Abstract The nascent debate on corporate governance in India has tended to draw heavily on the large Anglo-American literature on the subject. This paper argues however that the corporate governance problems in India are very different. The governance issue in the US or the UK is essentially that of disciplining the management who have ceased to be effectively accountable to the owners. The problem in the Indian corporate sector (be it the public sector, the multinationals or the Indian private sector) is that of disciplining the dominant shareholder and protecting the minority shareholders. Clearly, the problem of corporate governance abuses by the dominant shareholder can be solved only by forces outside the company itself. The paper discusses the role of two such forces - the regulator and the capital market. Regulators face a difficult dilemma in that correction of governance abuses perpetrated by a dominant shareholder would often imply a micro-management of routine business decisions which lie beyond the regulators¶ mandate or competence. The capital market on the other hand lacks the coercive power of the regulator, but it has the ability to make business judgements. The paper discusses the increasing power of the capital market to discipline the dominant shareholder by denying him access to the capital market. The newly unleashed forces of deregulation, disintermediation, institutionalization, globalization and tax reforms are making the minority shareholder more powerful and are forcing the companies to adopt healthier governance practices. These trends are expected to become even stronger in future. Regulators can facilitate the process by measures such as: enhancing the scope, frequency, quality and reliability of information disclosures; promoting an efficient market for corporate control; restructuring or privatizing the large public sector institutional investors; and reforming bankruptcy

and related laws. In short, the key to better corporate governance in India today lies in a more efficient and vibrant capital market. Of course, things could change in future if Indian corporate structures also approach the Anglo-American pattern of near complete separation of management and ownershipCorporate Governance in India: Disciplining the Dominant Shareholder - Jayanth Rama Varma Reproduced with the permission of IIMB Management Review, the journal of the Indian Institute of Management, Bangalore , in which the paper was first published (OctoberDecember 1997, 9(4), 5-18). IIMB Management Review(http://www.iimb.ernet.in/review). All rights reserved 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. This paper argues however that the crucial issues in Indian corporate governance are very different from those in the US or the UK. Consequently, the corporate governance problems in India require very different solutions at this stage of our corporate development. The corporate governance literature in the US and the UK focuses on the role of the Board as a bridge between the owners and the management (see for example; Cadbury, 1992; Salmon, 1993; Ward, 1997). In an environment in which ownership and management have become widely separated, the owners are unable to exercise effective control over the management or the Board. The management becomes self perpetuating and the composition of the Board itself is largely influenced by the likes and dislikes of the Chief Executive Officer (CEO). Corporate

governance reforms in the US and UK have focused on making the Board independent of the CEO. Many companies have set up a Nominations Committee of the Board to enable the Board to recruit independent and talented members. There is now increased recognition of the role that the Board could play in providing a strategic vision to the company. The Compensation Committee of the Board has been strengthened to exercise greater control over CEO compensation following widespread complaints that top management pay is disproportionate to performance. There is also a great deal of discussion in the literature on the role of the Board in firing non performing management and in managing the CEO succession. Perhaps the most powerful and well established of the Board committees is the Audit Committee. Apart from acting as a deterrent against financial improprieties and frauds, the Audit Committee also enables the Board to keep a pulse on the financial health of the company. Turning to the Indian scene, one finds increasing concern about improving the performance of the Board. This is doubtless an important issue, but a close analysis of the ground reality in India would force one to conclude that the Board is not really central to the corporate governance malaise in India. As elaborated at length in this paper, the central problem in Indian corporate governance is not a conflict between management and owners as in the US and the UK, but a conflict between the dominant shareholders and the minority shareholders. The Board cannot even in theory resolve this conflict. One can in principle visualize an effective Board which can discipline the management. At least in theory, management©IIMB Management Review (http://www.iimb.ernet.in/review). All rights reserved. 2 exercises only such powers as are delegated to it by the Board. But, how can one, even in theory, envisage a Board that can discipline the dominant shareholders from whom the Board derives all its powers? Some of the most glaring abuses of corporate governance in India have

been defended on the principle of ³shareholder democracy´ since they have been sanctioned by resolutions of the general body of shareholders. The Board is indeed powerless to prevent such abuses. It is indeed self evident that the remedies against these abuses can lie only outside the company itself. It is useful at this point to take a closer look at corporate governance abuses by dominant shareholders in India. The problem of the dominant shareholder arises in three large categories of Indian companies. First are the public sector units (PSUs) where the government is the dominant (in fact, majority) shareholder and the general public holds a minority stake (often as little as 20%). Second are the multi national companies (MNCs) where the foreign parent is the dominant (in most cases, majority) shareholder. Third are the Indian business groups where the promoters (together with their friends and relatives) are the dominant shareholders with large minority stakes, government owned financial institutions hold a comparable stake, and the balance is held by the general public. The governance problems posed by the dominant shareholders in these three categories of companies are slightly different. Public Sector Units (PSUs) The governance structures of PSUs date back to the days when they were typically wholly owned by the government and were merely an extended arm of the state. These structures allowed the administrative departments in the concerned ministry to exercise virtually complete control over the functioning of these enterprises. It is now evident that these structures are incompatible with the efficient and successful operation of the PSUs in an increasingly competitive and deregulated economy. These issues are discussed extensively elsewhere in this volume (Vittal, 1997), and I shall not go into them again here. It is interesting however to observe how totally irrelevant the Board really is in the governance of the PSUs today. The Board has no role to play in any of the areas where US and UK reformers have sought to strengthen the Board. The Board has very little say in the selection

there is a clear difference between directing and managing. There was a well-known case a few years ago where a dispute of several billion rupees arose between two PSUs. Many operating decisions have to be brought to the Board for decision making. The current governance structure allows the Board to play a highly obstructive role if it chooses by opposing the CEO on©IIMB Management Review (http://www. All rights reserved. again the dominant role is that of the Comptroller and Auditor General (CAG). 3 operational matters. What it does not allow the Board to do is to play a meaningful strategic role since all strategic decisions are taken by the dominant shareholder through the concerned ministry.iimb. One of these was wholly owned by the government while in the other there was a minuscule public shareholding. the Board may still be powerful on paper because the delegation of financial and operating powers to the CEO is very limited.ernet. and the Board¶s legitimate function is directing.of the CEO or in the composition of the Board.in/review). 1997). there is a serious corporate governance problem in the resolution of the dispute in this manner without . The more interesting issue which has not received much attention so far is the potential that exists for conflict between the dominant shareholder and the minority (public) shareholders. This does not however make for an effective Board because it pushes the Board into ³managing´ rather than ³directing´. In many PSUs. The government sided with the wholly owned forced PSU and forced the other PSU to pay up the disputed amount. As far as audit is concerned. There is very little that an Audit Committee could add to what the CAG does. The Board cannot fire the CEO nor can it vary his compensation package. The government as the majority shareholder takes these decisions through the concerned ministry with the help of the Public Enterprises Selection Board. and the impact on the earnings of the concerned PSU was quite substantial. The merits of the dispute apart. As discussed elsewhere in this volume (Balasubramaniam.

This obviously meant a large loss to the minority shareholders. In fact when the government introduced regulations to prevent such preferential issues. A minority shareholder could certainly have regarded it as a simple case of enrichment of the dominant shareholder at the expense of the minority shareholder. . the MNCs protested against what they called an assault on ³shareholder democracy´. Multi National Corporations (MNCs) Government regulations have required most MNCs in India to operate through subsidiaries which are not 100% owned by the parent. In the 90s when the law permitted higher foreign ownership.either arms¶ length negotiation or a resort to a judicial process. The controls that then existed on pricing of public issues meant that these issues were at substantial discounts to the market price. These regulations have created severe corporate governance problems in several key areas as may be seen from the examples below. the government enacted a law limiting foreign ownership in most industries to 40% while allowing 51% in a few high technology areas. conflicts of this kind would become more frequent and more serious. This and other similar share issues by MNCs were made with the explicit consent of the shareholders in general meeting. The parent companies with their dominant shareholding were able to get the resolutions passed with impressive majorities. One particular case where shares were issued to the parent at less than one-tenth the market price was analysed in detail by Barua and Varma (1993a and 1993b). MNCs were forced to issue shares to the Indian public to comply with the law. In the 70s. these MNCs raised the foreign stake by issuing shares at very deep discounts to the market price. This law was liberalized in the 90s and now 51% is permitted in most industries while 74% or even 100% ownership is allowed in some cases. In the 70s. They calculated that the net gain to the foreign parent after compensating for the loss that it suffered in the 70s (together with interest thereon at market rates of interest) amounted to over $200 million. As government divestiture of minority stakes in PSUs gathers pace.

4 There have been allegations in some cases that the most profitable brands and businesses have been transferred from the long established 51% subsidiary to the newly formed 100% subsidiary at artificially low prices. Minority shareholders could only watch in dismay as the royalties knocked off a sizeable chunk of the earnings of the company. It is sometimes difficult to establish the total effective holding of this group. In the Indian business groups. First.iimb. Second. One well-known example involves a company where the parent has recently started collecting royalties for the use of a brand.Another corporate governance problem arises where the foreign parent has two subsidiaries in India in one of which it holds a higher stake (say 100%) while in the other it holds a smaller stake (say 51%). Indian Business Groups The situation in this category of companies is more complex than in the PSUs and the MNCs where there are clearly defined dominant shareholders. the aggregate holding of all these entities taken together is typically well below a majority stake.in/review). the concept of dominant shareholders is more amorphous for two reasons. All rights reserved. The manner in which the MNC structures its business in India between these two subsidiaries is riddled with problems as far as the minority shareholder is concerned. the promoters¶ shareholding is spread across several friends and relatives as well as corporate entities. In many .©IIMB Management Review (http://www. In this case. Yet another problem is the payments that parent companies increasingly demand for all the services that they provide to their subsidiaries.ernet. India is actually the principal market for this brand and the Indian company had assiduously cultivated the brand through decades of advertising paid for in part by the minority shareholders. This implies a large loss to the minority shareholders of the 51% subsidiary who have after all contributed to in equal measure to the investments that were made in the past to build up these businesses to their current dominant position.

the promoter may not even be the largest single shareholder.iimb. the true picture of the business is much healthier because of the©IIMB Management Review (http://www. All rights reserved. many Indian business groups have succumbed to the lure of black money. the promoters are effectively dominant shareholders and are able to get general body approval for all their actions.cases.structuring of businesses and transfer of assets between group companies. 5 profits pouring in in the form of black money. Though there have been several honourable exceptions. This allows the promoters to play all the games that dominant shareholders play in PSUs and MNCs . The literature on black money views it primarily as a means of cheating the government of its legitimate dues. The situation in some of these business groups is strongly reminiscent of what the father of . It is a standard joke among bankers in India that there are many financially sick companies but no financially sick promoters.in/review). they were widely seen as acting at the behest of their political masters and not in pursuance of their financial interests. What makes the promoters the dominant shareholders is that a large chunk of the shares is held by state owned financial institutions which have historically played a passive role. Quite often when a company makes losses in its books. payments for ³services´ to closely held group companies and so on. preferential allotments of shares to the dominant shareholder. So long as the financial institutions play a passive role. So passive have they been that in the few cases where they did become involved in corporate governance issues. a large parallel black economy has developed in India where transactions are carried out in cash and are not recorded in the books of accounts. But the fact that it is not accounted for in the company¶s books means that it is also cheating the minority shareholders. Over several decades of the command economy. But there are a number of new games too.ernet. Some industries were at one stage so strongly permeated by the black economy that it was almost impossible to carry on business without using black money.

