Adversity brings the best out in men. It also brings skeletons tumbling out from corporate closets?recognised incomes fail to materialise, derivatives and off-the-book transactions turn around to sink rather than save the firm and related party transactions sour. As the marketplace gets tougher around the world for the next few quarters, it may be instructive to point out a few chinks in India?s corporate armour identified by recent academic research.
Let?s begin with ownership. Shareholding patterns in India reveal a marked level of concentration in the hands of the promoters. A glance at India?s 500 most valuable companies, that together account for over 90% of the market capitalisation of the Bombay Stock Exchange, reveals that about two-thirds of them are part of conglomerates, or ?business groups?. Family-run business groups continue to play a crucial role in the Indian corporate sector. On average promoters own over 50% of the shareholding in these companies. Such concentration of ownership is hardly surprising?it is, in fact, quite the norm in developing economies marked with information and contract enforcement problems arising from relatively weak legal protection of minority stockholders and property rights in general.
But if such concentrated ownership has allowed India?s past growth, it also provides the controlling shareholders with both the temptation and the means to exploit the minority or non-family holders. Studies of Indian business groups have produced evidence of significant ?tunneling? activity-that is, related company transactions that have the effect of transferring assets and cash flows from minority to controlling shareholders. Facilitating this activity, and compounding the problem of ?outside? investors, the actual ownership within these companies is far from transparent, with widespread pyramiding, cross-holding, and the use of non-public trusts and private companies for owning shares in group companies. Diversified business groups help increase the opacity of within-group fund flows driving a wider wedge between control and cash flow rights. Firms with greater ownership opaqueness and a lower wedge between cash flow rights and control from where funds are finally appropriated by the majority shareholders are likely to be located farther away from the core activity of the group. This incentive for tunneling may well explain the persistence of value destroying groups in India and occasional heavy investment by Indian groups in businesses with low contribution to group profitability. Most related party transactions in India occur between the firm and ?parties with control,? as opposed to management personnel as in, say, the United States. Also, group companies consistently report higher levels of related party transactions than stand-alone companies. Unsurprisingly, firm performance tends to be negatively associated with the extent of related party transactions for group firms but positively so for stand-alone companies.
How well do boards supervise the management? Group firm directors on average sit on more boards than their counterparts in stand-alone firms. This is particularly true for insider directors. Perhaps expectedly, busier inside directors are correlated negatively with firm performance.
Earnings management, as measured by discretionary accruals, is an informative indicator of board control over management, or lack thereof. CEO-duality, the top executive also chairing the board, and the presence of controlling shareholders as inside directors are related, perhaps unsurprisingly, to greater earnings management. Busy independent directors also appear to be correlated with a greater degree of earnings management. Multiple positions and non-attendance of board meetings by independent directors seem to be associated with greater degree of earnings management as measured by discretionary accruals. After controlling for these characteristics of independent directors, the proportion of independent directors hardly affects the degree of earnings management.
Finally, we turn to executive and board compensation in India, the former freed from the strict regulation by the Companies Act in 1994. The average total compensation of Indian CEOs has risen almost three-fold between 1998 and 2004 (and anecdotally at least another 3-fold since). Here again, it pays to belong to the controlling family. Being related to the founding family can raise CEO pay by as much as 30% while being related to a director can cause an increase of about 10%. The board compensation also appears to be higher, on average, if the CEO is related to the founding family.
To be sure, these flaws are, by no means unique to India. Conglomerates are cesspools of corporate governance problems anywhere in the world. They create a mutually supporting ecosystem but at the cost of transparency and firm independence. If anything, Indian firms and conglomerates are probably cleaner and in better shape than those in most other Asian and developing countries. Nevertheless, greater caution and focus on business groups may avoid many an unpleasant situation for investors and regulators alike.
Rajesh Chakrabarti teaches finance at the Indian School of Business, Hyderabad