It is so true that the adequacy and the quality of corporate governance shape the growth and the future of any capital market and economy. The concept of corporate governance has been attracting public attention for quite some time in India. The topic is no longer confined to the halls of academia and is increasingly finding acceptance for its relevance and underlying importance in the industry and capital markets. Internationally also, while this topic has been accepted for a long time, the financial crisis in emerging markets has led to renewed discussions and inevitably focused them on the lack of corporate as well as governmental oversight. The project firstly discusses, in chapter-1, as to what are the traits of good corporate governance and its role in a capital market. Moreover, the project discusses about the problems faced by the regulators in terms of abusing of corporate governance by the dominant shareholders, in chapter-2. Focus on corporate governance and related issues is an inevitable outcome of a process, which leads firms to increasingly shift to financial markets as the pre-eminent source for capital.
One of these issues is preferential allotment of shares by the companies. The project discusses, in chapter-3, in detail, the ways of issuing preferential allotments and various issues regarding them and how these days their pricing has become an issue in the market and measures taken by SEBI to solve these issues.
Role of Corporate Governance
The recent worldwide accounting scandals have underscored the role of corporate governance in protecting the interests of investors. However, the growing awareness of corporate governance has also made it more difficult to define good governance.
The complexities behind corporate governance arise on account of two reasons. First, the multi-disciplinary nature of the subject. Among other disciplines, accounting, financial economics, law, philosophy and political science have linkages with corporate governance.
The second factor is cultural diversity. Anglo-Saxon countries such as the US and the UK equate corporate governance with firms pursuing the interests of shareholders. Whereas in Japan, Germany, and France, corporate governance is concerned with the interests of a wider set of stakeholders, including employees, customers and shareholders.
A more accurate system of measuring corporate governance must be in place if the standard of corporate governance in the country is to be improved. In today's market economy, notwithstanding some limitations, it is market reaction which provides the best measure of corporate governance. The way the market reacts to information about a company says a lot about corporate governance. In other words, market reactions depend on the quality and timeliness of disclosures. Even from a larger societal point of view, companies must make timely disclosures to the investing public to facilitate reasonably quick, if not immediate, adjustment of share prices.
Mis-pricing is bad for society because it leads to sub-optimal capital structures resulting in inefficient usage of scarce resources. Thus, a company with overpriced shares attracts more equity capital than it requires from investors, while one whose shares are under-priced attracts less than it needs. In both cases, the economic resources are being diverted to less optimal uses.
Regulators, market structure/design and market participants have an equally important role to play in ensuring instantaneous adjustment of stock prices to information. If one assumes that most of the mispricing is due to poor corporate governance, the following hypotheses must hold good.
Well-governed companies should have less mispricing than badly-governed ones;
Firms practising good governance should have less private information.
Companies with good governance should have lower volatility compared to bad governance companies. They should make timely disclosures, thereby ensuring that the stock price does not overshoot or lag the intrinsic value significantly.
These hypotheses were used to test some leading Indian companies. Standard and Poor's (S&P) corporate transparency rating of Indian companies was used as the basis for identifying good and bad governance companies. The S&P ranking, which covers around 50 Indian companies, takes into account corporate structure and investor relations, transparency and information disclosure and management structure and processes.
While companies make announcements about various events, four events were selected, which vary with respect to the nature of information, private or public — dividends, merger/takeovers, preferential allotment and sale of assets.
Dividends have a higher degree of public than private information. This is because analysts follow dividend announcements closely and information on historical trends is easily available. Mergers/takeover events, due to their price sensitivity, have more private information. But some analysts may discern signals ahead of mergers/takeover announcements by tracking prospective companies' interactions. The remaining two events — preferential allotment and sale of assets — have the highest degree of private information.
In theory, bad governance companies should exhibit more mispricing than good governance companies during these four events. The mispricing should be more if the event has a higher degree of private than public information. These hypotheses were tested by examining the reaction of the markets when companies make announcements about important events. In India, the average mispricing is low for good governance companies compared to bad governance companies. The level of over/under-pricing is not that high for merger/takeover and dividend announcements. In support of this, it was found that there is more private information before the announcement of sale of assets and preferential allotments for good governance companies.