deregulation and competition would gradually reduce the role of black money to the point where it is confined to isolated cases of corruption. yet in the appointment of the plunderers of India .. It gives him a share. It has been alleged that in many of these cases. Part III. This is partly because tax rates are now lower. Tax reforms coupled with economic liberalization have tilted the balance away from black money transactions. he cares little about the dividend. though not in the plunder. Mergers are subject to approval by shareholder bodies of both companies as well as judicial review. the promoters had secretly built up large positions in this company as a cheap means of acquiring shares of the merged company.economics. Adam Smith. wrote over two centuries ago about the rampant corruption in the East India Company: ³Frequently. Provided he can enjoy this influence for a few years. There have been several instances where the valuation of two group companies for the purpose of merger has been perceived to be biased in favour of one of the companies.. or even the value of the stock upon which his vote is founded´ (Smith. But shareholder democracy is an empty defence against the dominant shareholder. Another important corporate governance issue is that of mergers and restructuring of companies in the same group. The Regulatory Dilemma . sometimes even a man of small fortune is willing to purchase a thousand pounds share in India stock merely for the influence which he expects to acquire by a vote in the court of proprietors. and partly because increasing scale economies make it more difficult to operate with the informal organizational structures and financial arrangements that black money entails. Article 1st). 1776. Chapter I. The amorphous nature of the promoter group makes it very difficult to verify these allegations. Book V. a man of great fortune. and thereby provide for a certain number of his friends. It is to be hoped that tax reforms.

Regulators face a number of difficulties in tackling the problem of corporate governance abuses by the dominant shareholders. corporate governance is primarily contractual in nature. Shareholder Democracy A much talked about regulatory dilemma is that of balancing the rights of minority shareholders against the principle of shareholder democracy. In some cases (non voting .in/review). In many ways. this regulatory dilemma is not as serious as it might appear at first sight. 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.iimb. Some of these problems are highlighted below.rights to profits and assets. Shares are first and foremost ownership rights . All rights reserved. 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. it is difficult to decide how far the regulator should go in interfering with the normal course of corporate functioning. 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 very term shareholder democracy represents a misguided analogy between political governance and©IIMB Management Review (http://www. Shareholder democracy is not the essence of the corporate form of business at all. and corporate governance is at bottom a matter of enforcing the spirit of this contractual relationship. Unlike political governance. 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. 6 corporate governance. On closer examination.ernet. In many cases.

The dilemma of micro-management Corporate governance abuses perpetrated by a dominant shareholder pose another and far more difficult regulatory dilemma. 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. The company would then effectively become an extended arm of the state.rights to appoint the Board and approve certain major decisions. In a competitive world. it is no answer to say that his control rights have been fully respected. 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 . 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).iimb.they are drastic remedies suitable only for the gravest cases of misgovernance. Regulatory intervention would often imply a micromanagement of routine business decisions.in/review).shares for example) that is all there is to it. All rights reserved. If a shareholder¶s ownership rights have been trampled upon. 7 . Regulatory intervention must perforce be confined to a few clearly defined prohibitions and restrictions that require minimal exercise of regulatory discretion. shares also carry some secondary rights including the control rights . highly complex business decisions have to be taken quickly and smoothly.ernet. the regulator would end up running the company by remote control. In other cases. Some examples of these issues are discussed later in this paper.©IIMB Management Review (http://www. This approach carries with it the danger that broad prohibitions would also stand in the way of many legitimate business transactions. Subjecting a large number of these decisions to the process of regulatory review would make a travesty of a free economy.

This is. 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 ³going concern´. In particular. The Tribunal could also provide for some directors of the company to be appointed by the Central Government. Rather than let the value of his shareholding be frittered away by the enrichment of the dominant shareholder. In most realistic situations. the ultimate resort for a shareholder to enforce his ownership rights. order the buyout of the minority shareholders by the other shareholders or by the company itself. though one may wonder whether these . 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. he approaches the court to wind up the company and give him his share of the assets of the company. but that such winding up would unfairly prejudice the members. It is well known that winding up and other bankruptcy procedures usually lead only to the enrichment of the lawyers and other intermediaries involved. the Tribunal may regulate the conduct of the company¶s affairs in future. set aside or modify certain contracts entered into by the company.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. 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. of course. Instead of approaching the Court. they can approach the Company Law Board (now proposed to be renamed as the Company Law Tribunal). or appoint a receiver. 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. 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. or by proportional representation.

It also requires that when shareholder approval is sought for various decisions. All rights reserved. but it is a prerequisite for the minority shareholders to be able to exercise any of the other means available to them. 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. Effective participation by small shareholders is possible only if there is a cost effective way of waging a proxy campaign. 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. This would enable dissenting shareholders to collect proxies from others and prevent measures which are prejudicial to the minority shareholders. Disclosure does not by itself provide the means to block the dominant shareholders. Special majority 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.in/review).ernet. Regulatory Response: Securities Law . Disclosure is also a vital element in the ability of the capital market to exercise its discipline on the issuers of capital.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. 8 Information disclosure and audit Company law provides for regular accounting information to be supplied to the shareholders along with a report by the auditors. the company must provide all material facts relating to these resolutions including the interest of directors and their relatives in the matter.©IIMB Management Review (http://www. Even otherwise. The Indian system does not allow for postal ballots.iimb.

In India. Promoters¶ contribution and lock in Another aspect of the SEBI regulations is that in most public issues. One of the most valuable is the information on the performance of other companies in the same group. 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. the Securities and Exchange Board of India (SEBI) was set up as a statutory authority in 1992. no dominant shareholder. they would not make much of a difference to most of the companies in those countries as these companies would typically fall in this . 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 other words. and has taken a number of initiatives in the area of investor protection. most matters relating to the rights of shareholders were governed by the company law. Information disclosure As discussed above. The SEBI regulations provide an exemption to those companies where there is no identifiable promoter group. Some of these disclosures are important in the context of dealing with the dominant shareholder. that is to say. This however is not so at all. At first sight. in many countries. 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 information enables investors to make a judgement about the past conduct of the dominant shareholder and factor that into any future dealings with him.Historically. if these regulations were copied by US and UK regulators. 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. Over the last few decades. particularly those companies which have accessed the capital markets in the recent past.

9 The SEBI regulations deal with a corporate governance problem very different from the US and UK problems. 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. Apart from this category of promoters. All rights reserved. Many of them might even otherwise plan to have a stake of more than 20% (probably as high as 51%) to exercise unquestioned control. 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. 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.in/review).©IIMB Management Review (http://www. 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.iimb. 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.ernet. 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. the requirement of shareholder approval is quite meaningless when there is a dominant shareholder. This regulatory intervention illustrates very nicely the problems that the regulator faces in . In 1994.category of not having an identifiable promoter group. As has been pointed out earlier in this paper. the SEBI regulations may not be much of a constraint for most dominant shareholders. but from one sided deals which help them transfer profits to other entities owned by the promoters themselves.

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.ernet.©IIMB Management Review (http://www. 10 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.in/review). 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. At the extreme. This suggests that the six month period mandated by the regulator is perhaps excessive. the regulatory problem created by averaging can be reduced but cannot perhaps be eliminated. All rights reserved.iimb. 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 price. There have been many occasions where the Indian stock market index has fallen by about 50% during a period of six months.dealing with governance abuses by the dominant shareholder. In other words. However. 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 . one may even consider just the closing price on the day on which the allotment is made. One possible regulatory solution to this problem might be to use an average over a significantly shorter period than six months. This option is typically based on the market prices for 30 or more consecutive trading days and not just one trading day. 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. There is an interesting parallel with issues of convertible bonds in international markets where there is a call option to the company. One situation could be where the stock market as a whole has fallen sharply over the last six months and the six monthly average is far above the prevalent market price.

Market gossip has long speculated on the prevalence of such trades in the build up to large mergers especially between group companies. 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. Again. The regulatory intervention on preferential allotment may thus have the wholly unintended consequence of denying the company access to the capital market completely. 1997). In the context of this paper. in the United States and the United Kingdom there have been a large number of well publicized and successful actions against insider trading. Some . insider trading may be indulged in by directors and other senior employees. the interesting cases are large scale trades by the dominant shareholder.equity significantly below the ruling market price. At the same time for reasons of size or otherwise. In a few instances. In short. a public issue may be infeasible. however. Insider trading Securities regulators around the world have framed various regulations to deal with the problem of insider trading. However. The situation is not very much better in many other countries. Many of them involve small trades by junior employees who come to know of price sensitive information. The existence of regulations does not necessarily mean that they are enforced. but no such definition can be wholly satisfactory. one can think of modifications in the regulations that would exempt arms¶ length transactions defined in some suitable way. for example. a recent report on insider trading pointed out that in the quarter century that the insider trading law has been in existence in that country. Most instances of insider trading have nothing to do with the dominant shareholder. Many public issues for example are typically made at discounts of 15-20% to the ruling market price. there has not been a single prosecution (King. The prohibition on making preferential issues at a discount would effectively rule out such private placements altogether. In South Africa. This is a dilemma that simply will not go away.

In a well functioning market for corporate control. The take-over regulations in India require that a slice of this cake be shared with other shareholders.promoters have merged small companies in which they have a large stake into a larger more widely held company at a swap ratio which is highly unfavourable to the widely held company. The acquirer of a controlling block of shares must make an open offer to the public for at least 20% of the issued share capital of the target company at a price not below what he paid of the controlling block. the acquirer is bound to accept only 20% on a pro-rata basis. A cash rich . These allegations have been difficult to prove in most instances as the promoters can act through numerous friends. All rights reserved. They can also sell their shares in the secondary market thereby depressing the share price.in/review). When SEBI recently initiated action for insider against a large multinational in a somewhat different situation. Minority investors may rarely attend shareholder meetings where the dice are loaded against them. Take-overs Instead of directly exploiting all the privileges that his controlling block gives him. but they are continuously voting with their wallets. the dominant shareholder can choose to sell his entire holding to somebody else. he can expect to get a premium over the market©IIMB Management Review (http://www. 11 price equal to the present value of all the privileges that the dominant shareholder can enjoy in future.ernet. Discipline of the capital market Corporate governance is such a burning issue for regulators that it is often forgotten that the capital market by itself exercises considerable discipline over the dominant shareholder. Of course.iimb. They can vote with their wallets in the primary market by refusing to subscribe to any fresh issues by the company. if more than 20% of the shareholders want to sell at that price. the action proved to be highly controversial and the ultimate resolution of this case remains uncertain. relatives and other fronts.

