CHAPTER 5

INVESTOR’S PROBLEMS AND

PROTECTION
 OBJECTIVES

The core, essence and substance of

corporate governance is long term
shareholder value that can be realised
only through investor protection. This
chapter studies investor protection
needs, problems, and grievance
redressal mechanisms that are
available in India.
 CHAPTER OUTLINE

► Introduction
► Relationship Between Investor Protection and
Corporate Governance
► Corporate Governance Through Legal Protection of
Investors
► Investor Protection in India
► SEBI’s Poor Performance—Suggestions for
Improvement
 Introduction

Strong investor protection is associated with

effective corporate governance. When an
investor places his hard-earned money in
the securities of a corporation, he does so
with certain expectations of its
performance, the corporate benefits that
may accrue to him, and above all, the
prospects of income from, and the
possibilities of capital growth of the
securities he holds in the firm.
Why is Investor Protection Needed?

When investors finance companies, they take a

risk that could land them in a situation in which
the returns on their investments would not be
forthcoming because the managers or those
whom they appointed to represent them on the
board may keep them or expropriate them
either covertly or overtly. This kind of betrayal
of the investors by the “insiders” may shake
their confidence, which in the long run would
have a deleterious impact on the overall
investment climate with serious repercussions
on the economic development of the country.
Why is Investor Protection Needed?
(contd.)

Research findings reveal that when the law and

its agencies fail to protect investors, corporate
governance and external finance do not fare
well. If there is no investor protection, the
insiders can easily steal the firm’s profits, while
when it is good, they will find it very difficult to
do it.
 Definition of Investor Protection

Investors by virtue of their investments in securities of

corporations obtain certain rights and powers that are
expected to be protected by the State which gave the
charter or legal entity to the corporate bodies or the
regulators designated by the State to do so. Their basic
rights include disclosure and accounting rules that will
enable them to obtain proper, precise and accurate
information to exercise other rights such as approval of
executive decisions on substantial sale or investments,
voting out incompetent or otherwise ineligible directors
and appointment of auditors.
Definition of Investor Protection (contd.)
There are also laws that mainly deal with bankruptcy
and reorganisation procedures that outline measures
and procedures that enable creditors to repossess
collateral to protect their seniority and to make it
difficult for firms to seek court protection in
reorganisation. In many countries, laws and legal
regulations are enforced in part by market regulators in
part by courts or government agencies and in part by
markets themselves. If the investors’ rights are
effectively enforced by one or all of these agencies, “It
would force insiders to repay creditors and distribute
profits to shareholders and thereby protect external
financing mechanism form breaking down.” Thus,
investor protection can be defined as both (i) the extent
of the laws that protect investors’ rights, and (ii) the
strength of the legal institutions that facilitate law
enforcement.
 Relationship Between Investor
Protection and Corporate Governance

Recent research confirms that an essential feature of

good corporate governance is strong investor
protection. According to Rafael La Porta et al,
“Corporate Governance is to a large extent a set of
mechanisms through which outside investors protect
themselves against expropriation by the insiders.”
Expropriation is possible because of the agency
problems that are inherent in the formation and
structure of corporations. The core substance of
corporate governance lies in designing and putting in
place mechanisms such as disclosures, monitoring,
oversight and corrective systems that we can align the
objectives of the two sets of players (investors and
managers) as closely as possible and minimise the
agency problems.
How do Insiders Steal Investors’ Funds?

The insiders, both managers and controlling

shareholders, can expropriate the investors in a variety
of ways. Rafael La Porta et al, describe several means
by which the insiders siphon off the investor’s funds. In
some countries, the insiders of the firm simply steal the
earnings. “In some other countries, the arrangements
they go through to divert the profits are more
elaborate. Sometimes, the insiders sell the output or
the assets of the firm they control, but which outside
investors have financed, to another entity they own at
below market prices. Such transfer pricing and asset
stripping have largely the same effect as theft. In still
other instances, expropriation takes the form of
installing possibly under - qualified family members in
managerial positions, or excessive executive pay.”
How do Insiders Steal Investors’ Funds?
(contd.)

Expropriation also is done by insider selling

additional securities in the firm they control to
another firm or subsidiaries they own at below
market prices, with assistance from obliging
interlocking directorates, and also by diverting
corporate opportunities to subsidiaries and so on.
Such practices, though often legal, have the same
effect as theft. However, these sharp practices of
insiders vary from country to country.
Rights to Information and Other Rights

Investor protection is not attainable without

adequate and reliable corporate information. All
outside investors, have an inalienable right to have
certain corporate information. Apart from the
rights to information, creditors have also certain
other rights, and these are to be protected.
Minority shareholders have the same rights as
majority shareholders in dividend policies and in
access to new security issues. Investors would be
unable to protect their turfs even if they have a
large number or chunk of the share, if they are not
able to enforce their rights.
 Rights to Information and Other Rights (contd.)

