1. Evolution Of Corporate Governance InIndia & Its Influence On Indias CapitalMarketProf. (Dr.) Uday Salunkhe, Prof. (Dr.) P.S. Rao, andProf. Amitha SehgalAbstractIn recent years the issue of corporate governance and the design of appropriate governancemechanisms have become important subjects of academic research and policy discourse inboth developed and developing countries. The increasing importance of governancemechanisms comes in the wake of major corporate scandals in internationally renownedcompanies like Enron , Tyco and Worldcom as well as East Asian crisis in the early nineties andSatyam in India, with a large body of empirical and theoretical research highlighting thesignificant impact that an economys corporate governance system can have on theprofitability and growth of corporations.Corporate governance is now increasingly being recognized as a crucial instrument toimprove the efficiency of companies and to enhance the investment climate in a country.This paper traces the history of Indias stock market and the impact of corporategovernance norms on its evolution and growth.KEY WORDS: Capital markets, Indias Economic Liberalisation, Corporate Governance.1.1 Understanding the meaning of corporate governanceRecent corporate scandals have focused attention on corporategovernance for all the wrong reasons. There is a need to cut through all the139

2. sensational corporate governance failures, like the case of Satyam, tounderstand what is the meaning of corporate governance.Shleifer and Vishny state that "Corporate governance deals with the waysin which suppliers of finance to corporations assure themselves of gettinga return on their investment ." (1997, p.737).Corporate governance in the Indian context spells out clearly that ethicsand values form the bases of corporate governance, while adherence tothe legal framework is the minimum requirement. Confederation of IndianIndustries (CII) - Desirable Corporate Governance Code (1998) defines it as"Corporate Governance deals with laws, procedures, practices and implicitrules that determine a companys ability to take informed managerialdecisions vis--vis its claimants - in particular its shareholders, creditors,customers, the State and employees. There is a global consensus about theobjective of good corporate governance: maximizing long-termshareholder value.""Corporate Governance is an art of managing companies ethically andefficiently for enhancing stakeholders value.The entire gamut of corporate governance system could be referred to as"corporate ethical and values system".(extracted from the Report of the Committee on the Companies Bill, 1997).The Narayana Murthy report, (2003) has a comprehensive definition :"Corporate governance is the acceptance by management of theinalienable rights of shareholders as the true owners of the corporationand of their own role as trustees on behalf of the shareholders. It is aboutcommitment to values, about ethical business conduct and about makinga distinction between personal and corporate funds in the managementof a company".140 3. These definitions reflect the Indian ethos of corporate governance asarticulated by Mahatma Gandhi in his writings. He believed thatmanagement is a trustee of shareholders capital and business is a trusteeof all resources, including the environment. As trustees the primary goal ofmanagement is to protect the interest of the owners and also, not to exploitresources for short term profits.In India, the initiative on corporate governance was not a result of anymajor corporate scandal, like Enron, World Com, etc. It started as a self-regulatory move from the industry rather than the rule of law.The earliest developments in India began in 1991, after the report of theCadbury Committee was released in the U.K. Industry groups held seminarsand conferences to discuss the Cadbury report and its relevance to India.The Confederation of Indian Industries (CII) was the first to introduce acode on corporate governance in April 1998. Some companies did complywith the same in their annual reports of 1998-99. It was voluntary in nature.Over the years, the Government of India and the Securities and ExchangeBoard of India (SEBI) have constituted several committees to makerecommendations. Recommendations of three landmark committeereports are milestones in the journey towards better governance.The Kumar Mangalam Birla Committee (1999), constituted by SEBI wasinstrumental in the addition of a new Clause 49 to the listing agreementwith the Stock Exchanges. This was a landmark in the history of corporategovernance in India. These recommendations, aimed at improving thestandards of Corporate Governance, are divided into 19 mandatory and 6non-mandatory recommendations.Its major contribution was in recommending the constitution of the Boardof Directors (specifying the minimum number of independent directorsand board procedures); the Audit Committee (including the mandatory141 4. requirement of an audit committee); Disclosures (mandatory ManagementDiscussion and Analysis section in Annual Reports + other disclosures). Forthe first time in the history of corporate India, specific corporate governanceprocesses and disclosures were mandated under the listing agreement withthe stock exchanges.This was followed by the Naresh Chandra Committee on Corporate Auditand Governance in 2002. The committee recommended best practicesregarding the statutory relationship between auditors and companies andset the highest standards for the role of audit committees. For example,Clause 49 has incorporated the recommendation of the Birla Committeethat the audit committee should have three non-executive directors asmembers with at least two independent directors, and the chairman of thecommittee should be an independent director.But the Naresh Chandra report set the benchmark higher. It recommendedthat all members of the audit committee should be independent directors,thereby plugging the loophole that could make it possible for a promoter-director without an executive role in the company becoming a member ofthe audit committee.Progressive companies like Infosys follow the benchmark spelt out by theChandra report and all the members of its audit committee are independentdirectors.The N.R.Narayana Murthy Committee (2003), raised the bar with greateremphasis on internal controls and risk management systems in companies.Several of its recommendations, concerning related party transactions andqualifications of audit committee members were accepted by SEBI andmade mandatory under Clause 49. Interestingly, the committee made animportant non-mandatory recommendation that companies must beencouraged to move towards a regime of unqualified financial statements(In many cases auditors taint financial statements with their disapproval/142 5. objection to some of the accounting practices). This recommendation hasnot yet been accepted.All these