A depressed share price makes the company an attractive take-over target. the price at which such companies can raise funds from the public will reflect the true worth of the business less the present value of all privileges that the market expects the dominant shareholder to extract in future. This impact is further strengthened when the minority shareholders are large institutions (both domestic and foreign) who. but the next time around. dividend discount model or discounted cash flow model) and then to subtract a ³management discount´ of 15% or 20% depending on the particular management group involved.company with no foreseeable need for additional funds can be relatively unconcerned about this kind of action by minority shareholders. in a sense. For these companies. the dominant shareholder (unless he holds a clear 51%) faces the risk of being ousted in a take-over battle. Indian companies that opened their doors to foreign investors have seen this power of the minority shareholder in very stark terms. In fact. however. It is quite common for investors in India to value a scrip using a standard financial model (like the price-earnings model. Even in this case. they have an even more profound effect on the ability of the companies to tap the capital markets. in equilibrium. The most powerful impact of voting with the wallet is on companies with large growth opportunities that have a constant need to approach the capital market for additional funds. shareholder disenchantment can be very expensive. This management discount reflects the present value of all future losses to the minority shareholder from governance abuses by the dominant shareholder. A well functioning market for corporate control makes this threat more real. but pretty soon they can form a fair idea of the nature of the dominant shareholders and what they are likely to do. . If these market expectations are fulfilled. The market may be fooled once or twice. the minority shareholders have little cause for complaint since they end up getting what they paid for. When they vote with their wallets and their pens. These investors can perhaps be fooled once as easily as any other intelligent investor. act as the gatekeepers to the capital market.

particularly the lead manager has with the issuer enables it to make a better assessment about the corporate governance of the company involved..©IIMB Management Review (http://www.iimb. there is no track record on the basis of which the market can assess the damage that the dominant shareholder is likely to do. 1997).in/review). The role of gatekeepers is quite crucial when a company accesses the capital market infrequently. It is unfortunate that the domestic financial institutions have played too passive a role so far and have so far failed to exercise their true powers both as large minority shareholders and as potential gatekeepers. All rights reserved. In the mid-90s. The experience of the last few years suggests that a more pro-active role is possible only when these institutions are fully privatized and are driven by their bottom lines rather than by their political bosses. The privileged relationship that the investment bank. The investment bank definitely is no stranger to the capital markets.. The other possibility is that the government persuades these institutions to . . 12 company after company in India has woken up in this manner to the power that minority shareholders enjoy when they also double up as gatekeepers to the capital market.ernet. and it has a reputation to defend because it needs to come back to the market again and again. In well-developed capital markets. ³The apparent failure of government controlled FIs [financial institutions] to monitor companies in their dual capacity as major creditors and major shareholders has much to do with a pervasive anti-incentive structure. When a company comes to the market for the first time. large investment banks perform the gatekeeping function of making a judgement about the company and its management. The long term solution requires questioning the very basis of majority government ownership of the FIs´ (Bajaj.the company finds that its ability to tap the international markets with an offering of Global Depository Receipts (GDRs) or other instrument has practically vanished. This judgement is reflected in its pricing decisions.

Most debt contracts therefore involve covenants that make it less easy for the dominant shareholder to indulge in gross abuses. voting with the wallet is quite the opposite of shareholder activism (Pozen.in/review). On the contrary. the ability of debtholders to enforce their rights against recalcitrant debtors has been hampered by an inefficient legal system. the corporate bankruptcy laws work against the creditors by allowing the debtor to remain in possession of the assets for a long period while compromises or other arrangements are worked out. The ability of debtholders to monitor the company is quite high because typically they are large institutions with a strong gatekeeping role.is very different from the shareholder activism that is being projected as a solution to the corporate governance problems in the US and the UK. seize collateral or obtain decrees.ernet. 13 In a well functioning capital market. 1994). They thereby reduce the ability of the company to service its debt in accordance with contractual obligations. he has both the incentive and the ability to monitor the actions of the company. Moreover.divest their shareholdings in corporate India to more transparent private sector institutions. the debtholder has contractual rights to receive his interest and principal. It is important to emphasize that the role of the institutions in disciplining the dominant shareholder envisaged here . Unlike the shareholder who is a residual claimant. An untested management group is likely to find that .iimb. there is a strong incentive for corporate managements themselves to voluntarily adopt transparent processes and subject themselves to external monitoring to reassure potential investors. In India. Many serious instances of corporate misgovernance reduce the future earnings stream of the company or the value of its assets. All rights reserved. Another aspect of the capital markets is the powerful disciplining power of debt.©IIMB Management Review (http://www.essentially of voting with their wallets . It is difficult for creditors to foreclose mortgages.

but they apply with far greater force to the Indian context. A . the multinationals or the Indian private sector) is that of disciplining the dominant shareholder and protecting the minority shareholders. The problem in the Indian corporate sector (be it the public sector. They have sought to cultivate an image of being honest with their investors and of being concerned about shareholder value maximization. the market is not bound by broad rules and can exercise business judgement. the market is very good at micro level judgements and decisions. It therefore makes sense for the regulator to pass on as much of the burden of ensuring corporate governance to the markets as possible.the market places a ³management discount´ on them that reflects what the market has come to expect of management groups in general. The management then has every incentive to take steps that will reduce this ³management discount´ by making governance abuses more difficult. In the last few years. Unlike the regulator. In fact the market is taking micro decisions all the time. The governance issue in the US or the UK is essentially that of disciplining the management who have ceased to be effectively accountable to the owners. 1993). It is its success in doing so that makes it such an efficient allocator of capital. we have seen Indian companies voluntarily accepting international accounting standards though they are not legally binding. The solution has been to improve the functioning of vital organs of the company like the board of directors. They have voluntarily gone for greater disclosures and more transparent governance practices than are mandated by law. Similar views have been expressed about corporate governance problems even in the United States (Pound. The regulator can then concentrate on making the markets more efficient at performing this function. Conclusion This paper has argued that structural characteristics of the Indian corporate sector make the corporate governance problems in India very different from that in say the US or the UK. What makes capital market discipline so much more attractive than regulatory intervention is that unlike the regulator.

©IIMB Management Review (http://www. They are also adopting more healthy governance practices.ernet. The past few years have witnessed a silent revolution in Indian corporate governance where managements have woken up to the power of minority shareholders who vote with their wallets.in/review).iimb. This paper has discussed the role of two such forces . The regulator is forced to confine himself to broad proscriptions which leave little room for discretionary action. . In response to this power. Many corporate governance problems are ill suited to this style of regulation. the more progressive companies are voluntarily accepting tougher accounting standards and more stringent disclosure norms than are mandated by law. it would not make the governance problem any easier to solve. the problem of corporate governance abuses by the dominant shareholder can be solved only by forces outside the company itself. What it has however is the ability to make business judgements and to distinguish between what is in the best interests of the company as a whole as against what is merely in the best interests of the dominant shareholders.board which is accountable to the owners would only be one which is accountable to the dominant shareholder. Clearly. 14 The capital market on the other hand lacks the coercive power of the regulator. All rights reserved.the regulator (the company law administration as well as the securities regulator) and the capital market. Denial of market access is a very powerful sanction except where the company is cash rich and has little future needs for funds. The only effective sanction that the market can impose against an offender is to restrict his ability to raise money from the market once again. Corporate governance abuses perpetrated by a dominant shareholder pose a difficult regulatory dilemma in that regulatory intervention would often imply a micro-management of routine business decisions.

investors and intermediaries to the higher standards of disclosure and corporate governance that prevail in more developed capital markets. frequency.It is evident that these tendencies would be strengthened by a variety of forces that are acting today and would become stronger in years to come: ‡ Deregulation: Economic reforms have not only increased growth prospects.ernet. 15 .in/review). the increasing institutionalization of the capital markets has tremendously enhanced the disciplining power of the market.©IIMB Management Review (http://www. While these factors will make the capital markets more effective in disciplining the dominant shareholder. but they have also made markets more competitive. ‡ Regulatory measures that promote an efficient market for corporate control would create an effective threat to some classes of dominant shareholders as discussed earlier. quality and reliability of the information that is disclosed. ‡ Institutionalization: Simultaneously. All rights reserved. This means that in order to survive companies will need to invest continuously on a large scale. The regulator can enhance the scope. there are many things that the government and the regulators can do to enhance this ability: ‡ Disclosure of information is the pre-requisite for the minority shareholders or for the capital market to act against errant managements. ‡ Disintermediation: Meanwhile.iimb. ‡ Globalization: Globalization of our financial markets has exposed issuers. This makes the worst forms of misgovernance less attractive than in the past. financial sector reforms have made it imperative for firms to rely on capital markets to a greater degree for their needs of additional capital. ‡ Tax reforms: Tax reforms coupled with deregulation and competition have tilted the balance away from black money transactions.

enforcement is a major problem with slow. notwithstanding copious reporting requirements. China and Russia. Over a period of time. ‡ Large blocks of shares in corporate India are held by public sector financial institutions who have proved to be passive spectators. these issues which dominate the Anglo-American literature on corporate governance are of peripheral relevance to India. it is possible that Indian corporate structures may approach the Anglo-American pattern of near complete separation of management and ownership. Alternatively. Until then. In short. and has a well-functioning banking sector with one of the lowest proportions of nonperforming assets.‡ Reforms in bankruptcy and related laws would bring the disciplining power of the debtholders to bear upon recalcitrant managements. Ownership remains concentrated and family business groups continue to be the dominant business model. There is significant pyramiding and tunneling among Indian business groups and. At that stage. While on paper the country¶s legal system provides some of the best investor protection in the world. corporate governance in India does not compare unfavorably with any of the other major emerging economies: Brazil. 2007 Abstract This study describes the Indian corporate governance system and examines how the system has both supported and held back India¶s ascent to the top ranks of the world¶s economies. These shareholdings could be transferred to other investors who could exercise more effective discipline on the company managements. these institutions could be restructured and privatized to make them more vigilant guardians of the wealth that they control. the key to better corporate governance in India today lies in a more efficient and vibrant capital market. India ranks high on the ease of getting credit. Corporate Governance in India December 8. . India too would have to grapple with governance issues like empowerment of the board. evidence of earnings management. over-burdened courts and significant corruption. The two main Stock Exchanges have among the highest number of trades in the world. However.

and the relatively young Securities and Exchanges Board of India has a rigorous regulatory regime to ensure fairness.edu William L. Price College of Business. Most importantly. 405-325-6640 E-mail: pyadav@ou. Adams Hall 205A. India should have the quality of corporate governance necessary to sustain its impressive current growth rates. Government Policy and Regulation JEL Classifications: G34. total equity issuance . In 2006. Keywords: Corporate Governance. with growth rates averaging in excess of 8% for the past four years. the corporate governance landscape in the country has been changing fast over the past decade. a stock market that has risen over three-fold in as many years and a steady inflow of foreign investment. Megginson Professor & Rainbolt Chair in Finance Michael F. International Financial Markets. G18 Rajesh Chakrabarti Assistant Professor of Finance Indian School of Business. 307 W.edu 2 Corporate Governance in India Introduction One of the major economic developments of this decade has been the recent take-off of India. particularly with the enactment of SarbanesOxley type measures and legal changes to improve the enforceability of creditor¶s rights. G15. Yadav W. India ± 500 032 Tel: +91-40-2318-8320 E-mail: rajesh_chakrabarti@isb. OK 73019 Tel. 205A Adams Hall The University of Oklahoma Norman. transparency and good practice. 307 West Brooks. Oklahoma University. OK 73019-4005 Tel/Fax: (405) 325-2058/325-7688 E-mail: wmegginson@ou. Michael F.edu Pradeep K. Hyderabad. Norman. Ross Johnston Chair in Finance and Professor of Finance. If this trend is maintained. Price College of Business. Brooks.