All this goes to show that despite the efforts by many leading companies to improve corporate governance, there is still a long way to go. Even the best governed companies need to improve their disclosures. They have to do much more to minimise private information, by making disclosures on a timely basis. Only then will mispricing be minimised, if not eliminated.
By constantly monitoring how the markets are responding to announcements of events by companies, regulators and market analysts can create the necessary pressure for improving disclosures and, consequently, corporate governance. Indeed, this may be as, if not more, effective as the numerous committees set up to streamline corporate governance practices in India.
Issues of corporate governance have been hotly debated in the United States and Europe over the last decade or two. In India, these issues have come to the fore only in the last couple of years. Naturally, the debate in India has drawn heavily on the British and American literature on corporate governance. There has been a tendency to focus on the same issues and proffer the same solutions. For example, the corporate governance code proposed by the Confederation of Indian Industry (Bajaj, 1997) is modelled on the lines of the Cadbury Committee (Cadbury, 1992) in the United Kingdom.
Dilemma of Regulators
Regulators face a number of difficulties in tackling the problem of corporate governance abuses by the dominant shareholders. In many cases, it is difficult to decide how far the regulator should go in interfering with the normal course of corporate functioning. Some of these problems are highlighted below.
A much talked about regulatory dilemma is that of balancing the rights of minority shareholders against the principle of shareholder democracy. On closer examination, this regulatory dilemma is not as serious as it might appear at first sight. In many ways, the very term shareholder democracy represents a misguided analogy between political governance and corporate governance. Unlike political governance, corporate governance is primarily contractual in nature, and corporate governance is at bottom a matter of enforcing the spirit of this contractual relationship.
It is important to bear in mind that the relation between the company and its shareholders and the relation between the shareholders inter-se is primarily contractual in nature. The memorandum and articles of association of the company constitute the core of this contract and the corporate law provides the framework within which the contracts operate. The essence of this contractual relationship is that each shareholder is entitled to a share in the profits and assets of the company in proportion to his shareholding. Flowing from this is the fact that the Board and the management of the company have a fiduciary responsibility towards each and every shareholder and not just towards the majority or dominant shareholder.
Shareholder democracy is not the essence of the corporate form of business at all. Shares are first and foremost ownership rights - rights to profits and assets. In some cases (non voting shares for example) that is all there is to it. In other cases, shares also carry some secondary rights including the control rights - rights to appoint the Board and approve certain major decisions. The term shareholder democracy focuses on the secondary and less important part of shareholder rights. Corporate governance ought to be concerned more about ownership rights. If a shareholder’s ownership rights have been trampled upon, it is no answer to say that his control rights have been fully respected.
The dilemma of micro-management
Corporate governance abuses perpetrated by a dominant shareholder pose another and far more difficult regulatory dilemma. Regulatory intervention would often imply a micromanagement of routine business decisions. In a competitive world, highly complex business decisions have to be taken quickly and smoothly. Subjecting a large number of these decisions to the process of regulatory review would make a travesty of a free economy. In the name of ensuring that corporate decisions are taken in the best interests of the company as a whole (rather than just the dominant shareholder), the regulator would end up running the company by remote control. The company would then effectively become an extended arm of the state.
Regulatory intervention must perforce be confined to a few clearly defined prohibitions and restrictions that require minimal exercise of regulatory discretion. This approach carries with it the danger that broad prohibitions would also stand in the way of many legitimate business transactions. Some examples of these issues are discussed later in this paper.
Regulatory Response: Company Law
The primary protection to minority shareholders is laid down in the companies law. Some of these provisions are the regulatory equivalent of an atom bomb - they are drastic remedies suitable only for the gravest cases of misgovernance.