progressive developments in improving corporate governancehave vastly improved the equity/capital market climate in India.The primary purpose of corporate governance norms is to ensure thatmanagers protect the investment of the owners (scores of minorityshareholders of the companys stock) and maximize their returns on suchinvestment. Since the stock markets are the conduit through which theseinvestments are made, the mechanics of the stock market and the principlesof corporate governance are enmeshed in a continual cycle of co-dependency.The goal of this research paper is to understand the evolution of corporategovernance in India, against the backdrop of the history of Indias stockmarket, its corporate culture and the government attitude that stronglyinfluenced the way business was conducted. It traces how corporategovernance has evolved in India, from the time of Indias independencetill date. It also attempts to assess how new listing norms under Clause 49issued by the Securities and Exchange Board of India and other regulatoryreforms impact the functioning of the Indian stock markets.Several recent measures taken to reform liberalize the Indian business/banking environment and simultaneously introduce sound corporategovernance practices, have helped create robust stock markets, which inturn have raised the standards of corporate governance.1.2 Early Developments In IndiaTraditionally, dominant promoter groups and lax oversight by debtproviders have been the underlying weakness of corporate governance inIndia.143 6. This has led to weak company boards, inept institutional activism and,therefore, poor protection of minority shareholders. Though India has notexperienced large scale corporate scandals like those experienced by theU.S., this is more a result of a convergence of the interest of managementand owners (both constituted by the dominant promoter-family/dominantgovernment holding), rather than because of higher standards of corporategovernance.But, in this context, it is crucial to understand how Indias culture andpolitical orientation were disincentives for higher governance standards.The idealism of socialism and equitable distribution of wealth formed thebasis of a very high tax structure - both personal/corporate and also wealthtax.Companies had no incentive to show higher profits on their books andenhance shareholder value. Simultaneously such high taxes encouragedthe growth of a strong parallel black economy. The private sector was deniedaccess to the equity market at fair market valuations due to strict control ofthe pricing of public issues by the erstwhile Comptroller of Capital Issues.The combination of high taxes and low valuations left no incentive forgood corporate governance.1.3 The Corporate Governance Model While corporate governance in India is modeled on the lines of theAnglo-American system, (with an emphasis on shareholder protection),with definite elements inspired by the German-Japanese system, (with itsemphasis on protecting all stakeholders); its chief concern has, throughthe decades, remained unique.1.3.1. Theory of the Firm & the Agency ProblemThe fundamental basis of corporate governance is agency costs.Shareholders are the owners of the limited-liability company and are the144 7. principals. The managers appointed by the shareholders, directly orindirectly are the agents. Shareholders surrender the management of thecompany to professional managers (agents), with the hope that they willprotect their interests. Agency problems occur when the principal(shareholders) lacks the necessary power or information to monitor andcontrol the agents (managers) and when objectives of the principal andthe agents are not aligned. The extent of misalignment of objectivesbetween the principal and agents measures the agency costs. The goal ofcorporate governance is to reduce this agency costs.This can be expressed diagrammatically as follows :The impact of the agency problem differs depending upon the ownershipstructure and whether it gives shareholders direct control overmanagement.In the Indian context we have five different structures and the impact ofagency costs varies for each of them.145 8. l Highly Dispersed Shareholding and professional management (Veryfew in number. e.g.: L&T, ICICI Bank, Infosys).l Concentrated Ownership and management control rests with majorityshareholders, mainly in family managed companies (The dominantstructure. e.g.: Grasim, Hindalco, Reliance Industries, Wipro).l Public Sector with government ownership and professionalmanagement (Another dominant structure representing around 30per cent of Indias market capitalization. E.g.: State Bank of India, ONGC,BHEL).l Multinational Corporations (Hindustan Unilever, Colgate, Siemens).l Family Ownership but professional management. (Very few in number:Exide, Eicher).The Anglo-American model, with widely dispersed shareholding in theUnited States fundamentally addresses the "Principal-Agency" conflictissue. It attempts to resolve the conflict of interest between management(agents) and shareholders (principals). While this conflict is a concern inIndia, the predominant issue in India is the conflict between "dominant"shareholder-promoter groups and minority shareholders.Illustrating this, is the Discussion Paper (February 8, 2008) by the FinanceMinistry that seeks to revisit the provisions of the Securities Contract(Regulation) Rules (SCRR).The paper revolves around the need to increase the mandatory minimumpublic holding to 25 per cent, from the existing 10 per cent, in a limited-liability firm listed for public trading on the stock market. This would applyto Initial Public Offers (IPOs) as well as already traded companies. Also, itwould equally apply to a government company and a private company.Interestingly, this is the first time that regulators propose to define "public"146 9. in terms of its literal meaning of people at large. The Discussion Paper notesthat since the word "public" has not been defined so far, it could mean"non-promoters" and include financial institutions, foreign institutionalinvestors, mutual funds, employees, NRIs/OCBs, private corporate bodies,etc, thus making the floating stock insignificant.There are around 250 big and small listed companies with promoter holdingof over 75 per cent each. The prominent among them are Wipro, TataConsultancy Services, Jet Airways, DLF, Puravankara Projects, Akruti City,Omaxe, Plethico Pharmaceuticals, Sobha Developers, Mundra Port, BGREnergy, Blue Dart, Parsvnath Developers, and Bosch Chassis. The promoters,in most cases, currently hold over an 80 per cent stake in these companies.Table 1.11: Public Shareholding in select CompaniesA clear definition ofthe word "public" will also restrict the growing dominance of ForeignInstitutional Investors.1Source : Business Standard, February 8, 2008.147 10. A case in point is the IT industry. Promoter and promoter group