You are on page 1of 9

Corporate Governance for Family Firms in India Pankaj baag Introduction The concern over the effects of separation

of ownership and control go back perhaps to Adam Smiths The Wealth of Nations (1776, Chapter 1, Part 3, Art 1) where he states: The directors of such joint stock companies, being the managers rather of other peoples money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own. Like.against private adventures. We can define this phenomenon with respect to owner managed firm where the ownermanager has two attributes. First it makes management decisions of the firm and Second it has acclaim to the profits of the firm.

Whereas in a public firm, the shareholders own residual claims but lack direct control over management decision attributed to free rider, collective action or coordination problems and the managers have control with hierarchical decision making, sometimes superior to the market and have transaction costs (Coase,1937, Williamson, 1979) but possess nil/small (if any) residual claims. This divorce creates benefits when hierarchical decisions making is more efficient than the market allocation, when the optimal firm size is large due to the economics of scale in both production and decisions and when investors diversify, pool, change allocations to changing market conditions to have the optimal investment strategy. This divorce also creates costs due to adverse selection and moral hazard besides the usual principal-agent costs like the monitoring costs, bonding costs and the residual loss from the divergence of behavior which are mitigated by mechanisms like business failure, market for corporate

control, financial incentives, institutional participation, fiduciary duties and corporate governance oversight. The corporate governance movement started as merely curiosity among firm law professors who were inspired by Berle and Means book on the Modern Corporation and Private Property (1933) who documented the rise of the modern corporation in the US and suggested treating shareholders as investors who have no necessary claims to control and went on to become one of the determining socially desirable policies for the governance of the corporation. The goals of which includes the efficient flow of investment funds, efficient production and distribution, optimal incentives for managers, shareholder protection, social justice and duties to other constituencies. The East Asian crisis and the financial scandals of the US brought the importance of governance and policy/lawmakers reacted by creating rules, many of which are one size fits all to protect the shareholders and other stakeholders which can be detrimental to the operation and growth of the family owned and controlled firms as well as non-listed companies which grow and function differently because of the geographical and cultural influences worldwide. However, it has also brought in new developments which compel us to initiate new corporate governance initiatives focused on family owned-controlled firms and non-listed firms like the undesirable spillover effects and ambiguities related to it. It has to be noted that the concept of government controlling the economy has now been replaced with the knowledge that market dynamics prevail in economic matters thus making the market as the most decisive factor in settling economic issues. The typical life cycle of family-owned firms, who are the backbone of a countrys economy, indicate that 1st generation establishes the business, the 2nd generation develops it and the 3rd generation destroys it. Only firms with strong professional governance structure survive besides training and education to assure the steady and healthy growth of these firms and ensuring the continued participation of family members. As such

separate corporate governance codes could well create awareness regarding the beneficial affects of such measures. Family Firms Family firms are firms which are controlled by their founders or by the founders families and heirs. It is almost common among private firms and dominant among public firms (La Porta et al. 1999). The crucial issue is succession from the perspective of corporate governance for a firm that survives. It may be that the founder no longer wishes to manage it and can happen from the very beginning by hiring managers to run the firms or midway when the founder reduces his workload or even later when he retires. This new manager can be the heir or a professional. In the later case, again the founder decides to stay and monitor or sell out outright thus separating the ownership and management In India, both the ownership and management typically tend to stay with the family when the founder retires and if a professional is needed, is usually inducted into the family. The benefit of a professional is better management and the cost is the private benefits of control (Jensen & Meckling, 1976). A crucial factor is level of the legal protection of outside shareholders from tunneling by the insiders which moulds the financial development and ownership structures (Johnson et al. 2000). In general, the founder has the following options-owner manager or professional manager, no separation of ownership and management, separation of ownership and management. Thus, he can sell out completely, can stay as a large shareholder and monitor a professional manager, or can pass the management to an heir. Whatever decision he takes, it is to maximize the value of the firm. In India, with weak shareholder protection, the founders ability to control expropriation is limited; hence, management stays with the family showing perhaps a negative relation between protection and ownership concentration (Shleifer, Panunzi & Burkart, 2002).

With ownership controlled by one or a few people from a family, these firms have competitive advantages and disadvantages over publicly held firms. The advantages are like controlling ownership can take the long term view, patient and consistent investments can yield excellent future benefits and can pursue contrarian strategies and reject mediocre conventional wisdom whereas the disadvantages can be that firm can be isolated and insulated from market realities besides seeking personal comfort and forsaking external accountability can lead to stale strategy, no succession planning and stagnation and that quarrels among owners can be catastrophic. The difference between a family firm that succumbs to its weaknesses and one that exploits its relative strengths lies in the quality of the governance system. Successful family firms appreciate the power of their ownership control, volunteer for the accountability of an independent board and take care to properly define the roles and responsibilities of ownership, management, and the board of directors. The essence of the family firm difference is that the nature of ownership is different. Successful family firms also understand how governance practices need to evolve to reflect the changes in business and within the family. Family ownership groups not only concentrate control but also often have a strong emotional attachment to their businesses and see the business as a social legacy built by past generations which should continue in succeeding generations. It can also have a sense of moral obligation to other stakeholders and make a positive contribution to the society. The lack of readily available liquidity is another difference. Relinquishing ownership of family is also sometimes difficult through legal restrictions on the sale of stock. In such cases creating a market for the sale can be complex and costlier than continued ownership. Owning stock in a family firm tends to concentrate the wealth of individuals in a single asset. In family ownership groups, a disproportionate percentage of the net worth of many individuals is often tied up in the family firm which means that the family firm owners, as a group of investors, have less diversification and higher risk than they would

as investors in the broader stock market. Such concentrated risk makes the owners more attentive to their investment and tends to keep them more active and engaged which makes them more committed to fix the wrong rather than flee from it economically besides can be as important as the investment in the business. The Indian context and its comparison with the East Asian Countries Values are shaped by history and institutions and create the backbone of businesses in a region (Aguilera & Jackson, 2003). Indian cultural values are different from other countries (Ronen & Shenker, 1985) resulting in a complex blend of ownership forms that in majority include family owned firms besides government, professional and foreign owned firms. The evolution of governance in India can be divided into four phases (Gupta & Gollakota, 2006) as shown below in table 1:

The emergence of family firms in India goes with the study that in economies where property rights are not well defined or effectively enforced by the government, concentrated ownership confers significant benefits (Shleifer & Vishey, 1997). In India during the first phase, there was little confidence in the British Governments commitment to protecting the rights of the Indians. Family firms allowed for lower risk in business besides it also substituted internal markets for less developed external markets for capital and labor (Claessens & Fan, 2002).

Family business were inclined to act with conservatism and thrift, allowed for a multigenerational continuity of firms values and resources and also emphasized corporate responsibility (Sunder, 1999) to ensure their long term survival by satisfying the interests of their community. In India, many families with small equity investments exercise considerable control over firms which implies the ability to effectively determine decision making in an organization (Fama & Jenson, 1983). This is possible because the equity base is low and debt financing is used for growth (Goswami, 2000). In family-controlled firms and in smaller firms it is more likely to detect separation of ownership and control than in middle-sized firms. It is also common, that the managers of a firm are relatives of the owning family. Older firms are mostly family-controlled. This also suggests that the assumption of ownership becoming dispersed over time is not necessarily true. In general, family capitalism precedes shareholder capitalism. Concentrated ownership exists at any point of time because of institutional voids, the absence of specialized intermediaries in capital markets. Pyramid structure helps to tap equity financing while retaining family control. These groups and the concentrated ownership that they represent, whether in history or in contemporary emerging markets like India, are robust form of business organizations. They potentially last centuries changing their footprint and functional form, and weathering severe shocks. If the family firm is not engaged in rent seeking behavior or entry deterring behavior, it is not inimical to competition. During the period of severe government intervention, some families exploited the system, and some reinvented itself. Adjusting itself to the changing times, it has demonstrated a remarkable resilience. Further, owners define the value of the firm and the value of the firm reflects the family value. Businesses group and not the individual joint stock company is the unit of decision. Relationships in a family business build on trust between owners and managers and between owners and the board of directors. Owners prefer to appoint kin in top positions if talent is available internally or from friends and philosophers. Often, familys unity and commitment get priority over the core business objective, that is, maximizing the value of the firm. Entrenchment of management is more common in family firms.

Size of the firm does matter in the sense that decay takes long time or business is resilient enough to take challenges. The basic reasons of decay can be family split because of sibling rivalry, internal management problems, absence of succession plan, inability to face challenges posed by younger companies. According to the Statistical outline of India (1995), there were 297000 companies of which the number of non family businesses were around 3000, around 6925 were listed and 75% of the largest companies are family firms (as cited Phanil et al. 2005). Dutta (1997) avers that family firms in India constitute 99.9% of all private Indian companies. According to the ET corporate governance survey 2004, among top 20 companies, 10 companies belong to business groups, in terms of governance structure, 10 companies belong to business groups and in terms of value creation, 11 companies belong to business groups. To evaluate it used the parameters like accounting quality, value creation, fair policies and actions, communication, effective governing board and reliability. According to CII study, 38% of family business survives into second generation, 12% survive into the third generation and 3% survives third generation. In India, like in East Asia, wealth is still concentrated on a few families. Research shows that most assets are in the hands of one or more family groups (Claessens, Djankov & Lang, 2000). In South Korea, Singapore, and Taiwan the families seem to have certain mechanisms that separate ownership and control in large firms. Family groups for example in the Philippines, Hong Kong, or Indonesia also control large companies. To draw a comparison, for example, in America the 15 riches families only have 2.9% of GDP. Similarly, in India, like in most East Asian countries, pyramid structures where one company holds a majority of a stock of a company which further holds a majority of the stock of another one and cross-holdings which are companies within a business group hold shares of each other are present.

The dominance of the business groups often relies on the advantages that come with crony capitalism and connections to the government. These factors provide many business groups with: Exclusive export/import rights Protection from foreign competition Monopoly power in the domestic market Procurement of large government contracts, etc.

A deviation from one-share-one-vote-mechanisms through shares with different voting rights is scarce as is shown by the fact that 19.76% of ownership of all shares equals 20% of control rights (Claessens, Djankov & Lang, 2000). In Japan, Korea, and Taiwan, concentration of control rights is lower than in the other countries as is the concentration of cash flow rights in case of South Korea and Japan. Additionally research found out that a correlation exists between control and company size. In most countries, the share of family ownership increases for smaller firms. Again, Taiwan, Korea, and Japan show similarities. In these countries, the largest 20 groups show the lowest percentage of family ownership amongst the countries which is not necessarily true in case of India. There is a theory about the correlation between the development of a country and its concentration of control. The theory states that higher level of economic development might come along with lower concentration of control. This theory is supported by the example of Japan, which is highly developed and has the lowest concentration of control with its mostly widely held firms. Does the development of a country change its company structure? Research shows a tendency in that direction. Japan - followed by Korea and Taiwan - has the largest share of widely held firms, while Indonesia and Thailand have the smallest. But again in the case of India, this is not true. As such, this theory cannot be verified, as further research is necessary to confirm the assumptions. Empirical studies in the future will have to examine the history of development of several countries all over the world to reach this goal.