the highest in the rankings presented by Rafael La Porta. including developments affecting corporate governance of financial institutions. pp. up 38%. on paper.´ Journal of Political Economy 106. And. Section 5 reviews the recent literature on corporate governance in India.2 billion in India. The aim of this paper is to present an overview of India¶s corporate governance system. United Kingdom.reached $19. The next section makes an assessment of the legal and institutional aspects of investor protection and corporate governance in India ± both the letter of the law and the reality of its implementation. Indian companies were also among the world's most active issuers of depositary receipts in the first half of 2006. 1998. and South Africa (all English-origin-law countries). 1113-1150. and is equal to those of the United States. Hong Kong. Florencio Lòpez-de-Silanes. driven by a 371% increase in outbound acquisition--exceeding for the first time inbound deal volumes. and several times greater than the number of trades on the London Stock Exchange or Euronext. Florencio Lòpez-deSilanes. accounting for one in three new issues globally. while merger and acquisition volume was a record $27. the number of trades on the National Stock Exchange of India. in each of the years 2005 and 2006. Andrei Shleifer. 2. Canada. just behind NASDAQ and the New York Stock Exchange. according to the Bank of New York. Debt issuance reached an all-time high of $13. India has a shareholder rights index of 5 (out of a maximum possible of 6). Pakistan.8 billion. 3 .7 billion. ³Law and Finance. provides one of the highest levels of investor protection in the world. one of the two major Indian Stock Exchanges. and 1 See Rafael La Porta. and Rob Vishny in their 1998 study 1 . up 28% from a year earlier. Section 6 summarizes and concludes. and Rob Vishny. while section 4 looks at changes in corporate governance since liberalization started in the early 1990¶s. The Institutional Environment in India ± An Assessment Business Laws and Regulations The Indian legal system is built on English common law and. Andrei Shleifer. up 22%. was third highest in the world. Section 3 briefly describes the historical evolution of corporate governance in India. The long-term sustainability of the India ³success´ story depends critically on the state of corporate governance in the country.

better than that of Australia. the requirement that secured creditors are to be paid first. et al (1998) enforcement variables. With no automatic stay on assets in the reorganization phase. India has been ranked 72 nd out of 180 countries in the Corruption Perception Index 2007. but they lag behind each of the English-origin countries rated. On the other hand. constructed using figures obtained from private country risk rating agencies. the Indian legal system also seems to provide excellent protection for lenders. Doing Business 2008. just behind the English-law average of 8.67.17 on the ³Rule of Law´ index.higher than all the other 42 countries in the study including countries like France. bribery. Japan. now popularly labeled as the BRIC countries. et al (1998) metric. kickbacks in procurement. also gives India a relatively high score of 6 on creditors¶ rights. Germany. Scores from 3 to 5 indicate that corruption is perceived to be a . On the corruption dimension. and the provision for replacing management in reorganization. a World Bank publication. a poll of polls. This Corruption Perceptions Index is intended ³as a composite index. ranking 41 st out of 49 countries studied. the La Porta. China (3). India has a corruption perception index of 3. not to mention civil law countries. e. However. India has a score of 4. Canada. India¶s accounting standards are also better than the sample average across all countries rated.7. India gets a score of 8 out of 10 on the ³efficiency of judicial system´ variable. and the strength of anti-corruption policies. and Switzerland.g. In terms of creditor rights. and Russia (3).3 to 3. India has a creditor rights index of 4 (the maximum possible). suggest that the that de facto protection of investor¶s rights in India lags significantly behind the de jure protection. published by Transparency International. drawing on corruption-related data from expert and business surveys´ carried out by 14 sources originated from 12 independent institutions on the ³degree to which corruption is perceived to exist among public officials and politicians´. Ireland. well ahead of the other major emerging economies. Brazil (2). New Zealand and the United States.15 and better than the overall sample average of 7.5 with a ³confidence interval´ of 3. according to the La Porta. It focuses on the public sector and on abuse of public office for private gain. embezzlement. restrictions on going into reorganization.

However. worse than Brazil ranked 107 th but still much better than China ranked 175 th and Russia ranked 177 th . the U. It is ranked 36 th .³serious challenge´ while scores below 3 indicate ³rampant corruption´. Brazil and China have the same corruption perception index of 3.S. which is worse than the global average but compares favorably with the average of 13 procedures over 72 days for the other BRIC countries. India is ranked 85 th .6. Red tape and regulations are among the main deterrents for business and foreign investment in India. but slightly ahead of Brazil ranked 122. each of whom are ranked 84 th . on average. leading to its latest ranking of 120 out of 178 in the World Bank¶s Doing Business 2008 publication 2 .3 (country rank 143). albeit with wider confidence intervals. Delays and costs of dealing with licenses in India are also far worse than the global average. a little behind China ranked 83 and Russia ranked 106. significantly ahead of Brazil. is ranked 20 th with a index of 7. Interestingly. 13 2 See World Bank. India¶s creditors¶ rights score is particularly good. Washington DC. India scores well on getting credit. but there is no credit information available from public registries. India is ranked 111 th out of 178 for the ease of starting a business. In comparison. 4 procedures over 33 days. while Russia has a much lower index of 2. World Bank and Oxford University Press.5. worse than Russia (ranked 50) but better than Brazil (ranked 122) and China (ranked 135). with India ranked 134 th out of 178. India¶s entrepreneurs must follow. Doing Business 2008. 2008.8%). China and Russia. and there is a serious paucity of credit information available from private bureaus (only 10.

An extremely important aspect of investor protection in any country is securities markets regulation. while the sample mean is only 0. particularly in areas like . ahead of China ranked 86 th . as well as higher urban poverty and increased informal sector output. There is considerable variation in labor laws across Indian states. Suchismita Bose concludes that while the scope of Indian securities laws are quite pervasive. Russia ranked 101 st and Brazil ranked 119 th . investment.S. Using the framework of La Porta.67.47. and ranks 14 th in the sample. Indian states that followed more ³pro-worker´ policies experienced lower output. which is the third highest after the United States and Singapore.overall for the ease of employing workers. In terms of the quality of public enforcement²or the nature and powers of the supervisory authority--the Securities and Exchanges Board of India (SEBI) earns a score of 0. 3 World Bank¶s Doing Business 2008 publication gives India an investor protection score of 6. 4 As for liability standards.62. being the fifth highest. and Timothy Besley and Robin Burgess show that during the three and half decades before liberalization began in 1991. Payroll and social security taxes are 17% of salary in India half the average of the other BRIC countries. In comparing the regulatory powers and performance of the SEBI with those of Securities and Exchanges Commission in the U. employment and productivity in the registered or formal sector..92 in the index of disclosure requirements. there are significant problems in enforcing compliance. et al (2006)--which focuses on disclosure and liability requirements as well as the quality of public enforcement of the regulations controlling securities markets--India scores an impressive 0. respectively.66 is again high. significantly higher than the overall sample mean and the English-origin average of 0. ahead of each of the other BRIC countries.52 and 0. India¶s score of 0. but the costs of firing an employee are higher at 56 weeks salary relative to the BRIC average of 50 weeks salary.

1-32. 119. while SEC¶s corresponding figure was 52%. 2004. As for appeals before higher authorities--the Securities Appellate Tribunal or the Finance Ministry--in 30% to 50% of cases. Borrowers can appeal to a DRT only after the assets are seized and the Act allows the sale of seized assets. ³Can Labor Regulation Hinder Economic Performance? Evidence from India´ Quarterly Journal of Economics. Operations of these companies are restricted to asset reconstruction and securitization only. With the borrower¶s right to .3 See Timothy Besley and Robin Burgess. and 7 out of 27 in the five-year period 1999-2004.789 cases by the SEC. even though the latter regulates a significantly more mature market. with 1 out of 24 cases of issue-related manipulation in 1996-97. Though the SEBI has had some success prosecuting intermediaries. 5 Between 1999 and 2004. Florencio Lopez-de-Silanes. The ratio of action taken to investigations made is also quite low for the SEBI. The institution of Debt Recovery Tribunals (DRTs) in the early 1990¶s and the passage of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act in 2002 were aimed at speeding up the judicial process. the decision goes against the SEBI. SEBI took action against only 9% of the companies under its jurisdiction. The SARFAESI Act paved the way for the establishment of Asset Reconstruction Companies that can take non-performing assets off the balance sheets of banks and recover them. pp. however. The SARFAESI Act itself. Bose finds that the SEBI took action in only 481 cases as against 2. 2006. it appears that the quality of public enforcement of securities laws in India could potentially be significantly improved. 5 price manipulation and insider trading. 91-134. does not provide a final solution to debt recovery problems. SARFAESI also allows banks and financial institutions to directly seize assets of a defaulting borrower that defaults and fails to respond within 60 days of a notice. and Andrei Shleifer. ³What Works in Securities Laws?´ Journal of Finance 61. Thus. 4 This index is described in Rafael La Porta. pp. it has failed to convince the Securities Appellate Tribunal in its proceedings against corporate insiders and major market players.

Yet another positive development in the area of disclosure has been the adoption of Accounting Standard (AS) 18 by the Institute of Chartered Accountants in India (ICAI) in 2001 which. though it is difficult to attribute this to the new Act since the economy has also been booming significantly since then. even a High Court. a case can easily be dragged out for three to four years. as opposed to about 27% in . ³Securities Markets Regulation: Lessons from US and Indian Experience´. lending and leasing. in some cases. Related parties include holding and subsidiary companies. hiring and agency arrangements. makes reporting of related party transactions by Indian companies mandatory. 83-124. during which time the sale of the seized asset cannot take place. but public sector banks have had very notable success recovering their loans by seizing and selling assets since the Act came into existence. Jan-June. Consequently. and other parties like promoters and employee trusts. recovery rates have also been very low. 2005. 5 See Suchismita Bose. Transactions that must be disclosed include purchase or sale of goods and assets.approach the DRT. and has the dubious distinction of being among the countries where it takes the longest time to go through bankruptcy in the world (10 years on average). Adoption of this standard is a major positive development on the Indian corporate governance landscape by bringing transparency to the dealings of Indian companies. The recovery rates of bad debts has registered a sharp rise in 2005-06 and after. It is perhaps too soon to evaluate this Act¶s effects on reducing defaults generally. Money and Finance. below 12%. the DRAT (Debt Recovery Appellate Tribunal) and. among other things. pp. 6 borrowing. guarantee agreements. An area of the World Bank¶s Ease of Doing Business Index where India fares particularly badly is the ease of closing a business. key management personnel and their direct relatives. transfer of research and development and management contracts. India is ranked 137 th out of 178. particularly those of group-affiliates. ³parties with control´ (which includes joint ventures and fellow subsidiaries).