Protection of minority shareholders
Company law provides that a company can be wound up if the Court is of the opinion that it is just and equitable to do so. This is, of course, the ultimate resort for a shareholder to enforce his ownership rights. Rather than let the value of his shareholding be frittered away by the enrichment of the dominant shareholder, he approaches the court to wind up the company and give him his share of the assets of the company. In most realistic situations, this is hardly a meaningful remedy as the break-up value of a company when it is wound up is far less than its value as a “going concern”. It is well known that winding up and other bankruptcy procedures usually lead only to the enrichment of the lawyers and other intermediaries involved. Company law also provides for another remedy if the minority shareholders can show that the company’s affairs are being conducted in a manner prejudicial to the interests of the company or its shareholders to such an extent as to make it just and equitable to wind it up. Instead of approaching the Court, they can approach the Company Law Board (now proposed to be renamed as the Company Law Tribunal). The Company Law Tribunal which is a quasi-judicial body can make suitable orders if it is satisfied that it is just and equitable to wind up the company on these grounds, but that such winding up would unfairly prejudice the members. In particular, the Tribunal may regulate the conduct of the company’s affairs in future, order the buyout of the minority shareholders by the other shareholders or by the company itself, set aside or modify certain contracts entered into by the company, or appoint a receiver. The Tribunal could also provide for some directors of the company to be appointed by the Central Government, or by proportional representation. The Tribunal normally entertains such complaints only from a group of shareholders who are at least one hundred in number or constitute 10% of the shareholders by number or by value.
The powers given to the Company Law Tribunal are perhaps more effective remedies than the power of winding up which is vested in the Courts, though one may wonder whether these powers are too sweeping. However their scope is limited to very extreme cases of misgovernance where it is just and equitable to wind up a company.
Another safeguard in the company law is the requirement that certain major decisions have to be approved by a special majority of 75% or 90% of the shareholders by value. This may not be an effective safeguard where the dominant shareholders hold a large majority of the shares so that they need to get the approval of only a small chunk of minority shareholders to reach the 75% level. Even otherwise, it may not be a sufficient safeguard if the process of conducting shareholder meetings is not conducive to broader participation by a large section of the shareholding public. The Indian system does not allow for postal ballots. Effective participation by small shareholders is possible only if there is a cost effective way of waging a proxy campaign. This would enable dissenting shareholders to collect proxies from others and prevent measures which are prejudicial to the minority shareholders.
Information disclosure and audit
Company law provides for regular accounting information to be supplied to the shareholders along with a report by the auditors. It also requires that when shareholder approval is sought for various decisions, the company must provide all material facts relating to these resolutions including the interest of directors and their relatives in the matter. Disclosure does not by itself provide the means to block the dominant shareholders, but it is a prerequisite for the minority shareholders to be able to exercise any of the other means available to them. Disclosure is also a vital element in the ability of the capital market to exercise its discipline on the issuers of capital.
Regulatory Response: Securities Law
Historically, most matters relating to the rights of shareholders were governed by the company law. Over the last few decades, in many countries, the responsibility for protection of investors has shifted to the securities law and the securities regulators at least in case of large listed companies. In India, the Securities and Exchange Board of India (SEBI) was set up as a statutory authority in 1992, and has taken a number of initiatives in the area of investor protection.
As discussed above, the company law itself mandates certain standards of information disclosure both in prospectuses and in annual accounts. SEBI has added substantially to these requirements in an attempt to make these documents more meaningful. Some of these disclosures are important in the context of dealing with the dominant shareholder. One of the most valuable is the information on the performance of other companies in the same group, particularly those companies which have accessed the capital markets in the recent past. This information enables investors to make a judgement about the past conduct of the dominant shareholder and factor that into any future dealings with him.
Promoters’ contribution and lock in
Another aspect of the SEBI regulations is that in most public issues, the promoters (typically the dominant shareholders) are required to take a minimum stake of about 20% in the capital of the company and to retain these shares for a minimum lock-in period of about three years.
At first sight, it might appear to deal with a problem closer to the US and UK predicaments where the management has only a minuscule stake in the company. This however is not so at all. The SEBI regulations provide an exemption to those companies where there is no identifiable promoter group, that is to say, no dominant shareholder. In other words, if these regulations were copied by US and UK regulators, they would not make much of a difference to most of the companies in those countries as these companies would typically fall in this category of not having an identifiable promoter group.