There are, however, rules and regulations that are

designed to protect investors. Some of the
important regulations are with regard to disclosure
and accounting standards, which provide investors
with the information they need to exercise other
rights of investors such as the “ability to receive
dividends on pro-rata terms, to vote for directors, to
participate in shareholders’ meeting, to subscribe
to new issues of securities on the same terms as
the insiders, to sue directors for suspected
wrongdoing including expropriation, to call
extraordinary shareholders meeting, etc.
Rights to Information and Other Rights
(contd.)
Rules protecting investors come differently from
various sources, including company, security,
bankruptcy, takeover and competition laws but
also stock exchange regulations and accounting
standards”. In India, rules protecting investors
emanate from the Department of Company Affairs
of the Ministry of Finance, the Securities and
Exchange Board of India, the Listing Agreements
of Stock Exchanges, Accounting Standards of the
Institute of Chartered Accountants of India, and
sometimes decisions of the Superior Courts of the
country.
 Corporate Governance Through Legal
Protection of Investors
The importance of legal rules and regulations as a means to protect
outside investors against insider expropriation of their money is in sharp
contrast to the traditional “laws and economies” perspective and has
evolved over the past forty-five years. In the words of Rafael La Porta et al
(1999): “According to this perspective, most regulations of financial
markets are unnecessary since financial contracts take place between
sophisticated issuers and sophisticated investors. On average, investors
recognise that there is a risk of expropriation and penalise firms that fail
to contractually disclose information about them and to contractually bind
themselves to treat investors well. Because entrepreneurs bear these
costs when they issue securities, they have an incentive to bind
themselves through contract with investors to limit expropriation. As long
as these contracts are enforced, financial markets do not require
regulation.” While this line of argument is an oversimplification of the
process, management that gives room for expropriation that takes place in
firms and neglects the grey areas that exist in company administration,
this perspective too relies on courts to enforce contracts, when disputes
arise. So, in reality, laws and their enforcement are the major factors that
help outsiders to invest in corporate firms. Although the reputation and
goodwill of a firm do help it raise funds, law and its enforcement are the
clinching factors to decide on investment. Therefore, law and its
enforcement are important means to protect investors and would help
promote corporate governance.
 Impact of Investor Protection on
Ownership and Control of Firms
In many countries, firms are owned and controlled by
promoter families and in such closely held firms,
insiders use every opportunity to abuse the rights of
other shareholders and steal their profits through
devious means. In such cases where there is poor
investor protection, large scale expropriation is
feasible. Entrepreneurs who promote companies would
not like to lose control and thereby give up the chances
of expropriation by diffusing control rights when
investor protection is poor. The evidence from a number
of individual countries and the seven OECD countries
with poor investor protection shows more concentrated
control of firms than countries with good investor
protection. In the East, there is a predominance of
family control and family management of corporations.
 Impact of Investor Protection on Ownership and
Control of Firms (contd.)

Therefore, the available evidence on corporate

ownership patterns around the world supports strongly
the importance of investor protection. Evidence also
shows that countries with poor investor protection have
more concentrated control of firms than countries with
good investor protection. Studies testify to the fact
that in countries where there is a concentration of
ownership in the hands of few families, there may be
stiff opposition to legal reforms that are likely to reduce
their control over firms and promote investor
protection.
Studies testify to the fact that in countries where
there is a concentration of ownership in the hands of
few families, there may be stiff opposition to legal
reforms that are likely to reduce their control over
firms and promote investor protection. No wonder,
then that in all countries from Latin America, to Asia
to Western and Eastern Europe - the families are
opposed to legal reform.” There is also another
reason why the insiders in such firms are opposed to
reforms and the expansion of capital markets. Under
the existing conditions, these firms can finance their
own investment projects internally or through
captive banks or subsidiary financial institutions.
Poor corporate governance provides large family
owned firms not only secure finance but also easy
access to politics and markets. The dominant families
have thus abiding interest in keeping the status quo
lest the reforms take away their privileges and confer
outside investors’ protection.
 The Impact of Investor Protection on the
Development of Financial Markets

► Investor protection provides an impetus for the growth

of capital markets. Through investor protection,
financial markets can develop with ease and perfection,
which in turn can accelerate economic growth by (i)
enhancing savings and capital information; (ii)
channelising these into real investment, and (iii)
improving the efficiency of capital allocation, since
capital flows into more productive uses. Further
financial development improves efficient resource
allocation and through this investor protection brings
about growth in productivity and output, the two basic
ingredients needed to speed up economic development.
 The Impact of Investor Protection on
the Development of Financial Markets

