It appears that the corporate world, at large and business in India in particular, has of late, witnessed a spate of governance mishaps. Is this because people at the uppermost echelons of the corporate world have become greedy, selfish, and stupid?
I’m not a bad person. I’m not an unusual man. I just wanted to change the world…I know it is hard to understand…Everything I’ve ever done in my life worth anything has been in a bubble; in a state of extreme hope and trust and stupidity….” Jeffrey Keith Skilling, CEO of Enron
In 2006, JK Skilling was convicted of federal charges relating to Enron's collapse and sentenced to 24 years in prison. Closer home, both Chandra Kochhar and Chitra Ramakrishna, once the poster women representing success in corporate India, saw their careers end in ignominy. The recent sudden death of Cyrus Mistry brings back memories of the internecine conflict between him and Ratan Tata, during Mistry’s brief tenure as the head of Tata Sons. One recent Tuesday night, Ravi Narain, the former CEO and MD of the National Stock Exchange, was arrested by the Enforcement Directorate for alleged money laundering and co-location fraud.
It appears that the corporate world, at large and business in India in particular, has of late, witnessed a spate of governance mishaps. Is this because people at the uppermost echelons of the corporate world have become greedy, selfish, and stupid? On closer examination, this seems implausible. Skilling earned his MBA from Harvard Business School in 1979, graduating in the top five percent of his class. Cyrus Mistry, a scion of Shapoorji Pallonji Group, a $4.2 billion conglomerate, was in 2013 rated by The Economist as ‘the most important industrialist in both India and Britain’. Unlike Mistry, both Ms Kochhar and Ms Ramakrishna came from middle-class backgrounds and worked their way to the top without any family lineage or a godfather’s patronage to help them. Born in Rajasthan, Ms Kochhar graduated from the University of Mumbai and completed a postgraduate diploma from Jamnalal Bajaj Institute of Management Studies, while in the process receiving the Wockhardt Gold Medal for Excellence in Management Studies. In recognition of her work in the financial sector, Kochhar received Padma Bhushan (India’s highest civilian honour) in 2011 and an honorary doctorate from Carleton University in Canada in 2014. While Ms Ramakrishna started as a chartered accountant, her first stint in corporate finance came in 1985 at the Industrial Development Bank of India (IDBI). Impressed by her previous work, SS Nadkarni, who was then the IDBI chairperson, entrusted her with setting up the National Stock Exchange (NSE) of India from scratch. Ramakrishna was one of the four women named by Forbes magazine in 2013 as the Women Leader of the Year in recognition of her contributions as CEO of the NSE.
So, what went wrong with these individuals in these different instances? Were they solely responsible for these unfortunate events? Or were there a cascading set of oversights at these companies that culminated in their not having appropriate governance mechanisms in place to identify and dissuade inappropriate managerial behaviours? Our research indicates that it is not only the individuals involved in these alleged misdemeanours who were at fault but also, more importantly, that the organisations that they headed did not have the appropriate governance mechanisms in place to identify and eliminate the potential for these misdemeanours to occur. The absence of proper governance mechanisms might have caused such problems in these companies to arise undetected and unchecked. Why do such governance lapses occur and what could companies do to minimise them? Also read: Fall in winter: How CFOs became the fall guys
Management research has long established that firm ownership and management are the primary governance mechanisms for running firms effectively. Two types of conflicts or problems could occur in firms that detract from their ability to maximise returns to their shareholders. One is where the firms’ dominant owners i.e., shareholders act in dubious ways to appropriate firm value and benefit themselves at the expense of minority shareholders. The second type of conflict occurs when managers mismanage firms (typically the CXOs) to appropriate shareholders’ wealth and enrich themselves. This kind of conflict occurs when owners or shareholders are large in numbers and are widely dispersed, with each having very low, fragmented ownership. In such instances, shareholders are unable to monitor and control the activities of powerful managers who are tasked with managing the firm on their behalf. Managers can reap benefits through outsized increases in their compensation or through making specific investments that benefit them rather than the owners of the firm.