stakes inIndias top five IT services exporters TCS, Infosys, Wipro, Satyam and HCLTechnologies have come down between FY2005 and FY2007, even as thesecompanies chart an aggressive roadmap to expand global footprint.Over the last three years, these companies witnessed a decline in theirpromoter group holding, and some of them saw the Foreign InstitutionalInvestor (FII) holdings going up. The decline was steep - in excess of fivepercentage points in case of Infosys and Satyam, while it was a little overthree percentage points in case of TCS, Wipro and HCL. The decline in Infosysis due to the companys sponsored secondary ADS (American DepositoryShares) offers during these years, wherein promoters diluted their holdingsto a certain extent. Infosys two sponsored secondary ADS offerings - inMay 2005 and November 2006 - saw its overseas float increase to 19 percent.Table1.22 : Falling Stake of promoters(in per cent)March 2005 March 2006 March 2007TCS84.84 83.69 81.65 Infosys 21.76 19.50 16.54Wipro83.11 81.44 79.58 Satyam15.67 14.02 8.79 HCL Tecno 70.67 69.44 67.55Though the non-promoters holding is about 48%, the public held only15.26% and the institutional holdings by (FIIs, MFs, FIs) accounted for20.67%. There is not much significant difference in the shareholding patternof companies in different sectors. About 80% of shares in companies ininfrastructure sector are held by Indian promoters. The German/Japanesemodel of corporate governance allows for a close relationship betweenbanks/financial institutions and companies. It is also characterized by largecross-holdings between companies.2Source : Kulkarni V. and Chatterjee, M.B., Hindu Business Line August 11, 2007148 11. Similarly, in the years prior to 1991, Indian companies had limited access tothe equity markets and were largely dependent on banks and FinancialInstitutions (FIs) for their funds (see Table 3).Table 1.3 : Pattern of Sources of Funds for Indian Corporate Percent of total 1985-86 to1990-91 to1995-96 to 1999- 2000-01 to 2004- Item 1. Internal Sources31.929.9 37.1 60.7 2. External Sources of which:68.170.1 62.9 39.3 a. Equity capital 7.218.8 13 9.9 b. Borrowings of which:37.932.7 35.9 11.5 i. Debentures11 7.15.6-1.3ii. From Banks13.6 8.2 12.3 18.4iii. From FIs8.710.39-1.8 c. Trade dues & other current liabilities22.818.4 13.7 17.3 Total 100 100100100 Note: Data pertain to a sample of non -government non -financial public limited companies.3 Source : Article on "Finances of Public Limited Companies", RBI Bulletin (various issues)But unlike in Japan/Germany, where banks play a critical role, as creditors,in the corporate governance of companies, in India, though banks/ FIs hadlarge debt exposures to the Indian corporate sector, (and with a conversionclause in the loan agreement the debt was often converted into an equityholding) several studies have shown that they did not exercise closemonitoring of the corporate governance standards in these companies.An analysis of the above table clearly shows that the proportion of fundsfrom internal sources started increasing from 1995-96 onwards, aftereconomic reforms started and after wealth tax was abolished. Wealth taxwas payable on dividend income post tax, which was insufficient to paythe onerous wealth tax, leading to a dilution of management holding inorder simply to pay it. Its abolition, therefore, gave every incentive topromoter management to retain profits in companies instead of siphoningit out.149 12. It is observed that in the Indian context, the external market exercises alimited force on corporate governance (since the floating stock in thesecondary market is limited). Nor is the internal force of a strong Board(since management and Board members are, very often, from the samedominant promoter group) always effective in protecting the principles ofsound corporate governance.Despite globalization, and an increase in foreign institutional investmentin Indian companies, institutional activism is also weak and yet to emergeas a strong counter force. Institutional investors, both domestic and foreign,are more prone to vote with their feet, by exiting the stock, than to influencea change in management behavior.The onus of protecting the interest of minority shareholders and otherstakeholders, thereby ensuring high standards of corporate governance,falls primarily on the market regulator, Securities and Exchange Board ofIndia, Reserve Bank of India, the Department of Company Affairs,Government of India, the media, both print and electronic, and the stockexchanges.1.4 A Historical Perspective: Early Years After Indias IndependenceOn gaining independence in 1947, Indias first Prime Minister, JawaharalalNehru, emphasized the need for the country to build heavy industry (steel,cement, capital goods) and the primacy of the role of the public sector in it.The corporate sector had inherited a managing agency structure that wasstacked in favor of managing agents. The first managing agency in Indiawas British. It was established in 1809. Carr, Tagore & Company is known asthe first equal partnership between European and Indian businesses and italso initiated the managing agency system in India.From then on, for over a century, growth of joint stock companies and150 13. managing agencies was simultaneous and it was dominated by the powerand influence of the managing agencies.In 1850, an Act was passed for the registration of companies with limitedliability. It marked a turning point in the history of Indian business. Agencyhouses formed new joint stock companies, to attract savings from a largepool of investors. The managing agents controlled these companiesthrough inter-locking of directorship and inter corporate investments.Several malpractices and speculative trends emerged on the Bombay andAhmedabad stock exchanges. This system dominated Indian business tillindependence. It was formally abolished in 1969.Indian business families continued the controlling streak that the managingagency system had put into place. In 1950-51, for example, 9 leading Indianindustrial families held 600 directorships, with only two families, viz. Dalmiaand Singhania holding 200 of them. One hundred individuals were foundto hold 1700 directorships, 30 of them holding 860 directorships and thetop 10 held 400 directorships.The practice of multiple directorships continued to plague Indian corporateboards. The Bhabha Committee (1953-54) recommended as upper limit of20 directorships.This was incorporated in the Companies Act, 1956. Ram Jethmalani, thelaw minister in the Union Government (1996-2000), specified the maximumnumber of directorships to be 15, the limit that continues till date. Dr. JJIrani Report on Amendments to the Companys Act (2005), has alsorecommended 15 as the maximum number of directorships.In 1964, the Monopolies Inquiry Commission (MIC) was appointed to lookinto the concentration of ownership in industry. MIC concluded