The author is former director general, National Council for Applied Economic Research [email protected]
The American economy is a strange phenomenon. Despite huge public debt held by foreigners and locals, and enormous dollar holdings overseas, it continues to attract overseas investors. The sheer size of its domestic market and high productivity growth make it a magnet for money, brains and technology. The American economy has almost crash- ed in the last few months. The primary reason is the collapse of the stock markets triggered by the cheating, falsehoods and criminal actions by a variety of the operators — top management of major companies, investment banks, financial analysts, audit firms, among others.
There are, of course, other reasons. The market was grossly overvalued on the back of “irrational expectations”. The Federal Reserve did not pull the plug when it should have but continued with depressed interest rates, keeping the markets over-stimulated. The Bush administration has compounded matters by converting a huge budget surplus into an equally huge but rising and uncertain deficit. The talk of war and its effects on the oil economy as well as on trade have had their adverse impact. But the Americans are boldly tackling the loss of confidence in corporate managements and equity with a number of tough measures.
They started by making chief executive officers and chief financial officers liable for the veracity of the financial statements of their companies, with imprisonment for false statements. Audit firms are to be independently regulated, not self-regulated, as they have been. Substantial penalties have been levied on top broking firms and investment banks. Criminal charges against top executives and others who helped cover up financial misdeeds in companies must have had a salutary effect on their colleagues all over the country. New accounting rules are in the offing, including rules on valuation of stock options in the accounts.
What can we learn from the United States of America' India will not learn the fundamental lesson, that however large the scandal and celebrated the offender, once the suspicions are there, investigators and journalists gather evidence. It goes to the courts that settle matters quickly. In hardly a year, Arthur Andersen is a part of history, Enron top executives are before the judges, and a couple have been in custody. By comparison, Harshad Mehta has died but is yet to be convicted; Ketan Parekh may be in jail, but he is not a proven criminal. Many others are moving about scot-free. In almost every case, our investigators have weak evidence and charges, prosecutors are not as effective as defence lawyers, and courts treat such offenders more leniently than they do the obvious thieves who break and enter.
We are now embarked on the course of imitating America’s methods but not the quality of its practices. For example, we have mandatory filing of quarterly accounts, the availability of stock options to managers and commissions to them as well as to outside directors. These are practices that even in the US are being questioned.
With stock options and commissions, there is considerable incentive for managers as well as directors (even “independent” ones) to cook the figures and show consistent quarterly growth and sizeable profit growth at the end of the year. Indeed, this fixation on showing consistent growth has been at the back of many of the accounting scandals there, allied to the need to show large and growing profits so that stock values can keep rising, making stock options more remunerative. The new regulations in India seek to have a minimum number of independent directors, and setting up of audit and compensation committees. They also put considerable responsibility on the management and the board for ensuring the quality of the accounts and for transparency.
But how can we ensure that independent directors are independent' So long as things are going well, no independent director will rock the boat. This happens in the US despite long experience with independent directors. Jack Welch’s not-on-record benefits, which he wisely gave up when they were disclosed during his wife’s divorce proceedings against him, were perhaps not even known to the board, and if they were, it did not oppose them. There are many such instances, albeit with smaller benefits, in India. Independent directors and auditors must ensure that there is full disclosure and necessary approvals of the board and of shareholders.
Giving independent directors a share in the profits as commission could act as an inducement to them to fudge figures and show high and growing profits. It would be much better to pay substantial fees as fixed payment. Similarly, the time available and devoted to the company by board members is derisory in most companies in India. There must be a way to monitor this and get greater involvement. For this reason also, they must be compensated regularly and adequately. Who evaluates a board’s performance' Should it be the board or the management' Good American companies have methods of doing this and we must learn from them.
There are other practices that we have borrowed from the Americans without having the quality of their institutions and procedures, however flawed they appear today. For example we have the phenomenon of companies or their “promoters” who are usually the largest shareholders, buying back their shares from the market. When a US company does this, it helps protect against hostile takeovers because it reduces the floating stock, uses up cash reserves and thus makes itself a more difficult and less attractive target for a takeover.
This has not many times been the reason in India. Big shareholders are able to artificially depress stock prices and then buy them in the market. The purchaser is not the company itself, reducing its share capital. It is the principal shareholder who is enlarging his holding at low cost to himself. Then he is able to de-list the shares from the stock market. Any smaller holder who has not sold his shares is then left at the mercies of the large holder. The regulators are not able to ensure that accounts are audited and released at all or on time to other holders. There may be no dividends declared. The small holder can sell his stock only to the large one at a price determined by the latter since there is no market to do so.
What is a practice with some rationale in the US becomes, in India, a method for private enrichment and control. The desirable thing would be for some way to protect the remaining shareholders from losing out. Perhaps de-listing should not be permitted at all, or the penalties for doing it made quite severe. For example, why should a de-listed company enjoy limited liability and be able to borrow on similar terms as others'
We are continuing with the self-regulation of professionals like chartered accountants, cost accountants and company secretaries. There is no formal regulation of merchant bankers, management consultants, legal advisors, and so on. All these people have more access to the internal records of their client companies than any investor. Surely, there must be independent regulation of all these professionals' The regulation should be not by a body of peers from the profession but by others with knowledge of the basic precepts and practices in business.
Thus there is a lot we have to learn from the Americans before we can have a reasonably honest corporate culture. No amount of legislation or talk of good governance, or rating companies for the quality of their governance processes will achieve this objective.