once again. been a very positive recent positive development in the form of the Companies (Second Amendment) Act of 2002 seeks to address these problems by establishing a National Company Law Tribunal and stipulating a time-bound rehabilitation or liquidation process of less than two years. and the National Securities Depository. Money and Finance. and the Debt Recovery Tribunals all contribute to the costs and delays of bankruptcy. duly 6 See Nimrit Kang and Nitin Nayar. It follows a rigorous µrisk containment¶ framework involving collateral and intra±day monitoring. The economic reforms of the early nineties created four new institutions: the Securities and Exchanges Board of India (SEBI). bankruptcy code. the National Stock Exchange. 2004. 7 assisted by the National Securities Depository. the National Securities Clearing Corporation. pp. This Act also brings other positive changes to the bankruptcy code.S. Until 1992 the BSE was a monopoly. and the Bombay Stock Exchange (BSE). ³The Evolution of Corporate Bankruptcy Law in India´. established in 1875. The National Securities Clearing Corporation is the legal counter-party to net obligations of each brokerage firm. The National Stock Exchange (NSE) is a limited liability company owned by public sector financial institutions and now accounts for about two-thirds of the stock trading in India. 37-58. Nimrit Kang and Nitin Nayar point out that there is no single comprehensive and integrated policy on corporate bankruptcy in India along the lines of Chapter 11 or Chapter 7 of the U. the Company Law Board. Stock Exchanges in India India currently has two major stock exchanges--the National Stock Exchange. the oldest stock exchange in Asia. and thereby eliminates counter-party risk and the possibility of payments crises. has an excellent record of reliable settlement schedules . 6 Overlapping jurisdictions of the High Courts. as well as virtually all of its derivatives trading. marked with inefficiencies. established in 1994. The NSCC. Oct 03 ± Mar 04. there has. the Board for Industrial and Financial Reconstruction (BIFR). so external market users often found themselves disadvantaged.the other BRIC countries. However. high costs of intermediation. and manipulative practices.

about 5000 companies are listed and traded on NSE and/or BSE. immediately after trade execution. transparency and good practice. it is important to note that the number of equity trades on BSE/NSE is about ten times greater than that of Euronext or the London Stock Exchange. Equity and equity derivatives trading in India has skyrocketed to record levels over the last ten years. 7 Some of these problems arise because of unsettled questions about jurisdictional issues and powers of the SEBI. and efficient regulation led BSE to also become a transparent electronic limit order book market in 1996. and dealing with violations of the Companies Act. For example. insider trading. Brokers must disclose to the Stock Exchange. with an efficient trading system similar to the NSE. Similarly. Figure 2 provides a summary comparison in this regard. The number of trades is an important indicator of the extent of investor interest and participation in equities and equity trading. the number of derivatives trades on NSE is several times greater than that of Euronext or London. Enforcing Corporate Governance Laws Enforcement of corporate laws remains the soft underbelly of India¶s legal and corporate governance systems. and is comparable to US derivatives exchanges. and of the same order of magnitude as that of NASDAQ and the New York Stock Exchange. While the dollar value of trading on the Indian stock exchanges is much lower than the dollar value of trading in Europe or the United States. The World Bank¶s 2004 Reports on the Observance of Standards and Codes (ROSC) finds that while India observes or largely observes most of the principles.since its inception in the mid-1990s. and the Exchange must then disseminate this information to the general public on the same day. the SEBI has mandated disclosure of all transactions where the total quantity of shares is more than 0. The Securities and Exchanges Board of India has introduced a rigorous regulatory regime to ensure fairness. Currently. including the use of nominee directors. fairness.5% of the equity of the company. it could do better in many areas. the enforcement of laws and regulations pertaining to stock listing on major exchanges. the name of the client and other trade details. The new environment of improved transparency. and provides important incentives for improving corporate governance practices in India. for greater transparency. Indian Courts ± an assessment .

World Bank-IMF. Indian courts seem to perform well (relatively speaking) on these two types of cases. For collection on a bounced check.000 courts (not counting . however. Thus. India has the 16 th shortest duration (106 days) among English common law origin countries (average 176 days).76 but slightly lower than the 3. following the step-by-step evolution of a commercial sale dispute before local courts. In spite of having around 10. ³Report on the Observance of Standards and Codes (ROSC). They estimate the time for contract enforcement as 1420 days! This is not surprising. higher than the English-origin average of 2. India¶s total process duration is significantly shorter than the overall mean duration for all the 109 countries considered (254 for eviction of a tenant and 234 for collecting on a bounced check. This assurance notwithstanding. 8 Among the 42 English-origin countries in their sample. ROSC´. on the basis of tracking the efficiency of the judicial system in resolving a commercial dispute. respectively). Simeon Djankov and his co-authors give India a score of 3.34 on their formalism index. in spite of their formalism and their otherwise poor reputation on their speed. Case arrears and decadelong legal battles are commonplace in India. 8 In their analysis of ³formalism´ in the judicial process around the world. In both cases. Washington DC. contract enforcement through the court system remains a major problem in India. The World Bank Doing Business 2008 publication ranks India virtually the worst in the world in this regard with a rank of 177 out of 178. The data are reportedly collected by them through study of the codes of civil procedure and other court regulations as well as surveys completed by local litigation lawyers. Corporate Governance Country Assessment: India.53 average for all countries.7 See World Bank. India has the 11 th highest level of formalism and the 16 th longest process for evicting a tenant (212 days) among English common law origin countries (average 199 days). 2004.

326-340. Florencio Lopez-de-Silanes. 9 In April 2003. an important role in India¶s growth story.org. ³Courts. for instance. Working Paper. pp. Simeon. Britain over 50 and Australia over 41. 2003. 2001. and the shortfall of judges all contribute to 8 See Djankov. 453-517. UNDP. Boston: Kluwer Academic Publishers. ³Access to Justice´ in Souvenir of All India Seminar on ³Access to Justice´. ³The Problem Of Court Congestion: Evidence From Indian Lower Courts´. and reform in China. India. The Small and Medium Enterprises (SME) sector in India The small and medium-sized enterprises (SME) sector in India has played. ³Some issues in law reform in India´. and the latter gets priority. underdeveloped alternative mechanisms of dispute resolution like arbitration. the Supreme Court of India had almost 25. economic disputes suffer even greater delays. and 31% are over three years old. decentralization. and continues to play. for India the figure is slightly over 10.in/events/AISAJ/. 118.´ Quarterly Journal of Economics. About 63% of pending civil cases are more than a year old. in Jean-Jacques Dethier ed.undp. Rafael La Porta.2 million cases are pending in High Courts. extensive litigation by the government. 11 See Arnab K. and Russia. while writ petitions in High Courts can take between 8 and 20 years. 9 this unenviable state of delays in Indian courts. Canada over 75. 10 Amab Hazra and Maja Micevska report that about 20 million cases are pending in lower courts and another 3. . Since the same courts try both civil and criminal matters. University of Bonn. this sector consists largely of family enterprises in India. pp.000 cases pending before it. 2004. and Andrei Shleifer. As in many other countries. Governance. 10 See Pravin Parekh. http://www. 9 These data are from Bibek Debroy. 11 A termination dispute contested until all appeals are exhausted can take up to 20 years for disposal. India has a serious shortfall of judges. While the United States has 107 judges per million citizens. Automatic appeals. 1999. Hazra and Maja Micevska.tribunals and special courts).

with little recourse to the legal system. For mediation in a business dispute or to enforce a contract. Over 80% of the firms surveyed needed a license to start a business. are usually far more important for these companies rather than the explicit arm¶s length systems of governance and contracts observed in Western businesses. The informal system. with the fear of legal consequences being the least important concern. In cases of default and breach of contract. Government officials were most often the problem. indicating that the legal system. which was usually solved through payment of bribes or by enlisting friends of government officials as negotiators. is far from perfect at resolving disputes and also has significant costs. About half of the firms surveyed did not have a regular legal adviser. networks and connections are crucially important to negotiating the government bureaucracy. the first choice was ³mutual friends or business partners.Franklin Allen and his co-authors conduct surveys to measure how well the formal legal environment directly supports and regulates businesses. while not as effective as the informal mechanisms. Relationship based systems. and less than half of those that did had lawyers in that capacity. particularly these small and medium enterprises. the business 12 . the primary concern is loss of reputation. Franklin Allen and his co-authors also document serious credit constraints for firms in this sector. Over a third of them renegotiated.´ Only 20% of the respondents mentioned going to courts as the first option. reciprocity and reputation. and for about half of them obtaining it was a difficult process. followed closely by loss of property. The owners of these businesses also must deal with widespread corruption. Clearly. In general. 12 Their research indicates that small firms operate in a system governed almost completely with informal mechanisms based on trust. while over 40% did nothing and continued doing business with the offending parties. characteristic of Asian countries. About half of all respondents experienced a breach of contract or non-payment with a supplier or major customer in the past three years. legal concerns are far less important than the unwritten codes of the informal networks in which firms operate. resulting in their ongoing reliance on informal finance. As for conducting day-to-day business. however. is not altogether absent.

Figure 3 provides a break-up by number and Figure 4 by value. and about 9% of companies comprising about 5% of the market capitalization are non-Group companies controlled by foreign promoters. and trust. 7% of shareholding is with foreign promoters. About 60% of these companies (comprising about 65% of the total market capitalization of the Exchange). banks.e.See F. though present. reputation. Working paper. Allen. Qian. are part of these business groups. mainly corporate entities (19%) and the government (16%). The Wharton School. Importantly. Legal remedies. promoters own about 53% of the shareholding of these firms. It does so separately for group companies. Recent studies have documented significant tunneling of funds among business groups. and the rest are Indian. Figure 5 indicates the percentage shareholding of different groups of shareholders for the 500 largest Indian companies based again on data from Prowess. 13 The actual ownership within these companies is far from being completely transparent with widespread pyramiding. mutual funds and insurance companies. De. R. Relatively few companies are widely held with no significant single-promoter control.1% 14 . financial institutions. i. Even in 2002. J. Qian and M. On average. 2006. Chakrabarti. 10 environment of the SME sector is marked by strong informal mechanisms like family ties. crossholding. there is a sizeable nonpromoter holding of foreign institutional investors (16%) and a 10% non-promoter holding of Indian institutional investors. the average shareholding of ³promoters´ in Indian companies was as high as 48. are far less important than the rules of the informal networks. stand-alone companies and all companies taken . S. Family-run business groups clearly play a crucial role in the Indian corporate sector. about 20% of companies comprising about 8% of the market capitalization are non-Group companies controlled by Indian promoters. and the use of non-public trusts and private companies for owning shares in group companies. About 11% of companies comprising about 22% of the market capitalization are companies wholly or significantly owned by the Central (Federal) or State Governments. ³Financing Firms in India´. Figure 6 provides a bird¶s eye view of the proportion of companies with different levels of promoters¶ shareholding. Overall Ownership Patterns Figures 3 and 4 provide a break-up of the shareholding and ownership of India¶s 500 largest companies that together account for over 90% of the market capitalization of the Bombay Stock Exchange.