that theoverall concentration of industrial power had increased since 1950.151 14. Professor RK Hazari Committee Report (1966) and Dutt Committee or theIndustrial Licensing Policy Inquiry Committee (1969), laid the frameworkfor the passing of the Monopolies and Restrictive Trade Practices (MRTP)Act in 1970.This restricted the size and scope of private enterprise. In 1977 it becamemandatory for the All India Financial Institutions to put the convertibilityclause and nominee directors appointment clause in their loan agreements.After the second phase of bank nationalizations (the first was in 1969) in1980, all major banks and all large financial institutions were in the publicsector. The stage was set for the Government to have a firm grip on, and asubstantial stake in, both the industrial sector and the financial sector.Government kept out of stock markets; up until the advent of the NationalStock Exchange (NSE) in 1992, it was the Bombay Stock Exchange (BSE), a130 year old exchange, which was the major exchange for companies tolist their shares on. The BSE was governed by brokers as a self regulatoryorganization. There were other, minor, regional exchanges which have died,or are dying, a natural death.1.4.1. Role of Private SectorThe private sector had a small role to play in industrial developmentand had to rely, largely, on financial institutions for their fundingrequirement. Although India boasts of having one of the oldest stockexchanges in the world, its equity market had yet to mature for severalreasons.Primarily, the offer price for new issuances was not market determined butwas based on a formula determined by a Government functionary calledthe Controller of Capital Issues (CCI). It used an average of the past threeyears high/low stock prices, the book value and the earning value of itsstream of profits capitalized at an assumed rate, to determine at what price152 15. stock could be issued. In essence, historical, rather than prospective,earnings were the determinants.Thus the private sector was denied access to the equity market except atprices so low that there was no incentive for good corporate governance. Ithad to rely on debt funding from the six All India financial institutions forproject finance, and from public sector banks for its working capital finance.Both came with a price tag.Bank loans for working capital were expensive whereas the rupee loansfrom all India financial institutions carried with them an option to converta fifth of the loan into equity at very attractive prices.Hence in the context of how financial markets were then structured, and inthe prevailing ethos of domination of the public sector, good corporategovernance was of the least importance for management. There was noreward for good governance. Industrial enterprise was licensed and simplyobtaining a license to manufacture anything was almost enough to assurea profit. Licensing restrained domestic competition and high tariff wallsensured that there was no foreign competition either.In short, the interest of shareholders became subservient to the interest oflenders, which were in the public sector and which permitted, evenencouraged, a high leverage. A debt: equity ratio of 3:1 (or more) was fairlycommon, and high profit margins for producers, due to a lack ofcompetition, allowed such high leverage.The interest of the customer became subservient to the fiscal interest of aGovernment that got a good chunk of its revenue from high import duties.Corporate governance thus did not necessitate finding ways to enhanceshareholder value nor did it involve customer care. The reasons were simple.Shareholder value was, in fact, sought to be contained, because not only153 16. were income tax rates were very high (going up to 97 per cent) but therewas also a wealth tax payable on such holdings. Dividend income, afterpaying tax, did not leave enough for the wealth tax, resulting in a dilutionof holding by promoter groups. Simultaneously, because of the option toconvert rupee loans, the share of the six all India financial institutions wasincreasing. This, of course, alarmed the private industrial groups.The biggest tax breaks were on capital investments including depreciationand allowances for setting shop in backward areas where Governmentwanted industrial development and job growth and gave fiscal benefits toachieve it. This, of course, led to a scramble for licenses to invest andapplications to finance the projects to the monopolistic all Indiainstitutions. Rupee loans from domestic financial institutions came, ofcourse, with a Damocles sword of conversion option into equity.This structure of financing of industry led to several consequences. Poorquality of goods to consumers for one, and mediocre returns to equityinvestors, for another. There was a time when the wait for a telephoneconnection (a monopoly of MTNL in metros and BSNL outside of them;both Government companies) or of scooters (a near monopoly of privatesector Bajaj Auto) was of several years.The quality of service or product was awful but given the absence of anyalternative supply source, Indian consumers accepted these with stoicism,in conformity with the Hindu philosophy of karma. Corporate governancewas thus restricted to producing more since this assured a profit irrespectiveof quality.Investors were content with investing in debt instruments of theGovernment of India, which yielded decent returns after factoring ininflation. Investor queries to management at annual meetings ofshareholders tended to focus more on why dividend was not increased or154 17. why bonus shares were not issued, than on the nature of business or thequality of management. Corporate governance was, largely, cozy meetingsof closed groups of associates. Director fees were governed by the Centreand were not conducive to encouraging an independent spirit of inquiry.The structure also led to poor productivity and lack of innovation, therewas simply no incentive to do either to survive, in the absence ofcompetition. The equity market, though old, had not created enoughexcitement to the number of investors willing to take its risk.This excitement came about in 1973 when a minister, George Fernandes,gave transnational companies operating in India an ultimatum. Either offer40% of your shares to domestic investors or quit. Two companies, IBM andCoca Cola chose to quit (only to return later); the rest diluted and so createdcommunity interest in their prosperity.Because the offer price of these issues (these companies were called FERAcompanies since they were covered by the Foreign Exchange RegulationAct) was controlled by the CCI formula, resulting in a low price, allotmentof shares in them was a safe and splendid investment. The FERA dilutiongave a major impetus to equity investment and thousands of new investorswere attracted to stock markets.But Government policies still stilted in favour of "public good" andmacroeconomic considerations, rather than encouraging privatecompetition. One such policy introduced during the aftermath of theBangladesh war (1971) to curb inflation, was introduced by the then PrimeMinister, Indira Gandhi, was control on dividend, by the introduction ofCompanies Dividends Restriction Ordinance in 1974, further dampeningthe development of the capital market.The structure of a protected market providing enough margin to sustain ahighly leveraged industrial sector at high financing cost, broke down in155 18. 