A few notes on governance

Institutional activism and class-action suits key to success

The Securities and Exchange Board of India’s (Sebi) proposals for reforms in corporate structures will lead to changes in the boards of many companies and also to a major change in the management pyramid in firms run by chairman-cummanaging director (CMD). Will it lead to better governance standards and therefore, to higher returns?

India Inc has many types of management structures. There is the family firm, run by senior family members. This is often a second-generation or third-generation business, set up by an ancestor of the current management. The various Birla groups, Reliance and ADAG, DLF, and Dabur, would be among the many examples of this structure.

Another common structure is a first-generation business. The promoter has conceptualised the business, owns a large stake and takes hands-on decisions. This may turn into a family business, or it may end up being professionally run by managers appointed by shareholders. Many of India’s best IT and pharma businesses, Suzlon, Bharti Airtel, the Adani group, etc, are first-generation plays.

Then, there is the professionally-run business where the management doesn’t own big stakes. Larsen & Toubro, ITC, and the Tata firms, would be some examples, along with MNC subsidiaries like Hindustan Unilever, where the majority owner is a transnational entity. A fourth type of corporate structure, specific to India, is the public-sector unit (PSU). The government is in control and appoints who it chooses. In PSUs, the focus is not on shareholder returns. Policy decisions are taken by the political establishment, which doesn't care if shareholder value is destroyed.

Management theorists consider it axiomatic that professional management is the best bet for shareholder returns. A professional manager will supposedly act in the interest of all shareholders and attempt to maximise returns. The best returns actually come from “first generation” start-ups. To take some global examples, big winners like Microsoft, Apple, Google, Facebook or Amazon, were “first generation”, with hands-on promoters. Many of these have become professionally managed. Some still have hands-on founders. In India as well, there have been huge returns from first-generation plays.

Many family-run ‘second generation’ firms have also given excellent returns. There is no reason why a family member would not be a good “professional” manager. He or she has a stake and has been brought up to understand the business. Most children from such families have good qualifications. The one reservation is that such a person might not care about minority shareholders.

The board is supposed to maintain checks and balances and also place the views of institutional shareholders on record. In practice, most boards are rubber-stamps and this is especially true for PSUs. Institutional activism is unknown in India.

Many of the proposals for reforms in corporate governance structures will just be minor irritants and lead to cosmetic changes. There will be no change in functioning styles if boards continue to be rubber-stamps. A larger board, with more female representation and more independent directors, will just be a larger rubber stamp. PSUs being delinked from ministries in terms of administrative controls could also be purely cosmetic.

Splitting the functions of a CMD could lead to more reworking of management styles and to more chances of internal conflict. The specific functions associated with such positions are undefined. Managements could allocate powers in different ways but CMDs used to exercising full control will have to delegate. It isn’t easy for either an executive chairman or an MD to be a rubber stamp. So, this could lead to some conflicts. My guess is most companies will comply with the letter of the law, while tweaking their preferred management styles as little as possible. The suggested framework of more directors, more independent directors, split CMD functions, more female representation, PSU independence, etc, could create preconditions for more ethical practice and better management. But, it doesn’t guarantee it.

World over, corporate practices have only improved when institutional shareholders used their clout, or companies faced punitive class-action suits. Neither is a likely prospect in India and PSUs are especially well insulated from either. These recommendations are good. But, governance is unlikely to improve until the two key elements — institutional activism and class-action suits — also come into the picture.