Column : In the right zone

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

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.

In good countries, companies with a low promoter ownership—such as 5% to 15%—work the best. In this Zone-III, the low ownership of the CEO makes him vulnerable to being sacked, so the incidence of theft is low. This helps to attract large quantities of public equity capital; these companies grow big. 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 theft by a promoter that can’t be sacked. The real story of corporate governance lies in Zone-III. 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. 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? In Zone-III there is a great temptation for a CEO who owns 8% of a company to make a grab for 100% of the cashflow of the company. The incentive for theft in Zone-III is the greatest. 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”. Visualise how “P” would regularly take stock of the progress of the business, exercise judgment on strategy, criticise flaws of execution, pay bonuses, and sack “A” when performance is inadequate.

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.

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. LIC and UTI are now the only big PSU shareholders. A wealth of private institutional investors, including FIIs, have sprung up, and it is now safe for India to move towards a proper configuration for corporate governance of Zone-III companies.

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 in taking interest in setting up a proper board of directors.