Corporate Governance. Many investors, when they hear the term, visualize a theoretical concept that has to do with boring things like morals and ethics but doesn’t directly affect them. But corporate governance has a direct impact on the wealth you take home from investing in equities. Here we attempt to explain why.
There is no formal definition of the term. It has evolved over time. If we look at how company evolves, there is a promoter, who has the idea and expends his energy in putting together a business. He starts it with his own money and over time, as he starts to scale up, he invites others to share in his journey. It could be through a public issue, a private placement or any other mode where he offers a share in his business to others. At this stage, he extracts a fair ‘premium’ where others have to pay a much higher price for the shares they acquire. This ensures that the promoter retains control (in fact, others putting in money are mere finance providers. They expect the promoter to manage the business and grow it) and also finds enough money to grow to the next level. He can use a mix of equity and debt to keep growing his business.
This separation between the promoter of a business and its shareholders is the root of corporate governance. Tracing the history of corporate governance, we do not have to go far back in time. A gent by the name of Robert Maxwell was discovered to have dipped into employees’ pension money for personal use. After this scandal was discovered, in the 80s or so, UK set up what is known as the “Cadbury Committee” to go in the abuse of power by a promoter in a board-managed company. This was early 1990-91. Till then, it is likely that legislators across the world did not dig in to this. Surely, Robert Maxwell was not the first off the block.
What shareholders expect
We buy shares in a company. Our expectation is that while we become ‘proportional’ owners in the company. But there is a big block of ownership with the promoter/manager who manages the business, gives it direction and also manages day-to-day affairs. Being a company with liability limited by shares, there is a Board of Directors. They meet at least four times a year and are ‘supposed’ to oversee the interests of the shareholders. Here, shareholder becomes an inclusive term, not making a distinction between the promoter and the others.
As a shareholder, who gets a part ownership of a company and has paid a substantially higher price than the promoter, I have the basic expectation that the “Return on Equity” is the same for both of us. In other words, I do not expect the promoter-manager to take away anything beyond the return on equity and his legitimately approved salary, commission and perquisites. There is a “Board” which is supposed to oversee and give an assurance that the two classes of shareholders are treated on par with one another.
Corporate governance: the backdrop
Before the nineties, promoters would also occupy pole positions on the boards of companies, in executive or non-executive positions. In addition some would be in executive positions too. Our absurd legal system had prescribed a cap of Rs 3000 as the monthly salary a managing director could take. This was changed later to a generous sum of Rs.6,000! Thus, in those days, as an ‘owner’ or ‘promoter’ you had to build your wealth from this salary and whatever dividends (subjected to usurious rates of taxation) you could get on your holdings. The other interesting thing was that when shares were offered either as IPO or rights etc, there was regulated pricing. Shares in companies where there was no promoter track record had to be offered at par. Rights issues and other issues were at controlled prices. Most companies preferred to grow with debt, since dilution was at government prescribed prices. Rights was the way to grow.
Promoters: First among equals!
So where did these promoters, in the old days, find money to subscribe to their rights? Surely not from salaries and dividends! And we could not get loans against shares like these days. It is obvious that the promoters had backdoor ways of taking money out of listed vehicles. This is the origin of ‘mis- governance’. But the world turned a blind eye.
Same was the case with insider trading. It was not illegal then. It was common to buy and sell based on inside information. Many companies/promoters had ‘house’ brokers who were entrusted with all the tasks of buying/selling by the promoter. There was no need to disclose promoter holding, no issues about changing it etc. It was a wonderful world.
One of the large business groups that I used to interact with in the eighties, used to traditionally have their Board Meetings for declaring the half yearly results (quarterly was a later insistence) at around 2 pm. The Bombay Stock Exchange would function from 11 am to 2.30 pm. The meeting was preceded by lunch. The files and papers with results were neatly laid out at the directors’ seats by noon.
The directors would troop in. Take a peep at the results. And some of them would rush to the strategically vacant cabins with ‘direct’ lines. From their put a call to their broker to buy/sell. And then on to lunch and the board meeting. One company that used to have its headquarters at Kolkata had its regional office at Bombay. One day before the results, there would be a Telex to the RM marked personal. It was the Chairman’s order to buy/sell some shares in the company. The telex machine used to be in the RM’s cabin.
While one may argue that this is not illegal, I view it as nothing less than theft. Let us say the results are good and will result in a rise in the share price. Since you have advance information, you buy it when others are not aware of it. You are forcing someone, who does not have this knowledge, to sell early. Similarly, you could use insider information to sell early when you know about a poor result.
These were common practices. Buying or selling by insiders was accepted by all as a market practice. We did not have SEBI till 1994. Till then, it was the Ministry of Company Affairs that was supposed to oversee governance.
Diversion by design
There were (still are) many ways for promoters to divert company funds for their purposes, so that the other shareholders don’t get to share the spoils. I give below a list of some popular methods:
- Selling through a distributor who gives some commission back to the promoter
- Buying from someone who passes on a commission- either locally or overseas
- Creating fictitious expenses
- Over-invoicing capital expenditure (a very popular method)
- Under-invoicing sales– to evade taxes and collect cash which company does not see
- Selling inventory or scrap in cash
- Sell through a family owned distribution channel
- Buy through a family owned commission agent
- Paying fancy salaries to related persons
- Buying personal property with company money
- Meeting all personal lifestyle expenses at company costs
- Manipulation of overseas acquisitions
- Writing off bad debts but collecting in cash with a discount
- Giving loans to family / related companies on soft terms, never seeking repayment
- Using an employee “Trust” to park shareholding with company money
Human ingenuity is unlimited. The above are just some examples. In most cases, there is not enough time and expertise in the Board/auditors to discover all these things. So, having an independent board or changing auditors or doing any external checks cannot really help, if a promoter is determined to be dishonest.
Governance lapses have also changed styles over time. In the ‘control era’ they were marked by promoter taking money away from the company. In the liberal area of ‘free pricing’, handsome salaries to promoters and other practices have taken over.
An even bigger game lies in valuation. In the control era, a PE or 8 to 15 was the norm. Now, it has doubled and beyond. So, if I take away a rupee of EPS from the company, my share value dips by Rs 15 to 40 (depending on the PE) and if I show a FAKE additional EPS of one rupee, it increases my share price manifold. So, it is a battle between enhancing your ‘take home’ or adding to your notional ‘wealth’.
Many promoters do not disclose the exact promoter holdings. They keep a ‘side pocket’ which is used to play games in the stock markets. Thus, the manipulation of earnings is a big thing now. Many find ways to keep earnings growth ticking like clockwork. By the time the world catches up, they have made a fortune.
This article discusses some of the creative ways on which promoters may practice mis-governance.
In the next article, we’ll look at some real-life examples where governance issues cost shareholders and investors dear. After that, maybe it will be useful to have a small part on what we can do as investors. Is there a way to kick the tyres of a company and check its governance, WITHOUT knowing the promoter? This is an unending debate and the idea here is to make you aware of governance issues and how they can impact your investment choices.