Consider the case of ICICI Bank and Chandra Kochhar. It is alleged that Kochhar, as CEO and MD of ICICI Bank, favoured the Videocon Group in 2012 by lending ₹3,250 crore as a loan from ICICI Bank. This eventually turned out to be a non-performing asset for the bank in 2017. Did the bank exercise due diligence and undertake the normal approval process before the loan was approved? When there are suspicions that managers are behaving in their self-interest, a firm’s owners should be vigilant and monitor management’s activities to ensure that managers are not sub-optimising their welfare. In the case of the ICICI bank, for example, the ownership was widely distributed with no dominant ownership blocks such as a family or the government having concentrated ownership, thus enabling better monitoring of management’s decisions. In 2012, when this transaction took place, the largest shareholder of ICICI was Deutsche Bank Trust Company Americas, a passive shareholder that had a shareholding of 29.18 percent, followed by LIC (once again a passive shareholder) with 7.20 percent ownership. Deutsche Bank, in turn, had distributed ownership with their largest shareholder being BlackRock Inc. (with only 5.14 percent shares). The few concentrated owners of ICICI Bank were themselves the managers of other professional firms. Predictably, the owners of these firms had little inclination or motivation to check the self-serving activities of ICICI managers. This absence of active monitoring might have led ICICI managers to act injudiciously in their interests rather than according to those of the firm’s owners. This problem or conflict is known as Principal (i.e., owner)-Agent (i.e., manager) or Type I agency conflict (PA conflict). Also read: How should a manager balance responsibility towards shareholders and society
Multiple solutions have been proposed to minimise principal-agent conflicts. These include tailoring employment contracts for the top management teams, implementing optimal compensation structures for managers, configuring board composition and structure to ensure board and director independence, and issuing shares to management personnel to align their goals with those of the owners. However, the dominant solutions proposed in these instances increase the concentration of ownership blocks. In most emerging markets such as India, ownership concentration can occur through different ownership types such as government ownership (e.g., PSUs), family ownership and/or promoter ownership. Concentrated ownership provides monitoring benefits where the concentrated and dominant owner groups can closely and effectively monitor managers to ensure that they do not engage in opportunistic self-serving behaviours that detract from creating shareholder value. Stemming from the diligent monitoring activities of these concentrated owners, an increase in concentrated ownership leads to a reduction in principal-agent conflicts in the firm. However, such concentrated ownership may also equip these dominant owners with the power and influence to control the company’s decisions as well as influence agenda-setting and strategic decision-making process. When these positions of power are combined with the motivation to pursue the concentrated owners’ private benefits rather than to increase the benefits equitably to all shareholders, it can result in a different type of conflict called Principal-Principal or type II agency conflicts (PP conflict).
Consider the contrasting case of Elcid Investments Ltd, a promoter-controlled entity of paints major Asian Paints Ltd and Hexa Tradex Ltd, an OP Jindal Group company. In May this year, the delisting proposal of Elcid Investments Ltd, failed to win the confidence of its minority shareholders, while a similar proposal by Hexa Tradex Ltd was approved by its board. Even though the outcomes of these proposals are in contrast, they had something in common—namely disagreements between majority shareholders and minority shareholders on the recommended course of action. This is the genesis of type II conflicts. In both these cases, the majority and minority shareholders experienced differences in the book values of their shares. The majority shareholders of Hexa Traders (shareholding of 63 percent) claimed that the book value of each share was Rs 400 when the stock was trading at Rs 2 in the open markets. Minority shareholders, on the other hand, claimed that the real value of Elcid which held a 4.3 percent stake in Asian Paints, was Rs 6 lakhs (a much larger sum than that offered by the dominant shareholder, Hexa Traders). They, therefore, claimed that they had to be better compensated during the delisting process. Similar was the case with Elcid Investments Ltd. where the minority shareholders were able to block the delisting of the company because they felt that the floor price offered by the majority shareholder group was much below the intrinsic value of their shares. Such kind of conflicts between the distinct groups of principals or owners (dominant versus minority groups) of a firm is referred to as principal-principal or Type II agency conflicts.