1991. India went into a financial crisis, with enough foreign exchange tosupport just two weeks of imports. Manmohan Singh, as Finance Minister,supported by the taciturn Narasimha Rao as Prime Minister, saw the writingon the wall. He ushered in economic liberalisation.Import tariffs were slashed and licensing requirements greatly reduced.This ensured competition from both imported goods as well as domesticallyproduced ones. In order to protect Indian industry from an onslaught ofimports and to give them time to prepare themselves, he did two things.One was a sharp devaluation of the rupee. The other was to bring downimport duty in steps. He then did a third thing, which was to open capitalmarkets to foreign investors.1.4.2 Liberalisation BluesEven as the economic reforms ushered a transformation in Indias corporatesector, investors had to carry the baggage of poor governance and laxregulation, into the next phase of Indias economic history.The first jolt was the Harshad Mehta securities scam in 1992, involvingseveral banks. (Harshad Mehta was an aggressive bull operator in theBombay Stock Exchange). The stock market crashed by 40 per cent, in thetwo months after April, 1991 when the media exposed the story, with a lossof around Rs.1,00,000 crores.This was followed by several cases in 1993 when transnational companies,seeing the "India growth story", started consolidating their ownership byissuing equity allotments to their respective controlling groups at steepdiscount to their market price. In this preferential allotment scam aloneinvestors lost roughly Rs.5000 crore.The third scandal was the disappearance of companies during 1993-94.Between July 1993 and September 1994, the stock market index shot up by156 19. 120 per cent. During this boom, 3,911 companies that raised over Rs.25,000crore vanished or did not set up their projects. The case of vanishingcompanies continues to persist. The issue is monitored by the Departmentof Company Affairs and not by SEBI or the stock exchanges, and there areregulatory shortcomings that have failed to plug this issue.Recently, a high powered Central Coordination and Monitoring Committee,co-chaired by the Secretary, Department of Company Affairs and Chairman,SEBI was set up to monitor action taken against vanishing companies. Itwas decided to set up seven task forces at Mumbai, Delhi, Chennai, Kolkata,Ahmedabad, Bangalore and Hyderabad with Regional Directors/Registrarof Companies of the respective regions as convenor, and regional officesof SEBI and stock exchanges as members. Their main task would beidentifying companies which have disappeared, or have misutilised fundsmobilized from investors, and to suggest appropriate action as per theCompanies Act or SEBI Act.Another scam involved the plantation companies in 1995-96. It saw aroundRs.50,000 crore of retail investor money disappear.Ketan Pareikh, a major bull broker, propelled the information technology,communications and entertainment stocks to dazzling heights from 1999onwards till the crash in 2001, when his speculative trades were exposedand the market crashed 177 points.Prior to 1991, the only mutual fund then was in the public sector, in theform of the Unit Trust of India (UTI), one of the six all India financialinstitutions. Its governance was, by virtue of Government ownership, at itssole discretion. Its flagship scheme was the US 64 scheme, which ended up,several years later, in deep trouble, because of bad governance.US 64 (a mutual fund product launched by UTI) started, like all open endedmutual funds, as an open ended scheme, with redemptions and purchases157 20. linked to net asset value (NAV). NAV linked redemptions impose their owndiscipline on investing; if investors do not like the performance, they exit. Itwas a regular income scheme (it had to invest around 80 per cent in debtinstruments) but it changed its investment portfolio and by the late 1990s,70 per cent of its portfolio was in equity.The crash of the stock market in 2001 saw its portfolio value crashing. US64s position became untenable, and the fund announced that it woulddrop its repurchase price to Rs 10, to the consternation of those who hadbought units at Rs. 16 in the recent past. Investor confidence was shakenand the Government bailed out UTI, taking over (at reduced liability) theassets and liabilities of US 64and segregating and spinning off the otherassets.The UTI episode shook the confidence of the small investors. There was anurgent need felt to reform Indias capital markets. Though the Securitiesand Exchange Board of India was established in 1988, it was empowered asa capital market regulator in 1992 (post-Harshad Mehta scam), with thepassing of an Ordinance, giving it statutory status and powers. Since then,SEBI had taken several steps to reform the market. But after the UTI episodeit had to tackle a confidence-crisis that hit the equity market on a warfooting.1.5 Reforms in Indias Capital MarketsAmong the first steps taken by the government was to repeal Capital Issues(Control) Act, 1947, in 1992 paving the way for market forces in thedetermination of pricing of issues and allocation of resources for competinguses. Companies were free to price their issues according to what investorsperceived to be their value, looking to the future, rather than on the basisof an antiquated formula, which peered into the past. The next major stepwas the abolition of wealth tax on shares in 1992-93.158 21. Tax rates were reduced from a peak 97 per cent to 56 per cent in 1991 and30% in 1997. Due to recent imposition of a surcharge and cess, it is almost34% today.Indian companies experienced the euphoria of market pricing and marketdriven valuations for their company. Book building was introduced toimprove the transparency in pricing of the scripts and determine propermarket price for shares. The primary market saw a boom.Simultaneously, the secondary market was given a lift up when tradinginfrastructure in the stock exchanges was modernized by replacing theopen outcry system with on-line screen based electronic trading. Thisimproved the liquidity in the Indian capital market and led to better pricediscovery.The trading and settlement cycles were initially shortened from 14 days to7 days. Subsequently, to enhance the efficiency of the secondary market,rolling settlement was introduced on a T+5 basis. With effect from