Column : In the right zone

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: 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.