The SEBI regulations deal with a corporate governance problem very different from the US and UK problems. It affects those promoters who might have planned to have a very small equity stake and still be dominant shareholders because of large blocks of passive shareholders. Such promoters would be in the position to exercise effective control while having very little stake in the company itself. Most of their rewards would come not from dividends or from appreciation in share values, but from one sided deals which help them transfer profits to other entities owned by the promoters themselves. Apart from this category of promoters, the SEBI regulations may not be much of a constraint for most dominant shareholders. Many of them might even otherwise plan to have a stake of more than 20% (probably as high as 51%) to exercise unquestioned control.
The next Regularity measure by means of Securities law is regarding “Preferential Allotment of Shares” which has been discussed in the next chapter.
Preferential Allotment- Ways and related issues
Preferential allotment in case of public unlisted company
Provisions have been made in Unlisted Public Companies (Preferential Allotment) Rules, 2003.
Generally, preferential allotment is made to promoters, collaborators etc., without making offer to members on pro-rata basis. If preferential allotment is to be made, provisions of section 81 in respect of Rights Issue must be complied with e.g. special resolution in general meeting.
Preferential allotment in case of public unlisted company –
Provisions are made in Unlisted Public Companies (Preferential Allotment) Rules, 2003.
Applicability Of Rules - The rules apply to all unlisted public companies in respect of preferential issue of equity shares, fully convertible debentures, partly convertible debentures or any other financial instrument which will be convertible into or exchanged with equity shares at a later date. These include shares issued through private placement by company and issue of shares to promoters and their relatives either in public issue or otherwise. [In case of unlisted company, how can there be ‘public issue’ ?
‘Promoter’ means persons who are in overall control of the company or those who hold themselves as promoters.
The intention of rules is to control preferential allotment to promoters. However, the wording of rules is such that the rules apply to all preferential issues of public unlisted companies covered under section 8(1A).
Special Resolution and Explanatory Statement - Issue of preferential shares will be by special resolution in general meeting. Such issue should be authorised under Articles (Otherwise, Articles will have to be amended before passing the resolution. Model Articles in Table A do not have such specific provision. Really when Statute itself authorises preferential issue, providing for the same in Articles seems meaningless). Explanatory statement to notice of meeting shall indicate particulars about pricing and relevant date of pricing, object of preferential offer, class or classes of persons to whom preferential issue is proposed, intention of promoters/directors/key management persons to subscribe, shareholding pattern of promoters and other classes before and after the offer, proposed time within which allotment will be completed and whether a change in control is intended or expected.
Validity Period Of Special Resolution - Special resolution should be acted within 12 months. Thus, if issue is not made within 12 months, fresh special resolution will be required.
Certificate From Auditor/Pcs - Statutory auditors / practicing company shall certify that the issue of the instrument is being made in accordance with rules. The certificate shall be placed before the general meeting.
Preferential allotment in case of listed company
In case of listed company, the pricing of preferential issue should be made as per SEBI guidelines. In case of unlisted company, pricing of preferential issue can be made as may be decided by Board of Directors. Other provisions and procedures are similar to issue by private placement. - - Such increase by preferential allotment should be as per guidelines issued by Government of India, Ministry of Industry dated 10th April, 1995, RBI guidelines dated 9th April, 95 and 16th June, 1995 and SEBI guidelines dated 19-1-2000. Guidelines issued by SEBI are applicable to all preferential allotments in listed companies, while guidelines issued by RBI and Central Government are applicable only to foreign investment. Broadly, these guidelines are identical.
Preferential allotment in case of private companies – The rules are not applicable to private company. In fact section 81 itself does not apply to a private company.
Pricing of preferential share allotments
Another area in which SEBI has intervened to tackle the dominant shareholder is the pricing rule that it has imposed on preferential allotments. Company law itself provides that new issue of shares must be rights issues to existing shareholders unless the shareholders in general meeting allow the company to issue shares to the general public or to other parties. As has been pointed out earlier in this paper, the requirement of shareholder approval is quite meaningless when there is a dominant shareholder. Many dominant shareholders (both Indian and foreign) responded to the liberalization of the Indian economy by making preferential allotments to themselves at a small fraction of the market price. In 2000, SEBI issued new guidelines on preferential allotment that prohibited preferential allotments at a price lower than the average market price during the last six months. This regulatory intervention illustrates very nicely the problems that the regulator faces in dealing with governance abuses by the dominant shareholder. There are many situations where it may be in the interests of the company as a whole (and not just the dominant shareholders) to issue equity at below the six monthly average prices.