The much-discussed conflict in the Tata Group between two of its owners—Ratan Tata and Cyrus Mistry—is another prime example of the principal-principal conflict. Most Tata companies have concentrated ownership owned by Tata Sons Limited, the ’parent’ company of the diversified Tata Group. Sixty-seven (67 percent) percent of the shares of Tata Sons 6 are held by different Tata Trusts, while about 18.4 percent shareholding of Tata Sons is held by Mistry family members. Cyrus Mistry had alleged that Ratan Tata (a scion of the Tata family), through his dominant ownership of Tata Sons, interfered with the working of the Tata Group because of differences in opinion on certain courses of action undertaken by then-appointed CEO Cyrus Mistry. This created a conflict of interests and consequent suppression of the welfare of minority shareholders, such as himself. Also read: When two leaders collide, the result can be less fraud
These circumstances place companies in an unenviable position. Trying to minimise one type of agency conflict (PA conflict) often results in increases in the other type of agency conflict (PP conflict). Our research examined this issue to identify if there are mechanisms that will simultaneously enable the minimisation of both types of agency conflicts and thereby enable wealth maximisation as per the tenets of shareholder capitalism. It is axiomatic in ‘shareholder capitalism’ that firms are obligated to maximise returns to their owners (i.e., shareholders). If they consistently abrogate those responsibilities, those firms will either find it more difficult to raise capital or at the minimum, experience a higher cost of capital. As one solution to this problem, we suggest that companies need to maintain a fine balance between having concentrated shareholder ownership along with professional managers managing these firms. Although this resonates well theoretically, how would companies in the business world implement them? Our research appears to indicate a way. In our research, we examined the optimal governance structures that firms followed for their ownership patterns and management control to reduce the combined impacts of both types of agency conflicts. Analysing 675 firms listed on the BSE and the NSE over ten years, we found that in firms that didn’t have concentrated ownership, the possibility of PA (Type I) agency conflicts was enhanced. By contrast, we found minimal evidence of PP (Type II) agency conflicts in these firms. In the sample of firms that had concentrated ownership, we examined only family business firms where the family was the dominant ownership group. We also found that in family firms, PA agency conflicts decreased significantly. We then divided family firms into two categories (based on their managers’ affiliation), namely, family-managed and non-family-managed. We found that PP agency conflicts significantly increased in family-owned and family-managed firms, primarily because dominant family share ownership combined with family management control maximised the potential for an appropriation of private benefits (for the family) to occur, at the expense of other minority shareholders of these firms. However, when non-family affiliated managers were entrusted with running these family-owned firms, the governance combination appeared to curtail the family’s ability to appropriate benefits. Consequently, such firms appeared to exhibit only moderate (or no) increases in PP agency conflicts. Taken together, our pattern of results emphasised that to simultaneously minimise, both PA and PP agency conflicts, companies need to have dominant ownership (viz., the family, in this case), coupled with having management control vested in the hands of non-family affiliated managers. Would our findings be difficult to implement in the Indian corporate world? We do not believe that they should be. But one lingering question that might arise is why would family-owned firms voluntarily relinquish their management control by appointing non-family managers to run their businesses. Business families consider their firms as extensions of their family’s wealth. Thus, passing off management control to non-family managers may be anathema to many of them. Our study suggests that unless family firms try to follow our prescriptions, they might lose their ability to attract capital on competitive terms. This becomes especially important as Indian firms seek to attract inflows of portfolio capital from international investors who are more invested in the tenets of shareholder capitalism. We are encouraged to note that some family business firms have begun to realise and act on the import of our findings.
For example, the recent decision of the Tata Group to hand over management control to a non-Tata manager, Natarajan Chandrasekaran, is we believe, a step in the suggested direction. Further, the Tata Group has introduced self-regulation to enunciate the required distinction between ownership and management control. At their latest Annual General Meeting, the shareholders of Tata Sons, the holding company of the Group, approved a significant amendment to its articles of association. It is now legally required to separate the positions of the Chairpersons of Tata Trusts and Tata Sons, respectively. This is one step towards the suggested decoupling of ownership from management. This will, as our research suggests, go a long way towards ameliorating the pernicious effects of both PA and PP agency conflicts among family business firms. Our study is equally important for firms that have other forms of dominant ownership groups such as government owners (i.e., PSUs) and Promoter Owners. That being said, the government need not necessarily dilute their ownership stakes in PSUs. Instead, it should professionalise the managerial structures among PSUs by bringing in experts from outside the government bureaucracy to professionally manage these PSUs. We recommend that this course of action will enable Indian companies to be better positioned to compete for and more favourably attract global flows of investment capital.
Prof. Saptarshi Purkayastha, IIM Calcutta (email@example.com) & Prof. Rajaram Veliyath, Kennesaw State University (firstname.lastname@example.org)
[This article has been published with permission from IIM Calcutta. www.iimcal.ac.in Views expressed are personal.]