April 1,2002, the settlement cycle for all listed securities was shortened to T+3 andfurther to T+2 from April 1, 2003. Shortening of settlement cycles helped inreducing risks associated with unsettled trades due to market fluctuations.The establishment of National Securities Depository Ltd. (NSDL) in 1996and Central Depository Services (India) Ltd. (CSDL) in 1999 has enabledpaperless trading in the exchanges. Trading in derivatives such as stockindex futures, stock index options and futures and options in individualstocks was introduced to provide hedging options to the investors and toimprove price discoverymechanism in the market. The Investor ProtectionFund (IPF) has also been set up by the stock exchanges. The exchangesmaintain an IPF to take care of investor claims.Another significant reform has been a recent move towards corporatisationand demutualisation of stock exchanges. The Bombay Stock Exchange was159 22. corporatised and demutualised in 2005.Setting up of credit rating agencies, CRISIL, ICRA was significant but it hasnot made a significant contribution to the retail market for corporate debtinstruments. The recent failure of a few large Initial Public Offers (IPOs)issues and disappointing performance of some IPOs on listing, hasprompted regulators to suggest a mandatory rating for all new IPOs. Therecommendation has not yet been implemented.The setting up of the National Stock Exchange of India Ltd. (NSE) as anelectronic trading platform set a benchmark of operating efficiency forother stock exchanges.Table 1.45 : Comparision of BSE and NSE Bombay Stock Exchange Ltd National Stock Exchange ofMarketMarketYear/Turnover (Rs.Turnover (Rs.2002-5,72,1983,14,0735,37,1336,17,9892003- 12,01,2075,03,053 11,20,976 10,99,5352004- 16,98,4285,18,715 15,85,585 11,40,0712005- 30,22,1918,16,074 28,13,201 15,69,5562006- 35,45,0419,56,185 33,67,350 19,45,285* Rupees (Rs.) is the Indian currency and Rs. 1 is approximately equal to$40 (average).5Source : Bombay Stock Exchange and National Stock Exchange.Foreign Institutional Investors (FIIs) allowed since the mid-1990s, brought160 23. with them better disclosure and corporate governance standards.Foreign institutions were willing and able to pay a higher multiple forearnings and they were also willing to pay for good corporate governancestandards. At present, around 1000 FIIs are registered with SEBI.To attract retail investors into the equity market the mutual fund industrywas thrown open to the private sector and today one private fund, Reliance,has overtaken UTI in terms of assets under management, with others closebehind.Since 1980, after the second round of bank nationalization, the ReserveBank of India had not issued any private bank license. In a major move toincrease the efficiency of intermediation in the financial markets, the policywas reversed and private sector banks were set up. Some of the moreenlightened all India financial institutions converted themselves intocommercial banks. ICICI was the first of the three lending institutions to doso, and has now become the most valuable private sector bank in thecountry.Interestingly, ICICI was, ab initio, a listed company, with an independentboard accountable to public shareholders, which, perhaps, explains itsgreater ability to transform. The next to transform from developmentalfinance to commercial banking was IDBI. The last, IFCI, was closest to Delhiand hence most suitable for misdirected lending under political pressure;it nearly became a sick institution. Thus, even within financial institutionsthere were different governance standards.The advent of foreign institutional investors, the growth of the mutualfund industry and the freedom to price issues gave a huge impetus to goodcorporate governance. Institutional players were willing and able to paymore than individual investors, so promoters found that their wealth wasmultiplying in value. There was now no wealth tax, hence an incentive to161 24. increase shareholder value. Price/earnings multiples were higher and, theydiscovered, every rupee retained in the books of the company rather thantaken away through financial jugglery, enhanced their wealth far more.Increasing shareholder value thus became a mantra and improvedcorporate governance standards the means to achieve it.1.6 Outcomes of Equity Market Reforms and Proactive CorporateGovernance Processes.1.6.1.Impact on the CompaniesFreedom to price issues and access to capital markets provided to firstgeneration entrepreneurs, set in motion a chain of events. Whereas earlieronly the already established houses had the wherewithal and the contactsto obtain licenses to manufacture products and the connections with stateowned financial institutions to finance their projects, the field was nowopen to anyone. Thus sprang first generation entrepreneurs, such as InfosysTechnologies, led by the well known N. R. Narayan Murthy, which venturedinto software services. This, a field where the biggest assets walked out thedoor every evening, was not a venture traditional lenders, which lentagainst asset backed securities, would have earlier considered fundable.The equity market was also unsure of his venture and the IPO had to berescued by their investment bankers. Under Murthys leadership, Infosysraised the bar for good governance.In one of its earlier analyst meetings, Murthy confessed that GE, its largestcustomer accounting for a major share of turnover, had walked out onthem because Infosys refused to cut prices to get more business. More thanthe event, it was the honesty and the chutzpah of the disclosure thatimpressed analysts. The stock price never looked back and gave superlativereturns to early shareholders. Shareholders were willing to pay a higherprice for well-governed companies with good disclosures.162 25. On the flip side, corporate management realized that good governanceyielded commensurate returns.Another first generation entrepreneur was Dhirubhai Ambani, whofounded Reliance Industries, now a FORTUNE 500 company. He was astuteenough to appreciate the value of the equity market and clever enough toreward his shareholders so well that they subscribed to each new offeringof the group. He financed his ventures through frequent tapping of capitalmarkets, ensuring that he left enough on the table for his investors to wantmore. The group is now split between his two sons, with both growingsizeably.n telecom, a new entrepreneur, Sunil Mittal set up Bharti Airtel, one of thebest performing stocks. Mittals forte was finding strategic and financialinvestors with staying power, and building and maintaining relationshipswith them.Corporate governance has a cause-and-effect relationship with investorexpectations. As the market became institutionalised with the advent ofmutual funds, investor expectations of governance standards increased.Simultaneously, institutional investors were willing and able to pay