Management’s Responsibility to Shareholders

Sometimes, it is not clear whether management of Indian companies recognise that they owe a fiduciary responsibility to their shareholders. But for competitive reasons, management should ideally conduct business in a transparent manner and keep shareholders informed of material developments to the company. Of course, the line between management and shareholders blurs when the promoters of the company, usually the single largest shareholder, run companies as their own fiefdom.

I just take a few instances of recent times:

1. The stock of Bajaj Auto crashed on the date the company management announced a trifurcation of the company. Investors were caught on the wrong foot when they found that they had valued the stake of Bajaj Auto in the insurance joint ventures assuming a much higher shareholding. Bajaj Auto had given Allianz AG, it partner, an option to increase its shareholdings at a pre-determined price. Mr. Rahul Bajaj, the chairman of Bajaj Auto, was reported to have said “What can we do? We were bound by confidentiality clauses in our agreement. How can we declare it of our own?” http://www.dnaindia.com/report.asp?NewsID=1098114
2. After Mylan, an American company, bought out the promoter shareholdings in Matrix Laboratories Limited, the stock price of Matrix declined by almost 50%. The reason purportedly was the uncertainty over transfer pricing between Matrix and Mylan.

There are a number of other examples if one goes looking for them.

Historically, Indian financial institutions – typically large shareholders in any Indian company – tended to adopt a benign attitude towards the way management run companies. Very rarely was management decisions questioned, much less opposed.

However, the shareholding pattern of Indian corporates has changed dramatically in the past decade or so. It is well known that Foreign Institutional Investors – on average – own about 30% shareholding, and, Indian financial institutions own about 15% of leading Indian corporates. These institutions should demand more transparent workings of these corporates. Shouldn’t Bajaj Auto have revealed the arrangement with Allianz right from the time the insurance joint ventures were signed? After all, wasn’t shareholders permission sought to make these investments? Aren’t these arrangements material in nature, directly impacting the imputed value of Bajaj Auto’s shareholdings? Mr.Bajaj should realise that he owes it to all shareholders for the value erosion.

In India, institutional shareholders rarely ever drag the company and its management to the courts, suing them for misinformation and non-transparency. While we don’t need a litigious corporate world, we need active shareholders that seek and demand better corporate governance from their investee companies.

Disclaimer: As of today, the author has never owned shares in any of the above mentioned companies.

With Great Power Comes Great Responsibility

Large and prominent investors who invest globally have been under pressure to make what is known as Socially Responsible Investments (SRI). However, even those investors that profess to do SRI are finding their investments coming under increasing public scrutiny and criticism.

In recent years, a number of issues that are subject to strong negative public opinion include:
• Environmental issues
• Social Issues
• Human Rights Issues

Some recent instances when investors had to defend themselves:

Warren Buffett had to write a letter to shareholders of Berkshire Hathaway to defend his investment in Petrochina, whose parent Sinopec is operating in Sudan. (www.berkshirehathaway.com/sudan.pdf). Sudan has been under increasing international pressure for the Darfur crisis. Of course, Warren Buffett is an American capitalist. Petrochina shares have gone up 5 times since his investment!

Norges Bank Investment Management, a leading global investor, is the investment arm of the Government of Norway. In order to secure the future of the country, the government has focussed on converting petroleum assets in Norway into financial assets worldwide, under a fund called The Petroleum Fund, and subsequently renamed to Government Pension Fund. This fund has assets of over USD 300 billion dollars. The Fund has drawn up a list of blacklisted companies in which it cannot invest. The Fund has drawn criticism for blacklisting Wal-Mart, purportedly for child-labour violations.
www.iht.com/articles/2007/05/02/business/norway.php

These instances show that investors need to be treading carefully on these fronts. They need to learn from the advice Spiderman got “With great power, comes great responsibility”.

Takeaways from a CEO Breakfast

On May 18th, I had an opportunity to attend a CEO breakfast here in Hong Kong hosted by Economic Intelligence Unit (EIU), a sister unit of The Economist, and Marakon Associates (file://www.marakon.com/), a management consulting company. The meeting was largely a networking opportunity. The speaker was Ken Favaro (file://www.marakon.com/firm_loc_favaro.html), the co-Chairman of Marakon who made a ten slide presentation that was followed by discussions.

