, Competing Corporate Governance Mechanisms, and Earnings Management
[8] A study conducted by Shankariah and Rao, using a sample set of 40 private an public companies, showed that the majority of the sample companies (65%) disclosed using five to ten accounting policies. 22.5% of the sample companies disclosed using more than ten standards. The remaining disclosed using less than 5 standards. 87.5% of the sample public limited companies complied with five to ten accounting standards.

Has India Really Arrived?

The July 9th edition of the Economist carried an article with the title “Overconfident India”, claiming that “Indians are complacent about the perils of multi-lateral diplomacy, and much else”. The article which had a very condescending tone evoked a variety of responses from the Indian diaspora in London. There were some who felt that recently the Economist has taken a holier than thou approach towards emerging markets (recently the publication carried a similar article on Russia) which should soften. A few opined that the general judgemental nature of the bi-weekly magazine is on a rise and creating a bad taste in their mouths. Strangely some people I met were indifferent to this article as in their view it made no difference what the Economist had to say, India had arrived. And then there was a bunch, admittedly a minority, which did think the article was based on strong arguments and stating only the obvious albeit a little too abrasively.

After having read and re-read the article and having discussed it with a number of people, I have been trying to figure out where is it that I stand. I am not sure that the tone of the article is acceptable but then the truth of the content cannot be ignored either. As difficult as it is for me to admit, I have to be truthful and say that I do believe that we Indians have let the bull markets drive our confidence to a point where it is now bordering on arrogance. Like the group of indifferent Indians we would like to believe that India has arrived on the global map and we can demand the moon and the stars and the world should deliver.

However, is it really true that we can still tempt global investors to pump their money into our country which desperately needs foreign investment? Is FDI in India still as viable an opportunity? Will FII money get the same returns in India as opposed to say the Middle East? Has India Inc generated sufficient confidence with investors to back them in difficult times? Have our regulators worked with a larger view in mind? Is our legal framework strong enough to handout timely judicious decisions? These are questions that need some honest answers in order for us to be able to really review as to how truly India has arrived.

In the last few years, it is a fact; India has received a record amount of foreign investment. While lower than some other emerging markets, the capital inflow into India had been rising until the credit crunch started. However, if one inspects more closely, most of that investment came as all global investors wanted a piece of the action. The numbers also justify this. From April 2007 – March 2008, while the FDI in the country was c. USD 29.89bn, net FII into the country was also similar at c. USD 29.40bn. In fact this FII figure would have been higher had the market not tanked in 2008 when foreign investors were net sellers of c. USD 10.64bn in the months of February and March. Hence my conclusion that investors came into India to gain from an upward momentum in the stock market not with an intention to invest from a long term basis. This in itself should indicate that we as a country have not arrived. People are not buying into our long term strategy yet.

An infrastructure deficit country, representing a USD 500bn opportunity in the next four years, India should be able to attract a lot more FDI. What is rather interesting is that the highest FDI has come into the services sector (financial and non-financial) which is almost 2.5x that of infrastructure inflow. In fact the cumulative FDI figures from April 2000 – March 2008 indicate that the most attractive investment proposition has been the services sector with 22.64% (financial and non-financial) share of the entire pool, with infrastructure accounting only for 9.35%. There has to be a reason for foreign investors not putting money into Indian infrastructure. Yes, initially infrastructure was a closed sector; however, even with 100% ownership being permitted the sector is not attracting investors. Is it the absence of independent regulators? Is it the fear of governments not being able to fund annuities? Is it the absence of quality strategic partners? There needs to be a reason for this slow moving inflow. And we need to address this. In the absence of a domestic corporate debt market and limited availability of bank funding currently (both domestically and internationally) are we planning to fund the entire spend via equity markets, PE funds and sovereign reserves?

Well it can be proposed that infrastructure and FDI represent areas where interest is just beginning to develop and so over the coming years there is tremendous potential. I will buy that for a while. Let us turn our attention to India Inc in that case and see if we as a country have given the world enough confidence to invest in our propositions because that is the key to unlocking the dollar inflow. Indians are well known for their entrepreneurship and that has never been of any concern. However, corporate governance in India has questionable for quite some time now. To quote our premier Dr Singh from his recent (July 01, 2008) speech at the Jubilee year celebration of the Institute of Chartered Accountants of India, “….I do not find adequate attention being given to corporate governance. Unless Indian firms come to be recognized world wide for good corporate governance they will not be able to compete globally in an increasingly interdependent integrated world. In the era of protectionism few bothered about corporate governance and transparency in accounting and management. Such laxity, however, is no longer possible.” For the head of the nation to say this is publicly indicates that corporate governance is indeed an issue which needs to be addressed. The question is how are we addressing this.