P. 13 An example of this literature is M. and widespread red-tape that bred corruption and stilted the growth of the corporate sector. less than 2% companies have a promoters¶ shareholding between zero to 5%. and S. 6% companies between 15% to 25%. 38% companies between 50% to 75%. 4% companies between 5% to 15%. Bertrand. protection. and a banking system replete with well-developed lending norms and recovery procedures. marked by the 1951 Industries (Development and Regulation) Act and the 1956 Industrial Policy Resolution. ³Overview of the Indian Corporate Sector: 1989-2002. 2002. 04/64. 42% companies between 25% to 50%. 15 In terms of corporate laws and financial system. Corporate Governance in India ± A Historical Background The historical development of Indian corporate laws has been marked by many interesting contrasts. At independence. put in place a regime and a culture of licensing. trading and settlements. 11 3. The situation .´ IMF Working Paper No. The country also inherited four functioning stock markets (predating the Tokyo Stock Exchange) with clearly defined rules governing listing. Early corporate developments in India were marked by the managing agency system. Overall. therefore. a well-developed equity culture (if only among the urban rich). India emerged far better endowed than most other colonies.´ Quarterly Journal of Economics 117(1): 121±48. as did other laws governing the functioning of jointstock companies and protection of investors¶ rights. Mehta. Mullainathan. This contributed to the birth of dispersed equity ownership but also gave rise to the practice of management enjoying control rights disproportionately greater than their stock ownership. 14 See Petia Topalova. 2004. and 8% companies between 75% to 100% promoters¶ shareholding. ³Ferreting out Tunneling: An Application to Indian Business Groups. The turn towards socialism in the decades after independence. The 1956 Companies Act built on this foundation.together. India inherited one of the world¶s poorest economies but one which had a factory sector accounting for a tenth of the national product.

together with about thirty other state-government owned development finance institutions.worsened in subsequent decades and corruption. the Unit Trust of India. the legal process took over 10 years on average. nepotism. Along with the central government-owned and managed mutual fund. it won immediate protection from creditors¶ claims for at least four years. and its bankruptcy process was featured among the worst in World Bank . India¶s system has been driven by the 1985 Sick Industrial Companies Act (SICA). ³Corporate Governance in India. just to reach a decision. 2002. In the absence of a stock market capable of raising equity capital efficiently. and inefficiency became the hallmarks of the Indian corporate sector. these institutions also held (and still hold) large blocks of shares in the companies to which they lent. three central (federal) government development finance institutions (the Industrial Finance Corporation of India. and invariably had representations on their boards in the form of nominee directors. 15 This section draws heavily from the history of Indian corporate governance in Omkar Goswami. the BIFR took well over two years. Protection of creditors¶ rights had therefore existed only on paper in India. Between 1987 and 1992. became the main providers of long-term credit to companies. Chapter 9. and it has been referred to the Board for Industrial and Financial Reconstruction (BIFR). Exorbitant tax rates encouraged creative accounting practices and gave firms incentives to develop complicated emolument structures with large ³under-the-table´ compensation at senior levels. and even for those that needed to be liquidated.´ Taking Action Against Corruption in Asia and the Pacific (Manila: Asian Development Bank). on average. the Industrial Development Bank of India and the Industrial Credit and Investment Corporation of India). As soon as a company was registered with the BIFR. Very few companies emerged successfully from the BIFR. which considers a company ³sick´ only after its entire net worth has been eroded. by which time the assets of the company were usually almost worthless. 12 The corporate bankruptcy and reorganization system also had serious problems. though they traditionally played very passive roles in the boardroom.

Company Boards had often been largely ineffective in their monitoring role. Recent Developments in Corporate Governance in India Liberalization of the Indian economy began in 1991. All in all. and clear instructions for maintaining and updating share registers. and a major positive transformation of the corporate sector and the 13 corporate governance landscape. This could well explain why Indian banks have historically underlent and invested primarily in government securities. minority shareholders and creditors in India had remained effectively unprotected despite the laws on the books. this relatively dismal environment started changing rapidly after the monumental economic reforms and the major liberalization programs initiated by the Indian government in the early nineties. but non-compliance was neither rare nor punished. There were cases in which the rights of minority shareholders had been compromised by management¶s private deals in the relatively infrequent event of corporate takeovers. it has played a crucial role in establishing the basic minimum ground rules of corporate conduct in the country. For most of the post-Independence era the Indian equity markets were not liquid or sophisticated enough to exert effective control over the companies. we have witnessed wideranging changes in both laws and regulations. and their independence had been perceived as highly questionable. While the Companies Act has always provided an excellent framework. Sometimes non-voting preferential shares had been used by promoters to channel funds and expropriate minority shareholders. therefore. in reality minority shareholders had often suffered from irregularities in share transfers and registrations. Though financial disclosure norms in India have traditionally been superior to most Asian countries. Since then. however.surveys on business climate. The Institute of Chartered Accountants in India has rarely taken action against erring auditors. Established primarily to regulate and monitor stock trading. Concerns about corporate governance in India were. . Perhaps the single most important development in the field of corporate governance and investor protection in India has been the establishment of the Securities and Exchange Board of India in 1992 and its gradual and growing empowerment since then. However. noncompliance with disclosure norms had been rampant and even the failure of auditors¶ reports to conform to the law attracted only nominal fines and little punitive action. Listing requirements of exchanges enforced some transparency. 4.

the Naresh Chandra Committee on Corporate Audit and Governance in 2002. These efforts included the establishment of a study group to operationalize the Birla Committee recommendations in 2000.largely triggered by a spate of crises in the early 1990¶s²particularly the Harshad Mehta stock market scam of 1992--followed by incidents of companies allotting preferential shares to their promoters at deeply discounted prices. Clause 49 of the Listing Agreements 16 . one of the major architects of the Indian IT outsourcing success story 17 . and the second by Narayana Murthy. One of the first such endeavors was the Confederation of Indian Industry Code for Desirable Corporate Governance. a leading industrial magnate. All of these efforts were aimed at reforming the existing Companies Act of 1956 that still forms the backbone of corporate law in India. These two committees have been instrumental in bringing about far reaching changes in corporate governance in India through the formulation of Clause 49 of Listing Agreements (described below). 16 These concerns about corporate governance stemming from the corporate scandals.J. Concurrent with these initiatives by the SEBI. The committee was formed in 1996 and submitted its code in April 1998. coupled with a perceived need of opening up the corporate sector to the forces of competition and globalization. The first Committee submitted its report in early 2000. and the Expert Committee on Corporate Law (J. gave rise to several investigations into ways to fix the corporate governance situation in India. as well as those of companies simply disappearing with investors¶ money. and the second three years later. Later the SEBI constituted two committees to look into the issue of corporate governance--the first chaired by Kumar Mangalam Birla. another leading industrial magnate. Irani Committee) in late 2004. the Department of Company Affairs and the Ministry of Finance of the Government of India also began contemplating improvements in corporate governance. developed by a committee chaired by Rahul Bajaj.

The Narayana Murthy Committee worked on further refining the rules. and mandates certain disclosures for board members. 17 Importantly. and (vii) certification of compliance of a company with the provisions of Clause 49. and he has led key corporate governance initiatives in India. sets caps on committee memberships and chairmanships. a company that built its success on a widely held ownership structure rather than the traditional family-controlled Indian model. Clause 49 may well be viewed as a milestone in the evolution of corporate governance practices in India. lays down the minimum number and frequency of board meetings. (ii) the composition and functioning of the audit committee.5 million) or with a net worth of INR 250 million (§ $6. (iii) governance and disclosures regarding subsidiary companies. Chapter 9. and to other listed companies with a paid up capital of over INR 30 million (§ $0.See Omkar Goswami. 2001. It is similar in spirit and in scope to the Sarbanes-Oxley measures in the United States.´ Taking Action Against Corruption in Asia and the Pacific (Manila: Asian Development Bank).3 million) at any time in the past five years on March 31. The requirements of Clause 49 were applied in the first instance to the companies in the BSE 200 and S&P C&X NIFTY stock indices. ³Corporate Governance in India. on March 31. It stipulates that non-executive members should comprise at least half of a board of directors. It also lays down rules regarding compensation of board members. (iv) disclosures by the company. The key mandatory features of Clause 49 regulations deal with the following: (i) composition of the board of directors. (vi) reporting on corporate governance as part of the annual report. (vi) CEO/CFO certification of financial results. These rules were applied to companies with a paid up capital of INR 100 million (§ $2. and Clause 49 was amended accordingly in 2004. . It defines an ³independent´ director and requires that independent directors comprise at least half of a board of directors if the chairperson is an executive director and at least a third if the chairperson is a non-executive director. The composition and proper functioning of the board of directors emerges as the key area of focus for Clause 49. 2002. Narayan Murthy has been the Chair of Infosys. 2002.75 million) on March 31.14 The SEBI implemented the recommendations of the Birla Committee through the enactment of Clause 49 of the Listing Agreements. and all newly listed companies. 2003.

Clause 49 stipulates that at least one independent director of the holding company must serve on the board of the subsidiary. Clause 49 also mentions non-mandatory requirements . (v) remuneration of directors. Finally. With regard to ³material´ non-listed subsidiary companies (those with turnover/net worth exceeding 20% of a holding company¶s turnover/net worth). particularly its investment plans. In addition to these mandatory requirements. requiring at least three members on it. it is mandated that the process of share transfer (that had been a long-standing problem in India) be expedited by delegating authority to an officer or committee or to the registrar and share transfer agents. Finally. and the board members of the latter should be made aware of all 15 ³significant´ (likely to exceed in value 10% of total revenues/expenses/assets/liabilities of the subsidiary) transactions entered into by the subsidiary. The Clause spells out the role and powers of the audit committee and stipulates minimum number and frequency of and the quorum at the committee meetings. The company is also required to provide a separate section of corporate governance in its annual report. a board committee with a non-executive chair is required to address shareholder/investor grievances. The minutes of the subsidiary¶s board meetings should be presented at the board meeting of the holding company. The CEO and CFO or their equivalents need to sign off on the company¶s financial statements and disclosures and accept responsibility for establishing and maintaining effective internal control systems.Clause 49 pays special attention to the composition and functioning of the audit committee. (vi) a Management Discussion and Analysis section in the annual report discussing general business conditions and outlook. It is also required to submit a quarterly compliance report to the stock exchange where it is listed. (iii) risk management procedures. (iv) proceeds from various kinds of share issues. it needs to get its compliance with the mandatory specifications of Clause 49 certified by auditors or by practicing company secretaries. with an independent chair and with two-thirds made up of independent directors--and having at least one ³financially literate´ person serving. In addition. The audit committee of the holding company should review the subsidiary¶s financial statements. The areas where Clause 49 stipulates specific corporate disclosures are: (i) related party transactions. with a detailed compliance report on corporate governance. and (vii) background and committee memberships of new directors as well as presentations to analysts. (ii) accounting treatment.

The distinction drawn between boards headed by executive and non-executive chairmen and the lower required share of independent directors is special to India²and is also somewhat intriguing. they report that large firms that adopted these measures first witnessed a 4% (7%) positive price-jump in a two-day (five-day) event-window beginning with the announcement day compared to 18 See Tarun Khanna and Yishay Yafeh. however. 18 Focusing on the May 7. THIS IS NOT CLEAR). By and large. Corporate Governance of Banks The reforms adopted since 1991 have marked a shift from hands-on government control to market forces as the dominant instrument of corporate governance in Indian banks. areas of uniqueness as well. given the prevalence of family-run business groups. half-yearly reporting of financial performance to shareholders. 1999 announcement by SEBI about the formation of the Kumar Mangalam Birla Committee. The market reaction to the corporate governance improvements sought by Clause 49 seems to have been quite positive. Tarun Khanna and Yishay Yafeh use an event-study approach to measure the stock price impact of the adoption of Clause 49 by Indian firms. the remuneration committee.concerning the facilities for a non-executive chairman. like certification compliance. Finance Working Paper N° 92/2005. the provisions of Clause 49 closely mirror those of the Sarbanes-Oxley measures in the United States. 19 Competition has been encouraged with the issuance of licenses to new private banks and by giving more power and flexibility to bank managers. training and performance evaluation of board members. both in directing credit and in setting prices. There are. somewhat in contrast to the mixed response to Sarbanes-Oxley¶s adoption. moving towards unqualified financial statements. 2005. European Corporate Governance Institute. and perhaps most notably a clear ³whistle blower´ policy. when an earlier application to large companies was expected. 16 smaller firms that were required to implement the reforms at the same time (RAJESH. the Indian requirements are even stricter. Business Groups in Emerging Markets: Paragons or Parasites?. The Reserve Bank of India (RBI). In some areas. India¶s .