He talked about "The Three Tensions" corporates undergo:

• Growth in Topline versus Growth in Bottomline. (Profitability vs Growth)
• Long Term versus Short Term. (Short Term vs Long Term)
• Standalone Business Unit Performance versus Synergistic Performance. (Whole vs Parts)

The key point is that successful companies are those that manage these 3 tensions and hence achieve Total Shareholder Returns (TSR).

Just as a typical management consultant would do, he backed these points with data, largely from a survey of about 1100 companies worldwide. Some key insights from the presentation and the ensuing discussion that I took note of were:

• In a similar discussion in Tokyo, one Japanese executive had said "I balance 3 tensions - boss, spouse and commute. Do I need 3 more?”
• Companies that purely focussed on topline or bottomline growth were likely to do so by focussing on competitors and were less likely to achieve sustainable growth. On the contrary, companies that focus on customer benefits and grow the marketplace are likely to have sustainable performance.
• A large part of discussion was focussed around Long Term versus Short Term, about how Short Term is manifest in the form of quarterly results. The pressure from investors would be relentless, to the extent of it being almost self-destructive, that is, investors may force companies to chase short term growth over sustainable growth.
• Debate on how Asian companies now mirror the state of companies in Europe post the Second World War, where growth is pursued at the cost of bottomline.
• Asian companies (ex-Japan) had a TSR of over 30%, comparable to the rest of the world. Japan was quite low. Ken said that this seemed perplexing and the only explanation seems to be the share prices are reflecting the future predicted growth of these companies.
• The merits and demerits of publicly listed companies going private.

These form the basis of a book “Three Tensions” (www.thethreetensions.com) and an article in Harvard Business Review in December 2006 (www.marakon.com/ida_061201_favaro_01.html).

My thoughts on some of these insights:

• These 3 tensions seem to be driven by the need to deliver Total Shareholder Returns. Shareholders are only one of the many stakeholders in any company.
• The distinction between Asian companies and non-Asian companies seems to be artificial when measured on the basis of financials. Leading Asian companies – companies with headquarters in Asia - increasingly derive a large part of revenues from the US and Europe. Similarly, leading American and European companies derive a large part of revenues from Asia. So, logically the financials of all companies should be broken up geographically and compared.
• One of the main reasons attributed to publicly listed companies going private is to be away from the glare of Wall Street analysts. However, this presumes that private equity funds themselves are long term investors, which is not necessarily true.
• This analysis focuses on traditional measures of sustainability like TSR. Newer measurers and indicators of sustainability like environment friendliness, socially responsibility, etc have not been factored in.
• How would some of these tensions manifest for governmental departments, social development organisations, education institutions, small enterprises, etc.

Apart from me, the attendees included:

• Managing Director, Hong Kong - Atos Origin
• Partner - Bain & Company
• SVP/Head of Risk Office - Bayerische Landesbank
• Executive Director, Client Development - Colliers International
• Managing Director, ECCO
• Managing Director, Fiducia
• Chief Operating Officer, Hang Seng Bank
• Managing Partner, Human Capital Partners
• Vice President, iRobot
• Regional Vice President, Lundbeck
• Managing Director, Merck Sharp & Dohme
• Regional Director, LaSalle Investment
• Vice President, Merrill Lynch
• Chief Executive Officer, Pentland Asia
• COO, China Beverages, PepsiCo
• CFO, Prudential Holdings
• CEO, Regus
• CEO, Talent2
• President, Telstra
• Regional Director, Finance, Walt Disney
• COO, Three Towns Capital
• Regional Director, EIU
• Managing Partner, Asia, Marakon
• Partner, Marakon

SEBI - Great Diagnosis but Poor Medication

Authors: Gaurav Jetley, Vice President, Analysis Group and Shriram Subramanian, Principal Consultant, Infosys

In any investigation related to securities fraud, the verdict and compensation meted out should not only be adequate to punish the guilty, but also act as a deterrent for future fraud by others. To this extent, SEBI should lay out proper guidelines on:
* philosophies that drive investigations
* basis on which punishments would be handed out and compensation will be provided
* accountability of those who commit fraud

A recent ruling by SEBI is taken up to illustrate our arguments. On March 6, 2007 the Securities and Exchange Board of India (“SEBI”) ruled on the matter Bonanza Biotech Limited (“BBL”). By way of background, SEBI was investigating the role of BBL in selling approximately 98 lakh unlisted shares of Design Auto Systems (“DASL”) in the secondary markets between November 2001 and January 2002. BBL had received shares of DASL via a questionable stock swap in which DASL issued 10 crore of its unlisted shares to BBL in exchange for 10 crore unlisted shares of BBL. In essence, DASL “manufactured” 10 crore shares, gave them to BBL, who in turn tried to sell the, essentially counterfeit, DASL shares to unsuspecting investors.