morefor companies with better governance.Companies have now set up different committees for investor relations,compensation, audit and others, with independent board members sittingon each. Sometimes these committees are independent and effective,sometimes not. Infosys Technologies is considered the benchmark of goodcorporate governance; its CEO was recently fined by its audit committeefor neglect inadvertently failing to disclose certain transactions within the24 hour time set for such disclosure. The committee asked him to pay thefine as a donation to his favourite charity.Annexure 1.2 compares the top 10 companies based on their market163 26. capitalization in 1992, a year after the economic reforms started; 2001,around 10 years after the reforms were initiated; 2007, when the marketswere witnessing a boom and in 2008, after the sub prime problem in theU.S and the subsequent volatile international capital market, as also a slowdown in the world economies.The analysis is revealing. The top positions in 1992 were dominated byprivate companies in steel, engineering, cement, FMCG, and capital goods.In 2001, IT and telecommunications enjoyed the top slots and public sectorcompanies in oil and finance industries began making inroads into thecapital market.A comparison between 2007 and 2008 reveals that well-governedcompanies Bharti Airtel, TCS, Reliance Industries continue to find a placeamong the top 10 companies despite the turbulence in the market whileseveral government controlled companies in the metals, mining &commodities industries, enjoying a near monopoly position in theirindustries, are now placed among the top 10.1.6.2.Impact on the Equity MarketsOne of the most significant ratios to measure the impact of reforms on theequity market is stock market capitalization to GDP ratio.Graph. : 1.1 : 19911993199419951996 19971998 19992000200120022003 200420052006 20076 Source : Currency & Finance, RBI, 2005-2006164 27. Graph : 1.27 : Market Capitaliation as percent of GDP in select economies(As at end-2005)Hongkong UK SingaporeAust rali a USJapanK oreaThailand a Brazil Philipines Argentina Indi Mexico7Source : Currency & Finance, RBI, 2005-200During the recent boom in 2007, the market cap/GDP ratio in India jumpedup to 173 per cent, and it was feared that the market is overheated.The turnover ratio (TOR) is measured by dividing the total value of sharestraded on a countrys stock exchange by stock market capitalization. It is ameasure of trading activity or liquidity in the stock markets.The value traded ratio (VTR), is the total value of domestic stocks traded ondomestic exchanges as a share of GDP. This ratio measures trading relativeto the size of the economy.As is evident in the following table both TOR and VTR have significantlyimproved since 1990-91, when the economic liberalization process began.Between 1996-97 and 2000-01, the ratios reached high levels, largelybecause of the rise in stock prices due to the boom in informationtechnology stocks.165 28. Table 1.5 : Liquidity in the Stock Market in India (Per cent) Value Traded Year Turnover Ratio 1231990-91 32.7 6.31991-92 20.3111992-93206.11993-94 21.1 9.81994-95 14.7 6.91995-96 20.5 9.91996-97 85.830.61997-9898 381998-99 126.5 41.71999-0016778.12000-01 409.3 111.32001-02134362002-03 162.9 37.92003-04 133.4 57.92004-05 97.753.12005-06 78.966.92006-07 81.870.7The National Stock Exchange was a leader in the trading of single stockfutures in 2006, according to the World Federation of Stock Exchanges. Itwas at the fourth place in the trading of index futures.166 29. Table 1.68 : Top Five Equity Derivative Exchanges in the world - 2006A. Single Stock Futures Contracts No. of Exchange RankNational Stock Exchange, India 100,430,5051Jakarta Stock Exchange, Indonesia 69,663,3322Eurex 35,589,0893Euronext.liffe29,515,7264BME Spanish Exchange 21,120,621 5B. Stock Index Futures Contracts No. ofExchangeRankChicago Mercantile Exchange470,180,1981Eurex270,134,9512Euronext.liffe 72,135,006 3National Stock Exchange, India 70,286,258 4Korea Stock Exchange 46,562,881 5Source : World Federation of Exchanges.8Source : Currency & Finance, RBI, 2005-200As per the SEBI-NCAER Survey of Indian Investors, 2003, there has beenasubstantial reduction in transaction cost in the Indian securities market,which declined from a level of more than 4.75 per cent in 1994 to 0.60percent in 1999, close to the global best level of 0.45 per cent. Further, theIndian equity market had the third lowest transaction cost after the USand Hong Kong.Despite the positive impact of the reforms, households continue to have alimited investment in the equity markets, including the mutual fundsmarket. (See table 1.7).167 30. Table 1.79 : Share of Various Instruments in Gross Financial Savings of the Household Sector in India (Per cent) Bank and non -Insurance, PF,Units of Claims onShares andPeriod Currency1970-71 13.9 48.631.30.54.21.51980-81 11.945 25.92.211.1 3.91990-91 10.8 39.625.56.68.19.41995-969.7 43.430.50.910.8 4.72000-018.9 40.9 29-0.818.8 3.2@: Includes investment in shares and debentures of credit/non-creditNote : Gross financial savings data for the year 2004 are on new base, i.e.,-059Source :Handbook of Statistics on the Indian Economy, 2005-06, RBI.An important question is how far are do the reforms in the capital marketbenefit the Indian retail investors. In fact, the India growth story hasattracted foreign institutional investors (FIIs) in a big way, with global majorslike CLSA, HSBC, Blackstone, Fidelity, Goldman Sachs, Citigroup, MorganStanley, UBS, T Rowe Price International, among others, entering the capitalmarket. Several sovereign pension funds like, the Netherlands ABP(Algemeen Burgerlijk Pensioenfonds), Norways The Government PensionFund - Global (Statens pensjonsfond - Utland) and DenmarksLonmodtagernes Dyrtidsfond (LD Pensions) have invested over $1.2 billion(nearlyRs. 