In my twenties, I used to give anything to do with corporate governance a wide berth. It seemed like a dry subject divorced from the sexiness that surrounds financial markets. In my thirties, thanks to our clients, I am coming around to a very different view of the importance of corporate governance.
To be more specific, I manage a team of investment analysts and part of my job is to run around the world advising institutional investors. What I hear them say about Indian corporate governance and Indian accounting has made me realise that investors worry about these subjects much more than they about the daily news flow on earnings and GDP growth.
To give you a flavour of how worried investors are, I will give you a summary of my meetings in the US last week. Of the 20 institutional investors that I met:
- A quarter refused to invest in Indian stocks because they have been duped in the past by a cocktail of corrupt management and make-believe accounting.
- Another quarter refused to invest in Indian Power, Infrastructure & Realty stocks because they believe that the capital raised by these companies goes into the “wrong pockets”.
- The remaining 50% of investors have capital committed to Indian stocks but largely on the back of “longstanding….special relationships with promoters”.
So why is investor distrust of Indian management teams and accounts so high? I will dwell upon the three main issues that investors worry about and highlight some basic remedies.
While the Indian GAAP (Generally Accepted Accounting Principles) by itself is no more or less flawed than IFRS (International Financial Reporting Standards), our market suffers because of how these rules are applied. There are three areas which give particular cause for concern.
First, the lack of restrictions placed on auditors who do consulting work for the companies they audit. In a number of instances we have run into listed companies where the consulting arm of the audit firm earn advisory fees for help with M&A, new entity structuring, tax minimisation and so on. Often such consultancy fees dwarf the audit fees received by the accounting firm, thereby creating a conflict of interest. In western markets, following the Enron scandal, there are clear rules which limit how much consultancy work accounting firms can do for the firms they audit. India needs such limits to be put in place.
Second, in contrast to other large capital markets, the Indian market makes it all too easy for Annual Reports to be published many months after the financial year has ended. Since quarterly reports are unaudited, don’t contain a cash-flow statement and a balance-sheet, and don’t include subsidiaries’ numbers, the Annual Report is keenly awaited as it is the only document which gives a full picture of a company’s financial health.
Companies with weak cash-flows and weak balance sheets delay Annual Reports for six, even 12 months after the year-end by which time the market’s focus has moved on to the other things. The implications for investors in such companies is that they end up holding the stock for months without knowing how the company is actually performing. In stock markets larger than ours, the law says that the Annual Report has to emerge within three months following the year-end. We too need a similar rule and we need to compel companies to produce more comprehensive quarterly results.
In the Western world, the Boardroom can be divided into executive and non-executive directors, with the latter having a clearly defined stewardship role to play. In India, we have an all-powerful third force called the promoter who need not be an executive director but is more powerful than the Board. This inability to provide checks and balances on the promoter’s power is arguably the single biggest failing of our stock market.
Many western markets have now made it compulsory for the Chairman and the CEO roles to be split. We too need to think about such a split. Furthermore, we need more legal safeguards to protect independent directors from the promoter’s power.
Corporate shenanigans impose a very tangible cost on our country - Indian corporates have the highest cost of capital outside sub-Sahara Africa. One major reason for this is neither FIIs nor retail investors are fully convinced about the merits of long term investment in Indian stocks. As a result, money flows into our market are very volatile and this pushes up our cost of capital. If we want to change this state of affairs we have to raise our corporate governance standards.