► Research studies point out that countries with well developed

financial markets regulated by laws allocate investment across
industries more in line with growth opportunities in these
industries than countries with weak financial markets or poor
regulatory mechanism. These studies also reveal that (i) Most
developed financial markets are the ones that are protected by
regulation and laws while unregulated markets do not work well,
may be due to the fact they allow too much of expropriation of
outside investors by corporate insiders. (ii) Improving the
functioning of financial markets confers real benefits both in terms
of overall economic growth and the allocation of resources across
sectors; (iii) One broad strategy of effective regulation and of
encouragement of financial markets begins with protection of
outside investors, whether they are shareholders or creditors, and
(iv) Enforced outside shareholders’ rights, experience in many
countries reveal, encourage the development of equity markets as
measured by valuation of firms, the number of listed companies
and the rate at which firms go for public issues.
However, investor protection does not necessarily
mean rights just included in the laws and
regulations alone, but the effectiveness with which
they are enforced. In countries with poor investor
protection, the insiders may treat outside investors
fairly well as long as the firms’ future prospects are
bright and they need the continued external
financing by outsiders. But when the future
prospects tend to deteriorate, insiders may step up
expropriation. In such a scenario, unless there are
effective laws against such malpractices and they
are effectively enforced, outside investors will not
be able to do anything but to withdraw their
investments.
 Banks and Corporate Governance
Banks play a significant role in the growth of the corporate sector by
providing them finance for their operations. There are considerable
differences between bank-centered corporate governance systems
such as those of Germany and Japan compared to market-centered
systems such as those of the UK and USA. In the former, the main
bank provides both a significant share of finance and governance to
firms while in the latter finance is provided by large numbers of
investors and takeovers play a major governance role. Studies
showed that in the 1980s when the Japanese economy was being
touted as the best and worthy of emulation by other economies, such
bank-centered governance was widely regarded as superior, since it
enabled firms to make long term investment decisions, delivered
capital to firms facing liquidity crisis and thereby avoiding costly
financial distress, and above all, replaced the expensive disruptive
takeover with more surgical bank intervention when the
management of the borrowing firm under performed.
 Banks and Corporate Governance
(contd.)
The rosy situation, however, did not last long
enough. When the Japanese economy collapsed in
the 1990s, this form of financing and governance
was found faulty. Far from being the promoters of
rational investment, Japanese banks were found to
be the source of the soft budget constraint, over
lending to loss making firms that required
restructuring and resorting to collusion with
managers to prevent external threats to their
control and to collect rents on bank loans.
In the ultimate analysis of the two systems, the
market based system with its focus on legal
protection of investors, seems to be doing better
as was demonstrated time and again, the latest
being its successful riding of the American stock
market bubble of the 1990s.
 INVESTOR PROTECTION IN
INDIA
Small investors are the backbone of the Indian capital market
and yet a systematic study of their concerns and attempts to
protect them has been relatively of recent origin. Due to lack
of proper investor protection, the capital market in the
country has experienced a stream of market irregularities and
scandals in the 1990s. SEBI itself, though formed with the
primary objective of investor protection, took notice of the
issue seriously only after the Ketan Parikh Scam (2001) and
the UTI crisis (1998 and 2001) and has developed
sophisticated institutional mechanism and harnessed
computer technology to serve the purpose. Yet, there are still
continuing concerns about the speed and effectiveness with
which fraudulent activities are detected and punished, which
is after all, should be the major focus of the capital market
reforms in the country.
► The Household Investors Survey of SCMRD (1997) revealed
the following: (i) A majority of investors reported
unsatisfactory experience of equity-investing; (ii) 80% of the
investors said that they had little or no confidence in company
managements; (iii) 55% respondents showed little or no
confidence on the market regulator, SEBI; and (iv) Most
preferred saving instruments and government saving schemes
and banks’ fixed depositors. This reflected a considerable
erosion of investor confidence in securities and corporates.
Many subsequent investor surveys also found broadly the
same investor reactions.

► All these surveys underlined the need for restoring the

investor’s confidence in private corporates, which enjoy little
credibility with investors who have badly burnt their fingers in
a series of scams.
 Problems of Investors In India
Most of the investor complaints can be divided into three
broad categories:

1. Against Member–brokers of Stock Exchanges: Complaints of

this category generally centre around the price, quantity etc
at which transactions are put through defective delivery,
delayed payments or non-payments from brokers.
2. Against Companies Listed for Trading on Stock Exchanges:
Complaints against companies generally centre around
non-receipt of allotment letters, refund orders, non-receipts
of dividends, interest etc.
3. Complaints against Financial Intermediaries: These
complaints may be against sub-brokers, agents, merchant
bankers, issue managers and generally centre around
non-delivery of securities and non-settlement of payment
due to investors. However, these complaints cannot be
entertained by the stock exchanges, as per their rules.
Law Enforcement for Investor Protection

There are several agencies in India that are expected to

protect investors. Investor protection is a multi-dimensional
function, requiring checks at various levels, as shown
below:

► Company Level: Disclosure and Corporate Governance

norms.
► Stock Brokers Level: Self regulating organisation of
brokers.
► Stock Exchanges: Every stock exchange has to have a
grievance redressal mechanism in place as well as an
Investor Protection Find.
► Regulatory Agencies:

▪ Investors’ Grievances and Guidance Division of

SEBI
▪ Department of Company Affairs
▪ Department of Economic Affairs
▪ Reserve Bank of India
▪ Consumer Courts and Courts of Law
 Grievance Redressal Mechanisms
Redressal Mechanism of SEBI
Type Nature of Grievance Can be taken up with

Issue related i.e., non-receipt of refund order Investors Grievances and

I
allotment advice, cancelled stock invests. Guidance Division (IGG)
Investors Grievances and
II Non-receipt of dividend
Guidance Division (IGG)
Investors Grievances and
III Shares-related i.e., non-receipt of share certificates.
Guidance Division (IGG)
Debenture related i.e., non-receipt of debt Investors Grievances and
IV
certificates, non-receipt of warrants Guidance Division (IGG)
Non-receipt of letter offer of rights and interest on Investors Grievances and
V
delayed payments of refund orders Guidance Division (IGG)
Investors Grievances and
VI Complaints relating to collective investment scheme
Guidance Division (IGG)
VII Complaints relating to MF’s Mutual Funds Deptt., SEBI
Depositories and Custodian Cell,
VIII Complaints relating to Dematerialisation or DP’s
SEBI
It is likely that there may be complaints that
may be sometimes beyond the purview and
jurisdiction of SEBI. There may be many
problems arising due to corporate
misgovernance. The following table provides
a comprehensive mechanism of legal
protection to investors.
 Lacunae in Investor Protection
Though there is a redressal mechanism in place in the country,
investors could not get their complaints adequately addressed
to, much less solved to their satisfaction by these public
authorities. Multiplicity of authorities, overlapping functions,
lack of knowledge and understandingly the common investor
about these agencies and lack of enforcement have all acted
against investor protection. Notwithstanding the existence of
this seemingly comprehensive network of public institutions
established for investor protection in India, a series of scams
has taken place that has shaken the confidence of investors
since 1991, the year of economic liberalisation.

Loss of investor confidence due to these scandals that

conveyed an image of fraud and manipulation was so great that
even after several years of moribund stock market, things have
not improved. Scams burst out in the open due to
misgovernance, greed, corruption, inefficiencies and market
manipulations.
 SEBI’s POOR PERFORMANCE -
SUGGESTIONS FOR IMPROVEMENT

1. Poor Tackling of Price Manipulation and Insider Trading

Issues:
2. Poor Conviction Rate:
3. Need to Enhance its Manpower Skills:
4. It should Simplify and Trim Regulations:
5. It should Tone up Quality of Disclosures:
6. It should solve Issues of IPOs and Mutual Funds:
 Conclusion
► An objective analysis of the problems faced by investors
in countries like India, leading to an erosion of their
confidence in the capital market with the attendant
adverse impact on the economic growth shows that the
major problems arise due to corporate misgovernance
and not due to minor aberrations in following the
procedures set by SEBI. To rectify such a situation,
actions that lead to corporate misgovernance should be
codified and small investors be provided statuary rights
to enforce civil liability against the directors to recover
the losses to the company and its shareholders due to
their misdeeds and non-application of their minds in
investment or other decisions that have adversely
impacted the shareholders. Some of the misdeeds
would include:
 Conclusion (contd.)

► (i) Breach of fiduciary duty; (ii) Siphoning off corporate

funds; (iii) Misapplication of company’s funds; (iv) Price
manipulation or insider trading; (v) Manipulation of
accounts; (vi) Failure to disclose conflicts of interests;
(vii) Fraud or cheating; (viii) Misappropriation of
corporate assets; and (ix) Losses caused due to
mismanagement or negligence.

► In this context, it is pertinent to note that already law

courts have started imposing exemplary punishments to
directors who violated codes and guidelines on
corporate governance provided by competent
authorities.
► In India too, as per the dictates of a lower court, recently
the directors of a non-banking finance company have
agreed to pay back to the company a large sum of money
it lost, due to their indiscretion in an investment decision.

► Another important protection to the investor would be by

the strengthening the enforceability of accounting
standards in India, In India, though all the accounting
standards have been made mandatory as a result of
forceful pleas by various committees on corporate
governance, they have not still acquired the legal status, in
practice. This lack of legal sanction enables violators and
wrongdoers go scott free. Therefore, it is absolutely
necessary if the investor is to be protected and corporate
governance ensured for the larger benefit of the economy
and nation, all the accounting standards should be legally
enforced and exemplary punishments meted out to
violators.