Corporate governance depends on the commitment of managements towards integrity and transparency in business. The legal support provided by the judiciary also goes a long way in determining corporate governance standards in a county. Most of our businesses are promoter backed businesses with decision centres being at the helm of the family. While professionals are employed, in a number of cases, these individuals do not have the authority to make judgement calls. Why talk only about the corporates. Even Indian banks (public and private sector) which have offshore branches have a system where by all decisions are made by the same central committee in India. This decision making process behind closed doors does not suggest sufficient transparency. With a lack of autonomy and accountability it is difficult to retain talent which impairs management quality. With families owning majority of the voting rights in corporate India, sometimes via cross holdings, achieving an impartial vote is difficult. Concentrated shareholding also greys the area between generating shareholder value and creating personal wealth. It becomes even more critical, in countries like India, for the law of the land to protect rights of the shareholders. The English common law legal system, which India follows, could come to our rescue here. India in fact ranks highest in the shareholders’ rights index with a score of 5. However, the rule of law index which measures the implementation of written law shows a different picture. India ranks 41st out of 49 countries ahead only of Nigeria, Sri Lanka, Pakistan, Zimbabwe, Colombia, Indonesia, Peru and Philippines. In fact our judiciary has limited capacity to deal with securities cases. While High Courts of Delhi, Mumbai, Kolkatta and Chennai are equipped to deal with such cases, they can only deal with the cases that belong within their territorial jurisdiction and only if the claim is above a certain threshold.

India’s ranking in the global corruption perception index is not spectacular either. As a nation we rank 74th, down four positions from 2006. That does not sound like progress. In fact Transparency international reports that Indians below the poverty level cough up almost INR 9bn annually to pay for basic necessities such as electricity. In addition, recently the attitude of the Indian government toward the German government offering free information on un-accounted money belonging to Indians, lying in Liechtenstein, has raised eyebrows. While other nations have taken the information provided, Indian government has taken no action and only maintained silence. This does not speak well about our attitude towards transparency and curbing corruption.

Corruption can be cleansed with time and corporate governance can be developed with time. These arguments could be put forth. Well then let us see how our regulators stack up. As opposed to dealing with one or two regulators, Indian corporates need to deal with the government of India, the Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBI). While the government formulates big picture policies, the RBI and SEBI are responsible for implementation and execution. There is a clear lack of co-operation and co-ordination between the government and the regulatory bodies. Take for example the 2007 budget speech of the finance minister. He announced that post the February 2007 budget, short selling for institutional investors would be permitted. There was no action taken by SEBI until late 2007 when it was announced that short selling would come in effect on 21 February, 2008, however, there is still no sign of this being put into operation anytime soon. Similarly, the same budget spoke about exchangeable bond issuance being permitted. The RBI published the guidelines only in early 2008 and even then the execution framework has not been detailed. For a country that is looking to invite investors these delays just seems too long and irresponsible. And while these are just two instances, many more such examples exist. Investors do not wait for anyone but the right opportunity and if when the cash is available our policies are not, the country will lose out as it has in the past. In fact with multiple bodies governing inflows into India, it is already tedious to set up vehicles investing in the country.

When investigated closely, there is not a single stakeholder of the Indian economy totally developed and ready to take on responsibilities and accountabilities full on. There is still a long way to go for each party involved. How can we then claim that India has arrived?

India is indeed on a growth path, a path that will lead us towards prosperity. However, it is naïve to assume that we have arrived simply because we have been seeing witnessing inflows of capital. It is presumptuous and pretentious. Since the economy has only opened 16 years ago we have only started seeing the colour of money in the recent times. This does not illustrate our supremacy in any way. If we want to continue on the growth path then as a country we need to come out of the current very difficult environment. The global financial markets are in turmoil. Domestic inflation is increasing rapidly caused by the rally in oil prices. A net importer of oil, with subsidies on oil, Indian deficit is only widening. To curb the inflation we need to increase domestic rates which in turn will slow the growth. And a net import economy we have a weak rupee (the rupee depreciated c.9% since Jan 2008) which does not bode well again does it? Let us not forget that we also need to fund the rising food costs and an upcoming election which will eat into the exchequer’s reserves. These are difficult times. Times which call for prudence and perseverance. Times which call for collective measures to be taken. It is high time for India to wake up and smell the coffee!