SEBI’s ruling in the BBL matter clearly details the scheme hatched by the directors of BBL and DASL to defraud investors, and how the scheme violated the Prohibition of Fraudulent and Unfair Trade Practices (“PFUTP”) regulations. However, the remedy suggested by SEBI for the “entrapped public shareholders of DASL” seems arbitrary.

Specifically, the ruling states that BBL, by virtue of being “instrumental” in selling the DASL shares should offer to buyback the 98 lakh shares at, “the higher of the prices to be determined on the following parameters: i) the price paid for an acquisition made by BBL in the 26 weeks preceding the reference date (January 14, 2002 – the date on which the DASL shares were delisted); ii) other parameters relating to shares of DASL including return on networth, book-value, earning per share, price earning multiple vis-à-vis industry average.” In addition SEBI has ordered BBL to pay 10% interest to the defrauded interest fro the period from January 14, 2002 through the ultimate payment date.

Both parameters identified by SEBI are likely to result in compensation that does not reflect the actual loss suffered by the entrapped investors. In fact a simple measure of harm suffered by the entrapped investors is the price they paid to acquire the DASL stock. For example, if Mr. X bought 100 shares of DASL at price of Rs. 6, from BBL on December 2, 2001, the loss suffered by Mr. X on December 2, 2001 is Rs 600, because the shares he bought were essentially counterfeit and worth nothing. Paying Mr. X something other than Rs.6 per share simply because BBL’s average acquisition during a given 26-week period is arbitrary at best. In fact, this particular parameter seems to ignore fundamental finance theory that informs us that at any point in time, share prices reflect information about the company, industry and economy at that point in time. Thus there exists no economic rationale for basing compensation for fraud on some average acquisition price over a 26-week period. At this point we will not even try to discuss the question: why pick a 26 week period?

SEBI’s second parameter, i.e., basing price on average industry book-value and other financial metrics, seems more involved, but is equally inadequate. First, company specific factors do have an impact on valuation metrics such as the ones identified by SEBI. For example, size, amount of debt and credit quality is likely to cause variation in price-to-earnings and price-to-book multiples. Thus, anything less than an involved econometric exercise is likely to result in estimates with an unknown, but large bias. Second, there seems to be little academic evidence that a model such as the one alluded to in SEBI’s second parameter can help anyone ascertain the “true value” of a company’s stock price. Three, and perhaps most importantly, the second parameter implicitly assumes that DASL’s disclosed financials are reliable. This is because SEBI’s second parameter prescribes using metrics based on DASL’s financial statements - book value, earnings, etc - in conjunction with multiples based on industry averages to compute DASL’s stock price. Given that DASL’s top management was involved in fraud, it may be prudent not to base compensation to victims of that fraud on financial disclosures that could have easily been manipulated as well.

In addition to drawing attention to questions about economic rationale for determining compensation for victims of securities fraud, SEBI’s order also highlights broader questions that need careful evaluation. One such question is – Who was harmed and by whom? For example, SEBI’s order suggests that only investors who bought approximately 98 lakh shares from BBL over relatively short period ending in January 2002 were harmed.

However, a case may be made that all shareholders of DASL, except of course the one who help perpetrate the fraud, were harmed, because BBL’s fraud caused DASL’s stock to get delisted. This would include all shareholders who bought DASL stock from someone other than BBL during the period when BBL was selling the 98 lakh at issue in this matter, as well as anyone who had bought it any earlier point in time. Clearly, delisting eliminated the ability of all DASL’s shareholders to liquidate their investments. In fact, BBL’s shareholders were also similarly harmed because BBL’s shares were also delisted as a result of the fraud.

Eventually, the philosophies that guide the investigations of SEBI should be
* overall healthy functioning of capital markets
* protection of all investors – be it retail investors or institutional investors – not from risks, but from fraud
* swift redress of frauds - going by the philosophy of “justice delayed is justice denied” any fraud should be investigated swiftly
In addition, SEBI should be seen as an agency with sufficient tooth and a nastier bite!