Liquidity and Systems and controls) approach. with a stress on boards being elected rather than ³appointed from above. Earnings. From 1994. has moved to a model of governance by ³prudential norms´ rather from that of direct interference. Asset quality. market institutions have been strengthened by government actions attempting to infuse greater transparency and liquidity into markets for government securities and other asset markets. Audit committees in banks have been stipulated since 1995.central bank. This market orientation of governance in banking has been accompanied by stronger disclosure norms and greater stress on periodic RBI surveillance.´ There is increasing emphasis on greater professional representation on bank boards. Greater independence of public sector banks has also been a key feature of the reforms. with little professional involvement and considerable channeling of credit to family businesses. the Board for Financial Supervision (BFS) inspects and monitors banks using the ³CAMELS´ (Capital adequacy. Management. limiting the possibilities for professional excellence and opening the possibility of misdirecting credit. See Y. Corporate governance in co-operative banks and non-bank financial companies perhaps needs the greatest attention from regulators.V. thus allowing for ³related party´ transactions for banks. even allowing debate about the appropriateness of specific regulations among banks. Rules like nonlending to companies that have one or more of a bank¶s directors on their boards are being softened or removed altogether. The need for professional advice in the election of executive directors is increasingly being realized. . Nominee directors from government and the RBI are being gradually phased out. Reddy. concentrated ownership remains a widespread characteristic. It is generally believed that the ³new´ private banks (those established after the reforms process started in the 90¶s) have better and more professional corporate governance systems in 19 Reddy summarizes the reforms-era policies for corporate governance in Indian banks. Rural co-operative banks are frequently run by politically powerful families as their personal fiefdoms. 2002. As for the old private banks. Along with these changes. with the expectation that the boards will have the authority and competence to properly manage the banks within broad prudential norms set by the RBI.

The Indian Experience. from 5 to 242. MoUs specified various targets with . there are also many more smaller PSEs promoted and owned by different state governments. and five of the six Indian Fortune 500 firms are Central PSEs. The public sector still accounts for over 11% of India¶s GDP.´ BIS Review 25/2002. The Industrial Policy Resolution of 1956 reserved the ³commanding heights´ of the economy for the public sector. the collapse of the private Global Trust Bank and its subsequent acquisition by a public sector bank has. Though the cumulative profits of the PSEs have risen over time their performance has always been a concern. Basle. As these enterprises came under the purview of the government. It is noteworthy that India has one of the best banking sectors in Asia in terms of the ratio of nonperforming assets. In addition. with a stipulation of targets against which the government would hold its performance. and during the second half of the twentieth century the number of central (federal) PSEs in India climbed steadily. 17 place. strengthened beliefs that the government will ultimately bail out failing banks. they have often been subjected to political interference and governance by rigid bureaucratic norms rather than on the basis of performance and profitability. over 27% of industrial output and over a third of central government receipts. with close of half of the PSEs incurring losses. The India NPL ratios of around 4% of total banking assets are far below those of China (or Japan) and most other Asian and emerging markets. however. Over the same period their return on investment improved from barely 13% to over 18%. 20 In recent years. Public Sector Governance in India Public sector Enterprises (PSEs) have played a major role in India¶s mixed economy and industrialization program. Between 1996-97 and 200506 PSEs registered a 70% increase in investments to over US$87 billion. A break with this tradition happened in 1987 with the adoption of a Memorandum of Understanding (MoU) between the enterprises and the government that gave greater functional autonomy to the PSEs. Bank for International Settlements. They account for over 20% of the market capitalization of firms listed on the Bombay Stock Exchange.³Public Sector Banks and the Governance Challenge .

however. Recent findings about corporate governance in India Of late. Nevertheless.different weights. with unions and leftist political parties attempting to block almost every disinvestment effort. now referred to as the ³Navratnas´ (Nine jewels). 2006. India. was the principal architect of India¶s economic reforms of the early nineties while serving as the Finance Minister in the then government in power. nine large and profitable central PSEs. All of these are extremely positive developments from a corporate governance perspective. the disinvestment process effectively stalled because the national elections of May 2004 yielded a coalition government which had left and communist parties as vital members. 107 PSEs had signed MoUs with the government. 16 ³strategic sales´ with transfer of control took place between 1999-2000 and 2004-05. which now acts as the agency in charge of reconstruction (or liquidation) of PSEs in financial distress. Partial privatization (or ³disinvestment´ as it is called in India) of PSEs emerged as a policy objective in 1991. (with a Foreword by Richard Roll). and even though the newly elected Prime Minister. After 2004. PSEs have increasingly gained operational autonomy and moved to a ³board managed corporation´ model rather than reporting to government ministry officials directly. By the end of 2000. Oxford University Press. including the right to form joint ventures and engage in mergers and acquisitions. the PSEs are gradually being separated from direct government control. Manmohan Singh. with the more profitable ones gaining autonomy faster. a burgeoning empirical literature has begun to document important features of corporate . 42 Central PSEs had been partially privatized by the end of March 2005. Another major step in the administration of PSEs has been the constitution of the Board for Reconstruction of PSEs (BRPSE) in 2004. were granted even greater autonomy than others. New Delhi. In 1997. 18 97 other profitable PSEs gained the status of ³mini-Ratnas´ and with it greater autonomy than before. The Financial Sector in India ± Emerging Issues. In general. with the most important being gross profit margin and net profit as a proportion of capital employed (30% each). In addition. with the initiation of economic reforms. With the adoption of MoUs. 20 See Rajesh Chakrabarti. even though it was headed by the Congress party. Disinvestment has followed a rocky path in India. 5. Dr.

46 members on average in India compared to 11. 4. 22 21 See Jayati Sarkar and Subrata Sarkar. We summarize some of the major findings in this section. however.45 in America. 2000. 19 The median director in large Indian companies held 4. pp. Indian boards had relatively fewer independent directors. 23 The figures were similar for inside directors. the median number of positions held was 4.S.1. 435-443.S. respectively. Do board characteristics affect firm performance? Firm level evidence from India. Large shareholder activism in developing countries: Evidence from India.). 21 While the percentage of inside directors was roughly comparable (25.) and relatively more affiliated outside directors (over 20% versus 14% in the U. International Review of Finance.governance in India. Jayati Sarkar and Subrata Sarkar show that corporate boards of large companies in India in 2003 were slightly smaller than those in the United States (in 1991). and this number is considerably (and statistically significantly) higher for directors in group-affiliated companies (4. There is evidence that larger boards lead to poorer performance (market-based as well as in accounting terms).59. (just over 54% compared to 60% in the U.85 versus 3. group affiliates. and in over 30% of cases a promoter served as an Executive Director.34. 41% of Indian companies had a promoter on the board. with no major differences between group and stand-alone companies.95 and 3. and non-affiliated companies.S. As for inside directors.).09 for non-affiliated companies).06 for large companies. Applied Economic Letters 13. 22 See Saibal Ghosh. both in India and in the United States. it seems . As for independent directors. Busier independent directors are also more conscientious in terms of attending board meetings than their counterparts with fewer positions.38% compared to 26% in the U. pp. Interestingly. independent directors with multiple directorships are associated with higher firm value in India while busier inside directors are correlated negatively with firm performance.28 directorships in 2003. with 9. beginning with research examining corporate board composition. 161-94. being 4. 2006.

After controlling for these characteristics of independent directors. are related. 2003. 26 More recently. CEO-duality. Subrata Sarkar and Kaustav Sen.60%. the Indian public¶s share amounted to 34. and the presence of controlling shareholders as inside directors. for instance. perhaps unsurprisingly. 25 In comparison. to greater earnings management. Liberalization.78% of the shares of group companies and 45. However.that the pressure of serving on multiple boards (due largely to the prevalence of family owned business groups) does take a toll on the directors¶ performance. However. Shaw).74% of the shares in a sample of almost 2500 listed manufacturing companies. As for the impact of concentrated shareholding on firm performance.94% of stand-alone firms. Jayati Sarkar and Subrata Sankar find that promoters held 47. 24 Multiple positions and non-attendance of board meetings by independent directors seem to be associated with higher discretionary accruals in firms. board independence (measured by the proportion of independent directors) does not seem to affect the degree of earnings management. in Corporate Capitalism in South Asia edited by Ananya Mukherjee-Reed. Ekta Selarka reports a U-shaped relationship between 23 See Jayati Sarkar and Subrata Sarkar. busy independent directors also appear to be correlated with a greater degree of earnings management as measured by discretionary accruals. Corporate Ownership and Performance: The Indian Experience (with Subrata Sarkar). Shareholding patterns in India reveal a marked level of concentration in the hands of the promoters. an earlier study by these same authors finds that in the mid-90¶s (1995-96) holdings above 25% by directors and their relatives was associated with higher valuation of companies while there was no clear effect below that threshold. In 2002-03. Macmillan Press. where the top executive also chairs the Board. International Political Economy Series (ed by Timothy M. based on 2001 data that distinguishes between ³controlling´ insiders and non-controlling groups. and held 50. 28% and 38. UK 24 See Sarkar Jayati.51%. respectively. 2006 Board of Directors and Opportunistic Earnings .

1. for DFIs¶ holdings.000) in real terms.500) to INR 6. Indira Gandhi Institute of Development Research. suggesting better monitoring takes place when the stakes are higher. but a significant positive effect above 25%. 26 See Jayati Sarkar and Subrata Sarkar. insurance companies. of which the share of mutual funds. pp. between 45% and 63%. India. with the point of inflection lying at a much higher level.5%. Working Paper.4 million (§ USD 160. Based on an analysis of unbalanced panel data for roughly 300 firms each year. ³Multiple Board Appointments and Firm Performance in Emerging Economies: Evidence from India.´ International Review of Finance. 25 See Jayati Sarkar and Subrata Sarkar. respectively. after which there is no clear effect. .Management: Evidence from India. Large Shareholder Activism in Developing Countries: Evidence from India. Executive compensation in India. banks and DFIs.1. Mumbai. Jayati Sarkar and Subrata Sarkar find that company value actually declines with a rise in the holding of mutual funds and insurance companies between zero and a 25% holding. there is no clear effect on valuation below 25%. 2000. 3% and 11%. and foreign institutional investors--hold over 22% shares of the average large company in India. 27 Institutional investors--comprising government sponsored mutual funds and insurance companies. Mumbai. Managerial compensation in India often has two components--salary and performance-based commission²as well as retirement and other benefits and perquisites. 20 insider ownership (with insiders being defined as promoters and ³persons acting in concert with promoters´) and firm value. is another area of corporate governance that has received attention among researchers.1 million (§ USD 52. banks and development financial institutions (DFIs) that are also long-term creditors. and foreign institutional investors are about 5%. Analyzing cross-sectional data from the mid-1990¶s. 161-94. which was freed from the strict regulation by the Companies Act in 1994. Indira Gandhi Institute of Development Research. 2005a. India. Sonja Fagernäs reports that the average total compensation (salary plus commission) of Indian CEOs has risen almost three-fold between 1998 and 2004 (from INR 2. 28 On the other hand.´ Working Paper 2005-001.