5,000 crore) in India.168 31. This has increased the buoyancy as also the volatility in the stock markets.With a net cumulative investments of around $65 billion, FIIs account foraround 25 per cent of the floating stocks in the Indian stock markets.Till recently, Indian pension funds were disallowed investment in Indianequities. After three years of delays and discussions on Project OASIS (OldAge Social and Income Security) Report tabled by SA Dave in 2001, thePension Fund Regulatory & Development Authority Ordinance was passedin 2004. It allows investment of pension funds up to 5 per cent in to equitiesand another 10 per cent in to equity linked mutual funds. Around 95 percent of government backed pension funds are locked in low-yieldinggovernment paper.This denies Indian pension funds the right to reap the benefits of economicreforms and the great India shining story.India needs a market driven corporate governance culture with greaterparticipation from Indian retail investors, either directly or through mutualfunds; entry of government pension funds into the equity market in a reallycompetitive mode, with checks, balances and transparency in line with theNorwegian sovereign funds high standards of corporate governance anda close, alert regulatory oversight to ensure compliance with the well-drafted codes and clauses.The Indian equity market presents an opportunity for a real transformationto the Indian landscape. If India misses this opportunity, the Indian growthstory would benefit foreign pension funds and high net worth investors/promoter-families more than the Indian on the street. This is not muchdifferent from the British Empire days when Indias wealth enriched thecoffers of the British, and the wealthy Indian business community.1.10 Summing Upa)Historically Indian companies had no incentive to show higher profits169 32. on their books and enhance shareholder value. This was on accountof a very high tax structure - both personal/corporate and also wealthtax.b)The private sector was also denied access to the equity market at fairmarket valuations due to strict control of the pricing of public issuesby the erstwhile Comptroller of Capital Issues. The combination of hightaxes and low valuations left no incentive for good corporategovernance.c)The early beginnings of corporate governance was an outcome of therepealing of the Capital Issues (Control) Act, 1947, in 1992 paving theway for market forces in the determination of pricing of issues andallocation of resources for competing uses. Tax rates were reducedfrom a peak 97 per cent to 56 per cent in 1991 and 30% in 1997. Due torecent imposition of a surcharge and cess, it is almost 34% today.d)Indian companies experienced the euphoria of market pricing andmarket driven valuations for their company. Corporate managementrealized that good governance yielded commensurate returns.e)Though India has not experienced large scale corporate scandals likethose experienced by the U.S., this is more a result of a convergence ofthe interest of management and owners (both constituted by thedominant promoter-family/dominant government holding), ratherthan because of higher standards of corporate governance.f)The predominant issue in India is the conflict between "dominant"shareholder-promoter groups and minority shareholders. There arearound 250 big and small listed companies with promoter holding ofover 75 per cent each. The prominent among them are Wipro, TataConsultancy Services, Jet Airways, DLF, Puravankara Projects, AkrutiCity, Omaxe, Plethico Pharmaceuticals, Sobha Developers, Mundra170 33. Port, BGR Energy, Blue Dart, Parsvnath Developers, and Bosch Chassis.The promoters, in most cases, currently hold over an 80 per cent stakein these companies.g)Unlike in Japan/Germany, where banks play a critical role, as creditors,in the corporate governance of companies, in India, though banks/ FIshad large debt exposures to the Indian corporate sector, (and with aconversion clause in the loan agreement the debt was often convertedinto an equity holding) several studies have shown that they did notexercise close monitoring of the corporate governance standards inthese companies.h)It is observed that in the Indian context, the external market exercisesa limited force on corporate governance (since the floating stock inthe secondary market is limited). Nor is the internal force of a strongBoard (since management and Board members are, very often, fromthe same dominant promoter group) always effective in protectingthe principles of sound corporate governance.Despite globalization, and an increase in foreign institutional investmentin Indian companies, institutional activism is also weak and yet toemerge as a strong counter force. Institutional investors, both domesticand foreign, are more prone to vote with their feet, by exiting the stock,than to influence a change in management behavior.i)India needs a market driven corporate governance culture with greaterparticipation from Indian retail investors, either directly or throughmutual funds; entry of government pension funds into the equitymarket in a really competitive mode, with checks, balances andtransparency in line with the Norwegian sovereign funds highstandards of corporate governance and a close, alert regulatoryoversight to ensure compliance with the well-drafted codes and171 34. clauses. Corporate governance goes beyond crises, committees and compliances.j) The corporate board reflects the spirit of corporate governance of a company. To understand the corporate governance of a country it is imperative to understand the framework of its corporate boards. Table 1.1COMPARISON ON OF TOP MARKET CAPITALIZATIONCOMPANIES SINCE ECONOMIC LIBERALIZATION Rank CompanyType of Industry Ow nership 1TISCO LTD.Steel Private 2ITC LTD.Tobacco Private 3RELIANCE INDUSTRIES LTD.Diversified Private 4HIND LEVER LTD. FMCGMultinational as on 5TELCO Automobiles Private 6ACC LTD CementPrivate 7ICICI LTD Finance Private 8LARSEN & TOUBRO LTD.Capital Goods Private 9CENTURY TEXTILES & INDS.TextilesPrivate10GRASIM INDUSTRIES LTD.Diversified Private 1WIPRO LTD.ITPrivate 2HIND UNILEVER LTD.FMCGMultinational 3RELIANCE INDUSTRIES LTD.Diversified Private 4INFOSYS TECHNOLOGIES LTDITPrivate as on 5ONGCOil & Petroleum Public 6ITC LTD.Diversified Private 7HCL TECHNOLOGIESITPrivate 8INDIAN OIL CORPORATION LTDOil & Petroleum Public 9STATE BANK OF INDIA Finance Public10MTNLTelecommication Public 1RELIANCE INDUSTRIES LTD.Diversified Private 2ONGCOil & Petroleum Public 3BHARTI AIRTEL LTD Telecom Private 4NTPC LTDPower Public as on 5RELIANCE COMMUNICATIONS CommunicationsPrivate 6INFOSYS TECHNOLOGIES LTDITPrivate 7TATA CONSULTANCY SERVICES ITPrivate 8DLF LIMITED Housing related Private 9ICICI BANK LTDFinance Private10BHELCapital Goods Public 1RELIANCE INDUSTRIES LTD.Diversified Private 2ONGCOil &PetroleumPublic 3NMDCMinerals & Mining Public 4NTPCPower Public as on 5Bharti Airtel CommunicationsPrivate 6Mineral & Metal Minerals & Mining Public 7SBI Finance Public 8DLF Housing related Private 9RELIANCE COMMUNICATIONS.Commun ications Private10TATA CONSULTANCY SERVICES ITPrivate172 35. Authors ProfileProf. Dr. Uday Salunke Director - Welingkar Institute of Management is a mechanical engineer with a managementdegree in Operations, and a Doctorate in Turnaround Strategies. He has 12 years of experience in the corporate worldincluding Mahindra & Mahindra, ISPL and other companies before joining Welingkar in 1995 as faculty for ProductionManagement. Subsequently his inherent passion, commitment and dedication toward the institute led to his appointment asDirector in 2000. Dr. Salunkhe has been invited as visiting fellow at the Harvard Business School, USA and EuropeanUniversity, Germany. He has also delivered seminars at the Asian Institute of Management, Manila and has beenawarded "The Young Achievers Award-2003" in the field of Academics by the Indo American Society recently.173 36.