One situation could be where the stock market as a whole has fallen sharply over the last six months and the six monthly averages is far above the prevalent market price. There have been many occasions where the Indian stock market index has fallen by about 50% during a period of six months. One possible regulatory solution to this problem might be to use an average over a significantly shorter period than six months. At the extreme, one may even consider just the closing price on the day on which the allotment is made. However, regulators consciously chose a longer average because they feared perhaps rightly that prices could be easily manipulated for one day or for a few days but not for a longer period like six months. There is an interesting parallel with issues of convertible bonds in international markets where there is a call option to the company. This option is typically based on the market prices for 30 or more consecutive trading days and not just one trading day. This suggests that the six month period mandated by the regulator is perhaps excessive. But it also suggests that free contracting parties see some merit in the idea of an average price over a period of about a month or two as compared to just the closing price on a given day. In other words, the regulatory problem created by averaging can be reduced but cannot perhaps be eliminated.
Another situation where compromises may be desirable on price is when the company is making a private placement of equity to large investors in an arms’ length transaction. The private placement may be to avoid the costs of a public issue or because the company does not satisfy the entry norms for a public issue. It is well known that a company making a large additional issue of equity (whether by public issue or by private placement) has to price its equity significantly below the ruling market price. Many public issues for example are typically made at discounts of 15-20% to the ruling market price. The prohibition on making preferential issues at a discount would effectively rule out such private placements altogether.
At the same time for reasons of size or otherwise, a public issue may be infeasible. The regulatory intervention on preferential allotment may thus have the wholly unintended consequence of denying the company access to the capital market completely. Again, one can think of modifications in the regulations that would exempt arms’ length transactions defined in some suitable way, but no such definition can be wholly satisfactory.
In short, this example shows very well how regulatory interventions designed to discipline the dominant shareholder always run the risk of attempting to micro-manage the affairs of the company.
Indian corporate managements have never had it so good. Over the last couple of years, with active support from politicians, regulators and the finance ministry, they have wrangled the freedom to increase or decrease at will, the capital of companies that they control. This means in effect that the company can raise money, and the founders can get fabulously rich, by selling stock to the public, but even with a tiny minority of the shares, the founders will control the company. And the public shareholders can't do anything about it.
Democracy is actually a good solution to this. If we're all going to McDonald's, and we all have to get the same thing, it should be decided by majority vote. But it's even better if we each can get what we want. And you can be fairly confident that a majority of McDonald's customers prefer hamburgers, while a majority at Popeye's prefer chicken. You don't have to require a vote.
Advocates of shareholder democracy believe it will lead to companies that care more for the environment, treat their workers better and so on. Well maybe, maybe not. In a world of perfect corporate democracy, in which large public companies are required to pursue only those goals that can be agreed upon by the owners of a majority of the publicly traded shares at any moment, the most likely result would be companies focused exclusively on maximizing profits.
Requiring shareholder democracy actually stifles it. Why shouldn't shareholder democracy include the right to decide whether you want shares in a company that practices shareholder democracy?
- P.L.Kumar, A Paradox called Corporate Social Responsibility, ICFAI Journal of Corporate Governance, July, 2004
- SEBI (DIP) GUIDELINES, 2000, www.sebi.gov.nic.in
- Report of the Kumar Mangalam Birla Committee on Corporate Governance
- Michael Kinsley Voting 'No' on Shareholder Democracy, , Sunday, August 22, 2004; Page B07 , The Washington Post
- Sucheta Dalal, Preferential allotment is the latest stock market game, The Indian Express, December 9, 2001
- Jayanth Rama Varma, Corporate Governance in India: Disciplining the Dominant Shareholder, IIMB Management Review(http://www.iimb.ernet.in/review).
 Vijaya B. Marisetty A. V. Vedpuriswar, `Prising' out good corporate governance, Financial Daily from THE HINDU group of publications
Friday, Jul 08, 2005
Friday, Jul 08, 2005