55% to 1.1. 2005.9 million (§ USD 172. ³Ownership Concentration And Firm Value -. executive compensation as a fraction of profits has also almost doubled from 0. 27 See Ekta Selarka. Large Shareholder Activism in Developing Countries: Evidence from India.6 million (§ USD 190. Emerging Markets Finance And Trade 41. pp.´ International Review of Finance. 2000.4% to 25. during 1997-2002. There is also some evidence that this increasing performance-pay linkage is associated with the introduction of the corporate governance code or Clause 49. 28 See Jayati Sarkar and Subrata Sarkar. with wide variation across firm size. ³How do Family Ties. 21 A recent study finds that. she finds 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%.500) if the CEO is related to the founding family. 29 See Sonja Fagernas. and the proportion of CEOs with commission as part of their pay package has risen from 34% to 51%.3 million (§ USD 132. and CEO pay depends on past-year . Fagernäs also finds that CEOs related to the founding family or directors are paid more than other CEOs. University of Cambridge.6%. 161-94. Meanwhile. pp. In a firm fixed effects model.500). 2007. from 13. CEO pay has thus clearly become more performance based over the past decade. 83±108. on average.500) for small firms.5 million (§ USD 62. the average (of a sample of 462 manufacturing firms) board compensation in India has been around INR 5. 30 The average board compensation is INR 7. There is some evidence that the presence of directors from lending institutions lowers pay while the share of non-executive directors on the board connects pay more closely to performance.000) for large firms and INR 2.06%.A Study From The Indian Corporate Sector´. the proportion of profit-based commission has risen steadily.29 During this period. Both Board and CEO compensation depend on current performance. The board compensation also appears to be higher. Boards and Regulation Affect Pay at the Top? Evidence for Indian CEOs?´ Working Paper. at INR 6.

A greater degree of diversification also aids tunneling. This incentive for tunneling explains.performance as well. Ghosh. pp. the persistence of value destroying groups in India and occasional heavy investment by Indian groups in businesses with low contribution to group profitability. However. 33 There is also some evidence that firms associated with business groups have superior performance than stand-alone firms. 32 They find that firms farther down the pyramidal structure are less affected by industry-specific shocks than those nearer the top. 30 See A. 31 . 2006. Diversified companies also pay their boards more. issues relating to corporate governance in business groups are naturally very important. benefiting the controlling shareholders but hurting the minority shareholders. Given that almost two-thirds of the top 500 Indian companies are group-affiliated. 35 Using data for Indian firms in 385 business groups in 200203 and 384 groups in 2003-04. Tunneling. Kali and Sarkar find that firms with greater ownership opacity and a lower wedge between cash flow rights and control than those in a group¶s core activity are likely to be located farther away from the core activity. Bernard Black and Vikramaditya Khanna question how this logic would make them less sensitive to negative shocks. 66-90. according to them. 34 More recently Raja Kali and Jayati Sarkar argue that diversified business groups help increase the opacity of within-group fund flows driving a wider wedge between control and cash flow rights. or ³the transfer of assets and profits out of firms for the benefit of those who control them´ is a major concern in business groups with pyramidal ownership structure and inter-firm cash flows. ³Determination of Executive Compensation in an Emerging Economy: Evidence from India¶. 31 Marianne Bertrand and her coauthors estimate that an industry shock leads to a 30% lower earnings increase for business group firms compared to stand-alone firms in the same industry. suggesting that positive shocks in the former are siphoned off to the latter. Emerging Markets Finance and Trade 42.

Mehta. NBER. 22-27. ³Emerging Market Business Groups. Jayashree Saha finds that. India continues to be below the median within their 49 country sample in terms of the number of deviations from International Accounting Standards.´ Quarterly Journal of Economics 117. and S. pp. This further strengthens the circumstantial evidence of tunneling and its adverse effects. Johnson. and A. 34 See Tarun Khanna and Krishna Palepu. 2000. 22 Using a sample of over 600 of the 1000 largest (by revenues) Indian firms in 2004. F.´ in Randall Morck. ³Tunneling. after controlling for other corporate governance characteristics. Also. Shleifer. 2007. LaPorta.´ Working Paper. 37 Indian accounting standards provide considerable flexibility to firms in their financial reporting and differ from the International Accounting Standards (IAS) in several ways that can often make interpreting Indian financial statements relatively challenging. 33 See Bernard Black and Vikramaditya Khanna. R. Concentrated Ownership. 32 See M. Foreign Investors and Corporate Governance. 35 See Raja Kali and Jayati Sarkar. 2000. Bertrand. using a sample of over 5000 firms for the period 2003-2005. ³Ferreting out Tunneling: An Application to Indian Business Groups. 36 The same study also reveals that.´ as opposed to management personnel as in the United States. group companies consistently report higher levels of related party transactions than stand-alone companies. Mullainathan.See S. forthcoming 2007. P. Lopez-de-Silanes. Indira Gandhi Institute of Development Studies. University of Chicago Press. ³Diversification and Tunelling: Evidence from Indian Business Groups. ed. most related party transactions in India occur between the firm and ³parties with control. Two cross-country studies published in 2003 have put India among the worst nations in terms of earnings opacity and management. firm performance is negatively associated with the extent of related party transactions for group firms but positively so for stand-alone companies. In a 2007 study of Kee-Hong Bae and co-authors. ³Can Corporate Governance Reforms Increase Firms¶ Market Values?: Evidence From India. . 2002.´ American Economic Review 90.´ Journal of Empirical Legal Studies. pp. 121±48.

505-527.Tan and M. 2003. 641-678 and C. when the average number of mergers per year leapt from 30 between 1973-74 and 1987-88. IGIDR. H. Enforcement and the Role of Non-Profit Organizations. and P. 2003. Studying the relationship between leverage and Tobin¶s Q in 1996. In the presence of well functioning financial institutions. pp. Working Paper. Jayati Sarkar and Subrata Sarkar conclude that the disciplinary effect has been more marked in recent years as institutions have adopted a significantly greater market orientation. 37 See U. Bhattacharya. D. 38 See Kee-Hong Bae. Nanda. dissertation. 2007. ³The World Price of Earnings Opacity.´ Journal of Financial Economics 69. Canada 39 See Jayati Sarkar and Subrata Sarkar. Daouk. ³International GAAP Differences: The Impact on Foreign Analysts´. 40 See Manish Agarwal and Aditya Bhattacharya. 36 See Jayashree Saha. 40 Merger activity appears to occur in waves and is split roughly evenly between inter-industry and intra-industry mergers. to 171 between 1994-95 and 2002-03. 39 They also find limited evidence of the use of debt as an expropriating mechanism in group companies. The market for corporate control was relatively limited in India until the mid-1990¶s. IFMR. debt can be a disciplining mechanism in the hands of shareholders or an expropriating mechanism in the hands of controlling insiders.38 The nature of corporate governance can affect the capital structure of a company. ³Earnings Management and Investor Protection: An International Comparison.´ Accounting Review 78. 2006.D. and 63 between 198788 and 1994-95. H. India. Queen¶s University. Welker. ³Corporate Governance. Wysocki. 2005. and M. ³Mergers in India ± a Response to Regulatory Shocks. Leuz. Chennai. 2006.´ . 2000. Welker.´ Background Paper for IFMR Conference on Corporate Governance. The share of groupaffiliated mergers has increased significantly in the post 1994-95 period. and 2003. ³A Study of Related Party Transactions in Indian Corporate Sector. pp.´ Draft Ph.

far from being unique to India. Nandini Gupta finds that even when control stays in government hands. and has a well-functioning banking sector with one of the lowest proportions of non-performing assets. Familycontrolled businesses provide an organizational form that reduces transaction costs and asymmetric information problems under these conditions.Emerging Markets Finance and Trade 42. China and Russia. the reality is different with slow. Sangeetha argues that it may be difficult to disentangle the effect of partial privatizations from the effect of the application of MoUs to these cases before the partial privatizations. 41 She argues that the monitoring role of the markets has been responsible for this. inhibiting financing and keeping the cost of capital at levels higher than necessary. However. Conclusions This article outlines the salient features of the Indian corporate governance system. pp. Even among large companies. corporate governance in India does not compare unfavorably with any of the other major emerging economies: Brazil. In particular. This is not surprising: concentrated ownership and family control are important in countries where enforceable legal protection of minority property rights is relatively weak. She finds that the application of MoUs or performance contracts had a positive impact on the profitability and the operational performance of PSEs. and are present in many other economies as well. 23 With regard to public sector governance. Despite the above corporate governance shortcomings. the Indian economy and its financial markets have started attaining impressive growth rates in recent years. Much of the country¶s extensive small and medium enterprises (SME) sector displays relationship-based informal control and governance mechanisms. are in fact commonplace in Asia. Most of the corporate governance problems noted here. over-burdened courts and significant corruption. evidence of earnings management. partial privatization has a positive impact on profitability. even though India ranks high on the ease of getting credit. shareholdings remain relatively concentrated with ³promoters´ and family business groups continuing to dominate the corporate sector. 6. productivity. and display an exceptionally high . 42 . There is significant pyramiding and tunneling among Indian business groups and. and investment of the PSEs concerned. S. While on paper the Indian legal system provides one of the highest levels of investor protection in the world. 46-65. notwithstanding copious reporting requirements.

and the monumental changes that have already taken place pave the way for more changes to come. The reason is that India is now clearly and strongly committed to sustaining and rapidly furthering the major economic reforms and the liberalization started in the early nineties. Empirical Essays on Enterprise and Ownership Reforms in Public Sector Enterprises Evidence from India. Sangeetha. 987-1015. functions efficiently and transparently to now trade among the highest number of trades in the world. 2006. and enable it to sustain its new-found prosperity and growth. IGIDR 24 Specifically. particularly with the enactment of Sarbanes-Oxley type measures in Clause 49 of the listing agreements. All these positive developments should arguably help Indian industry ensure that their financial gains reach their investors fairly and transparently.level of optimism. transparency and good practice. just behind NASDAQ and NYSE.´ Journal of Finance 60. the Securities and Exchanges Board of India established as a part of these reforms. pp. also established as part of the reforms. ³Partial privatization and Firm performance. and legal changes to improve the enforceability of creditor¶s rights. 2005. 25 . 41 See Nandini Gupta. There is a strong momentum for continuing reforms. has a rigorous regulatory regime to ensure fairness. 42 See S. The traditional Bombay Stock Exchange has also reformed effectively. and make the individual shareholder their central governance focus. and the National Stock Exchange of India. Most importantly.D. We are also seeing the rise of companies like INFOSYS that are free from the influence of a dominant family or group. the corporate governance landscape in the country has been changing very fast over the past decade.´ Draft Ph. dissertation.